Cayman Economic Substance – the latest updates
Thank you for joining us today for our webinar on economic substance solutions.
Waystone has over 20 years of experience in providing governance and compliance solutions to asset managers. Today’s webinar we’re going to cover ￼. I’m very happy and delighted to have my colleagues, Niall and Darragh, joining us this morning from our Cayman office. Cayman economic substance. I’m very happy and delighted to have my colleagues, Niall and Darragh, joining us this morning from our Cayman office.
Niall is our executive director based in the Cayman Islands. He heads up our Cayman market asset solutions, which provides host and management company and economic substance solutions to fund operators and sponsors.
Darragh is one of our independent directors. He works very closely with Niall in implementing our economic substance solutions and overseeing the risk reporting.
Without further ado, Niall and Darragh, I know you both have worked with a lot of managers in helping them satisfy in the ES test. Would you share with us your experience and some of the key areas that managers need to take note of?
Core Income Generating Activities (‘CIGA’)
I’ll quickly recap on what the core income-generating activities are. This is what the regulator looks for with regard to satisfying the economic substance test. So briefly on screen, you’ll see here the three main elements.
So firstly, there’s the decision-making. Taking decisions on the holding and selling of investments. Calculation of risk and reserves, taking decisions on currency or interest fluctuations and hedging. Preparing reports or returns or both to investors or CIMA.
Managed in Cayman Islands
It also looks for the entity to be directed and managed in the Cayman Islands, which is your provision of at least two independent directors based in the Cayman Islands.
Adequate Operating Expenditure
The majority and quorum of meetings are held in Cayman, and then ensured as adequate operating expenditure, presence of personnel in the Cayman Islands, though most managers haven’t relocated to Cayman, so they look for an outsourced solution of which Waystone can help with.
Partnerships and the Cayman economic substance act
We’ve received a number of questions and inquiries from clients with recent announcement of partnerships being brought into scope for economic substance. From the 30th of June 2021, partnerships are considered relevant entities under the ES Act and must file an annual notification.
The good news is that funds remain out of scope of the ES Act, and as such, funds which are structured using a partnership structure will remain out of scope. The ES notification is a relatively straightforward return and is typically filed by the registered office at the beginning of each year.
Regulatory fines under the ES act
Regulatory fines, that’s always very topical. Most fund managers are now in their second year of operating under the ES Act. The fines for non-compliance remain the same at $10,000 in year one and $100,000 in year two. While the fine is relatively small in the first year, it greatly increases in year two. Subsequent non-compliance can lead to the authorities seizing control of the entity and its assets. There are also reputational risks to consider such as due diligence. Potential Investors may see this as a red flag and prevent investment.
The next question I’m always asked is how many fines have been issued so far? And the answer is I’m not sure, and perhaps none. Most investment managers were brought into scope for the first time in 2020, and the first deadline for the 2020 period is not due until 12 months after the period end. Many IMs have likely not filed the returns yet.
Linked to the regulatory fines, something that is quite topical at the moment is CIMA or the AML inspections. As of February, the Cayman Islands has been grey listed by the financial action task force, citing weaknesses in the island’s AML/CFT regime, particularly in the areas of fines and enforcement actions.
As a result, the regulator is conducting a huge number of inspections. Financial services companies are being inspected with fines being issued to a number of large companies on the islands. One totaling $5 million are just over $5 million. There’s another one in court at the moment which is being disputed but that’s rumored to be over double that, so around $10 million.
Investment Management Entities
For investment management entities, there’s no difference. There are currently 80 active inspections and fines depending on the severity of the breach will definitely be issued. Historically, CIMA would conduct an inspection, issue their findings, and return in 6 to 12 months to review the remediation of items.
With the greylisting, we don’t know if this will still be the case when they’re eager to be removed from the grey list and show the FATF that they are a strict regulator. The fines can also add up. They issue fines for each occurrence of a breach.
If for example, you had KYC on file that was not certified in a suitable manner for CIMA, they could issue a fine for each client which was not properly certified. At this point in time, I’m not aware of any inspections on the underlying funds, and this is typically a lower risk area given independent administrators are appointed to have global policies and standards in place.
IM entities would be viewed as self-administered, with policies varying from firm to firm. CIMA has also issued their findings that internal appointments for the AML officers would likely be conflicted and not independent.
One item that is quite topical as well, we’ve received a number of queries from clients about the annual returns and how they’re to be completed. I’ll break it down into the two returns.
Economic Substance Notification
One is the economic substance notification, and this is relatively straightforward. Your registered office would’ve reached out at the beginning of the year. There’s some static data and a confirmation if you were carrying out a relevant activity, and this is a precursor to the actual return.
Once the ES notification is filed, noting the entity in scope, the DITC, which is the department of international tax compliance authority here in Cayman, they expect to receive the annual return.
The second return is the annual return. It’s a very detailed return which is filed on the DITC portal, and it’s the same portal where FATCA and CRS returns are filed that some of you may be familiar with.
The authority looks for a wide range of information on the activities such as:
- Number of staff or outsourced services
- Hours spent on an annual basis
- Evidence of timesheets
- Operational expenditure incurred in Cayman
- Operation expenditure incurred outside of Cayman
- A copy of the investment manager’s financial accounts
With regard to the operational expenditure, one of the metrics they will use to gauge compliance is comparing your operational expenditure to your peers.
Annual Financial Accounts
I also mentioned the annual financial accounts. These typically won’t be your audited financial statements so there’s no requirement to have them audited, but it will be your income statement and your balance sheet for the period.
ESA Compliant Fund Solutions by Waystone
At Waystone, we offer a comprehensive range of services that allow relevant activities to conduct one or more relevant activities in a way that is compliant with the economic substance act that Niall mentioned.
