I have been working on an Economic substance matter recently and thought I would share the basics of what it means from a Cayman Islands perspective, particularly for fund management businesses.
Economic substance plays a crucial role in maintaining the favourable tax position of offshore entities, ensuring compliance with regulations and minimising the risk of profit shifting to low-tax jurisdictions.
On this basis, the Cayman Islands has the The International Tax Co-operation (Economic Substance) Act and Regulations requiring legal entities domiciled or registered in the Islands and carrying on certain activities to have demonstrable substance in Cayman.
These entities must make an annual notification to advise if they were in scope in the prior year and report if they were carrying on one or more of a defined list of activities (relevant activities) in that period.
Entities which are in scope (relevant entities) and which were conducting a relevant activity are required to meet an economic substance test which varies depending on the types of relevant activities conducted, and file a report to that effect.
It is worth noting that investment funds or entities through which investment funds directly or indirectly invest or operate are typically exempted.
Economic substance requirements for fund management businesses
There is no requirement for the manager of a Cayman investment fund to be resident or domiciled in Cayman. However, sometimes the management firm will, for tax or other reasons, establish an offshore management entity that may form part of its onshore group.
The ES Test is satisfied if the fund management business:
• is directed and managed in Cayman;
• has an adequate physical presence and appropriate amount of expenditure in Cayman;
• has an adequate number of suitably qualified personnel (including directors) in Cayman; and
• conducts sufficient core income generating activities in Cayman.
On this basis, the core income generating activities of a fund management business include:
• taking investment decisions;
• calculating risk and reserves;
• taking decisions on currency or interest exposures and hedging management; and
• preparing reports for investors and/or CIMA.
It is important to note that based on the Economic Substance guidance notes, the directors of a relevant entity may sometimes perform core income generating activities in addition to performing their fiduciary duties for the relevant entity and thereby reduce or even eliminate the relevant entity’s practical need for full-time employees or an outsourcing arrangement.
Prudential and anti-money laundering (AML) obligations
In addition to economic substance considerations, fund management businesses must comply with strict AML regulations. This includes appointing an AML compliance officer, a money laundering reporting officer, and a deputy money laundering reporting officer.
An internal audit assessing AML controls against AML regulations and other relevant regulatory requirements is essential for fund management businesses registered under the Securities Investment Business Act. This audit must be conducted by an individual/service provider who is independent of the entity and its AML officers.
The Cayman Islands Monetary Authority (CIMA) mandates compliance with several rules and statements of guidance. Key areas of focus include corporate governance, internal controls, outsourcing, and cybersecurity. Achieving compliance typically requires a comprehensive suite of policies and procedures, risk assessments, and board resolutions, all tailored to the unique circumstances of each fund management business.
Fund management businesses should be prepared for periodic interactions with CIMA, such as AML surveys and routine examinations.
Cayman-based directors, with their extensive expertise in financial services and relevant qualifications, can collaborate with fund management entities to ensure the performance of required core income-generating activities.
They can also play a crucial role in facilitating effective mind and management in the Cayman Islands and assisting with various regulatory requirements set by CIMA, including AML surveys, onsite inspections, and adherence to guidance notes.
Martin Laufer is a fund director at Channel Capital Cayman.
C +1 345 323 2748
E Martin.Laufer@channelcapital.ky
