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The introduction of the International Tax Co-operation (Economic Substance) Law (the Law) to the Cayman Islands has drawn mixed reactions. While it is clear that this Law comes with certain challenges, a closer examination suggests it may also provide significant opportunities for the Cayman Islands.
The Cayman Islands, as with many global financial centres, finds itself swimming against the tide of geopolitical upheaval that is reshaping the relationship between the global financial centres and the rest of the world. It is a tide that is rising fast, as evidenced by the unprecedented volume of legislative and regulatory change in the Cayman Islands, and one that shows no signs of abating in the near future.
The Law and its associated regulatory guidance was introduced by the Cayman Islands in order to comply with its obligations as an Inclusive Framework member under the OECD’s Base Erosion and Profit Shifting (BEPS) initiatives regarding geographically mobile activities and the ongoing global effort to encourage good tax governance in third country jurisdictions, previously identified as having, in particular, harmful tax practices (Action 5). This in itself is significant, given the historic misconceptions about the jurisdiction that have persisted, despite its best efforts to prove otherwise over the last two decades.
Of particular interest here, is the impact that the Law and the associated regulatory guidance will have on the use and operation of Cayman Islands companies performing fund management activities (i.e. specifically the managing of securities for a third party involving the use of discretion). A Relevant Entity (as defined), (an “RE”) falling into this category will need to satisfy the prescribed economic substance (“Economic Substance”) obligations with respect to the fund management activities that they carry on in the Cayman Islands. How these entities navigate the new landscape continues to unfold. Some may opt for a change of function, a change of relationship, or to simply retract altogether, however, there may be a far more straightforward practical solution available which would allow entities to maintain adequate operational substance, physical presence and personnel on-Island for the purpose of performing the Core Income Generating Activities (CIGA) in relation to its fund management activities.
Putting aside the requirement for prudent and appropriate corporate governance of the entity for present purposes (which we will assume will be incontrovertible given the strong international best practice governance culture that exists in the Cayman Islands), any uncertainty in the interpretation and application of the criteria, which needs to be satisfied in order for fund management entities to satisfy the Economic Substance obligations, is mitigated by the fact that the Law and associated regulatory guidance permit an entity to outsource CIGA on-Island. This is provided the entity can monitor and control the carrying out of that activity by any delegate.
Outsourcing Cayman Islands CIGA
The Guidance Notes issued by the Cayman Islands Monetary Authority (CIMA) with respect to the interpretation and implementation of the Law, state that an RE satisfies the Economic Substance obligations if the Cayman Islands CIGA, in relation to that relevant activity, are being conducted by any other person in the Islands and that the RE is able to monitor and control the carrying out of the Cayman Islands CIGA by that other person. The Law does not prohibit a fund management entity from outsourcing some or all of its fund management activity on-Island and further permits the outsourcing of other non-CIGA activities which are not centrally important to generating that entity’s income earned from CIGA, for example, back office functions, IT, payroll, legal services, or other expert professional advice or specialist services to providers outside the Cayman Islands.
Outsourcing solutions
If a careful and considered assessment of a RE’s specific circumstances suggest that an outsourced solution is appropriate, then some further careful thought must be given to the adequacy of any outsourcing solution. Specifically, the RE should look to ensure that the outsourced Cayman provider (the “OCP”) is able to demonstrate that it can conduct the CIGA relevant to the RE with regards to the specific circumstances and requirements of the relevant activity (note: Core Income Generating Activities outlined in the Law and Guidance Notes are neither exhaustive nor mandatory). In the case of fund management activities, a robust outsourced Economic Substance solution should address the fund management activities undertaken by the RE from both a quantitative and qualitative perspective.
From a quantitative perspective, and specifically targeting the CIGA head of ‘calculating risks and reserves’, the OCP should be capable of independently implementing risk monitoring systems to identify, measure, manage and monitor market risk, liquidity risk, credit risk to which the investment funds/vehicles managed by the RE are exposed. Quantitative reviews would typically be conducted by monitoring of;
- any investment restrictions outlined in the fund offering documents;
- asset liquidity and redemption mismatches;
- geographic and sector exposures;
- leverage and VaR (Value at Risk) ratios;
- specific portfolio stress tests.
The specific named employee of the OCP should have the appropriate qualifications, experience and expertise to conduct the monitoring as outlined. Detailed timesheets should be prepared outlining the time spent reviewing each investment fund/vehicle.
From a qualitative perspective, and specifically targeting the CIGA head of ‘taking decisions on the holding and selling of investments’, the OCP should conduct qualitative assessments and reviews of the investment funds/vehicles managed by the RE. This would typically take the form of periodic meetings and/or phone calls with the portfolio management team of the onshore Investment Advisor. Content of a report would typically cover;
- review of portfolio holdings;
- liquidity profile;
- fund performance;
- anticipated investment decisions;
- market outlook relevant to the investment fund/vehicle.
