The Cayman Islands introduced an Economic Substance Law (the Law) effective from 1 January 2019 that will require an increased level of substance to be maintained in the Cayman Islands for all companies that fall within the new regime. Similar new laws have been introduced in the British Virgin Islands, Bermuda and other similar offshore jurisdictions.

The Law was introduced by the Cayman Islands to ensure that it meets its commitments to the European Union as well as its obligations as an Inclusive Framework member under the OECD’s global Base Erosion and Profit Shifting (BEPS) initiatives – in particular, Harmful Tax Practices (Action 5).  

The Law is potentially a game changer for groups operating in Asia, especially with respect to their approach in using, managing and operating Cayman companies going forward.  This is because the new law requires all companies that fall within the regime (these are referred to as ‘Relevant Entities’ carrying on ‘Relevant Activities’) to maintain a level of operational substance that is effectively commensurate with the income generating activities of that company.  

The Law will apply to Cayman entities that are defined as “relevant entities” conducting “relevant activities”. Relevant entities will include most Cayman Islands exempted companies, limited partnerships and Cayman LLCs, except investment funds and entities held by such investment funds. Relevant entities also include registered foreign companies, unless they are tax resident outside the Cayman Islands.

The relevant entities are only in scope of the Law if they are carrying on “relevant activities”.  However, such activities are broadly defined to include a wide range of businesses, including fund management, banking, insurance, finance and leasing, distribution and service centre business, headquarters business, intellectual property business, shipping, and holding company business.

There are some important carve-outs under the Law for certain companies that do not need to comply with the new requirements. Investment funds and their investment holdings are specifically excluded, as are entities that are tax resident in another jurisdiction. Also, there is likely to be a reduced level of substance requirements for a pure investment holding company – a passive equity investment holding company – but this will be subject to further guidance.  In contrast, a high-risk intellectual property holding structure will likely face more onerous substance requirements.

If a company maintains that an entity is a tax resident elsewhere, this will need to be supported by way of evidence such as an overseas tax filing registration number; copies of filings; and/or a tax resident certificate issued by the tax authorities of the other jurisdiction.

Further, although an investment fund and its investment holdings have been carved out from the need to comply, a fund management company incorporated in the Cayman Islands is not exempted and will need to comply with the Law.  

The objective of the Law is effectively designed to ensure that substantive operations at the Cayman Islands entity level are commensurate with the profit generating activities being carried out by the company.  However, there remains a level of uncertainty and ambiguity over the application of the new substance rules in practice, and the level of substance that will be needed to satisfy compliance with the rules.  

On 22 February 2019, the Cayman Islands issued its guidelines on the Law.  We understand that an update to the guidance will be issued in the near future, and it is hoped that it will provide greater clarity for the international business community.  For example, further clarity is needed around:

• The level of substance requirements with regards to the income derived from the relevant activity carried out in the Cayman;
• The necessary amount of operating expenditure that must be incurred in the Cayman;
• What is considered a sufficient physical presence (including maintaining a place of business or plant, property and equipment) in the Cayman
• The number of full-time employees or other personnel with appropriate qualifications needed in the Cayman; and 
• Whether outsourcing of “core income generating activities” within the jurisdiction is permitted and can count towards satisfying the substance requirements, provided the entity can monitor and control the carrying out of that activity by any delegate.

Existing companies as at 31 December 2018 will have a six month transition period (i.e., until 1 July 2019) to comply with the new rules.  For companies established on or after 1 January 2019, substance requirements need to be satisfied starting from the time they provide the relevant activities.

Commencing in 2020, entities will have annual reporting obligations to the Cayman tax information authority in respect of their compliance to the new rules.  

There are heavy penalties for failing to satisfy the economic substance test.  A fine of USD 10,000 applies for the initial year and a fine of USD 100,000 may apply for any non-compliance in subsequent years.  The entities may also be struck off from the Registrar of Companies.

The Economic Substance Law introduced by the Cayman Islands and the other ‘offshore’ jurisdictions is potentially game changing for the international business community.  Many organisations use the Cayman Islands (as well as BVI and other offshore jurisdictions) incorporated companies within their group holding and operating structures.  The Law in the Cayman will require such organisations to review their entities to evaluate whether or not they will need to comply or be carved out and exempted from the new substance requirements.  Further, if they need to comply, a determination of the level of additional substance required in the Cayman will need to be evaluated.  There are also significant penalties for non-compliance.

In summary, all groups using Cayman Islands companies (and companies in similar offshore jurisdictions) need to review the impact of the Law.  It cannot be ignored.  This Law will therefore require corporates and other investors to:

• Review their organisational structures;
• Consider the level of substance and whether substance needs to be created specifically for the company or whether the substance can be outsourced; and
  
• Consider the tax implications of migrating the residence of a Cayman Islands company (or other offshore company) to Hong Kong or another jurisdiction and reporting the company in that jurisdiction. 

We will provide further updates as further guidance is issued.