Similar to the employee conducting the quantitative review, the named employee conducting the qualitative assessment should have the appropriate qualifications, experience and expertise to perform the role. Again, detailed timesheets should be prepared outlining the time spent on each investment fund/vehicle.
CIMA’s guidance is that “adequate” shall mean “as much or as good as necessary for the relevant requirement or purpose”; and “appropriate” shall mean “suitable or fitting for a particular purpose, person, occasion”. What is adequate or appropriate for each relevant entity will be highly fact specific and so it will fall to each RE to make a careful and considered assessment and determination of its own circumstances.
Additional compliance benefits of an outsourced solution
In addition to the key operational and administrative efficiencies that can be achieved using an outsourced solution, a RE performing fund management activities will also benefit from the named employees of the OCP being counted toward the number of personnel of the RE with appropriate qualifications in the Cayman Islands. A detailed assessment should also be made as to which CIGA relates to the relevant income flowing through the RE. Depending on the income generated from the RE’s fund management activities, an outsourced solution may also assist with demonstrating (i) an adequate amount of expense incurred in the performance of those activities within the Cayman Islands; and (ii) an adequate physical presence in the Cayman Islands (e.g., office space, plant and equipment).
Where the nature of the specific management structure (including the use of onshore and offshore entities) results in material fee income being earned by the RE in connection with the fund management activities being performed, the flexibility to structure the operational and administrative affairs of the RE in collaboration with an OCP, in accordance with the Law and the Guidance Notes, could be the difference between retaining rather than removing the RE from the management structure.
Responsibility rests ultimately with Relevant Entity
Notwithstanding the ability to outsource CIGA, the RE will ultimately be responsible for ensuring compliance with all aspects of the Law and the Guidance Notes and will also remain responsible for ensuring accurate information is submitted to the Cayman Islands Tax Information Authority. In this case, and in order to meet its ES obligations, a RE must be directed and managed in an appropriate manner in the Cayman Islands with respect to those CIGA functions. This points to a clear separation of functions between the governance of the RE and the performance of CIGA functions. On this basis, the RE must be able to monitor, control and where necessary, supervise the carrying out of CIGA by any OCP.
This places an onus on the board of directors of the RE to (i) act as a whole, sufficiently knowledgeable and experienced with respect to the fund management activities of the RE; (ii) conduct and exercise their fiduciary functions in a manner consistent with the requirements to be expected of prudent corporate governance (with respect to the frequency of meetings, quorum, decision making); and (iii) ensure the fiduciary process and procedure and the business of the RE are properly recorded, documented and maintained, including ensuring that the RE documents its own control procedures and process with respect to the CIGA.
Given the implicit supervisory expectation in the use of the term “directed and managed in an appropriate manner”, it is expected that the board of directors of a RE performing fund management activities will need to pay closer (and objective) attention to the ongoing activities of the entity and make their own case by case assessment of the most appropriate course of direction and management with regard to the RE’s business plan, specific activities, resources, financial affairs and performance of any OCP (together with the RE’s overall Economic Substance obligations).
An interesting post-script is that a RE conducting fund management business will be subject to CIMA’s “Statement of Guidance: Outsourcing Regulated Entities” in addition to the principles set out earlier under the Law and the Guidance Notes. The Statement of Guidance (SOG), which was published originally in 2015 sets out CIMA’s minimum expectations on the outsourcing of material functions or activities and outsourcing arrangements by regulated entities. A detailed discussion of the SOG is beyond the scope here, but interestingly the guidance therein was provided on that basis that the board and senior management remain ultimately responsible for all outsourced material functions or activities, together with any regulatory obligations of the entity.
The SOG requires a regulated entity to maintain the same level of oversight and accountability with respect to the outsourcing of any material function or activity as it would apply to its non-outsourced material functions or activities. In addition, the SOG also provides practical guidance for the regulated entity in formulating and maintaining internal practices and procedures for the management of its outsourcing arrangements. All of which would be easily transposed and highly relevant for any RE required to monitor and control the carrying out of any CIGA by an outsourced delegate.
Article by Finian Power, Director at DMS and Sean Scott, Partner at MJ Hudson.
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FINIAN POWER
Director
DMS Governance
Email
(p) +1.345.749.2768
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SEAN SCOTT
Partner
MJ Hudson
Email
(p) +44.20.3693.7058
The post Practical solutions for Economic Substance obligations appeared first on DMS Governance.
FINIAN POWER
SEAN SCOTT