Economic Substance Solution
Our economic substance solution has been designed to mirror that of the core incomegenerating activities or as it’s frequently referred to as CIGA. These are being directed and managed in the Cayman Islands by the provision of independent directors, the majority of which will be based in the Cayman Islands on a full-time basis.
Independent Risk Reporting
The second is independent risk reporting, which we produce in line with AFMD standards and deliver in line with the frequency of nav calculation, i.e., if the client is delivering it on a monthly or a quarterly basis as applicable.
The risk reporting typically looks at value at:
- Risk or VAR, stress tests
- Concentration limits
- Any offering document restrictions which have been imposed
The third and fourth elements of CIGA are grouped together as FX hedging, be it at a portfolio or share class level, and portfolio management and ongoing oversight is the fourth element.
We work with advisors and conduct periodic meetings with the advisor, coupled with the detailed risk reporting to ensure the portfolio is being managed to its stated objectives and agreed terms.
Filing annual Economic Substance Return
Lastly, our service offering also includes the preparation, completion, and filing of the annual economic substance return with the Cayman department of international tax cooperation and the provision of dedicated personnel and resources in our Cayman Islands office.
I think that’s a very comprehensive walk-through of our solutions to managers who might be looking for satisfying some of the ES requirements
How Many Stable or Investment Entities Have Closed Since the Implementation of Economic substance Law?
The regulator here releases statistics on an annual basis. I know a number of the smaller entities have closed, so it’s really each manager would have had to do a cost analysis to see if it was worthwhile maintaining the entity.
If you had assets around $5 million, $10 million, $15 million, $20 million, the tax benefit that you would receive on having a Cayman investment manager would not be worth it, so the cost of compliance would outweigh the benefits.
Once managers get $50, $60 million A1 plus, then there’s definitely a benefit to maintaining the investment manager, but I don’t know the exact figures of the number of entities that have terminated or restructured, but there certainly has been a number of the smaller ones which have closed.
When the managers, when they’re looking to whether to restructure, there’s, of course, some of the benefits they can enjoy and having a cost-benefit analysis is very important to look into the viability of having the different structure in place. And of course, the flexibility which may be potentially the Cayman manager can offer to some of the internal consideration manager thinking.
I Have a Cayman-based Director, is This Enough to Satisfy the ES Test?
There’s a requirement for each entity to have at least two directors. What we see is they look for the majority and quorum of directors to be in Cayman.
If you have one director based in Hong Kong and one director based in Cayman, well then, the director in Cayman is not sufficient to call a quorum for the meeting, and the majority of the directors aren’t in Cayman. The typical composition is having two Cayman-based directors and one onshore director. And depending on the jurisdiction, they may not wish to have an onshore director for tax purposes so it’s typically two Cayman-based directors.
Conditions to Satisfy the ES Test
It varies from structure and strategy. If you are a private equity fund or fund to fund or venture capital fund, the directors alone will be quite involved in the investment approval and decision making on an ongoing basis.
If you look at an equity long-short that’s more actively managed and traded, it’s a little bit different. The additional items and core income-generating activities are what Darragh touched on also. The ongoing portfolio management element and the risk reporting element where we look at the VAR stress testing etc., and we look at that on an ongoing basis.
And then, yes, if it’s a private equity structure where there’s only going to be 10 or 12 transactions during the life of the fund, directors alone can satisfy the core income generating activities.
The managers themselves, they should look into the type of strategies they’re deploying or employing to determine to what extent the economic substance requirement that they’re subject to.
Is A Physical Office Required to Satisfy the ES Test?
No, that’s not true. There’s two options or there’s two solutions.
One is the physical relocation and having premises in Cayman. And I am aware of a couple of managers who have moved with the physical office presence in Cayman, but there is not a requirement to do so.
Outsourced Service Provider
You can also use an OSP. That’s the abbreviated term. It’s Outsourced Service Provider. You can use an outsourced service provider in Cayman to discharge the core income-generating activities on your behalf.
Using a BVI-based Manager to a Cayman Fund
I am aware of a number of managers who had looked at restructuring and using BVI as a jurisdiction. I think BVI typically didn’t have the same infrastructure from a fund perspective historically.
Having said that though, BVI has about half a million companies incorporated versus about 120,000 companies in Cayman. Typically, those companies in BVI would be for property or single assets and it is quite efficient as a simple structure.
Historically for investment managers, BVI wasn’t a very common jurisdiction. I serve as a director on a number of BVI funds, and they were historical funds let’s say. A lot of the times from a structuring perspective, while BVI is known for companies, it’s not as popular for investment funds and investment managers. A lot of the times people will ask, well, why BVI for your fund? Investors aren’t as familiar with BVI.
I think in the instance that the question that you had here is having a Cayman fund and a BVI based investment manager, I think some have moved and there is certainly a benefit, or some people see it as a benefit in that they have I think it’s $400 million. If you’re managing less than $400 million, well, then the economic substance test does not apply.
Economic Substance Test
One thing to consider there is it may be cheaper not to comply with the economic substance test, but you’ll have to pay a number of fees to restructure and redomicile. Many clients may not be happy with the use of BVI, or some investors may not be happy with the use of BVI as the investment manager given it’s less regulated and less well known than Cayman.
And then also I think the economic substance law was as a result of pressure from the OECD in Europe. Most of or each country that has wrote into law has implemented it slightly differently.
I think Cayman and the Channel Islands etc. had a similar a similar viewpoint with the implementation and the drafting of it into law. BVI has taken let’s say a slightly reduced test. So it may be that after entities restructure, that we’ve seen in one and a half years when the first returns are applied, well then, the OECD may not be happy with the implementation by the BVI.
So that’s also an item which may lead further tightening of restrictions in BVI to mirror that of Cayman or the Channel Islands, etc. in the future.
I think it’s a bit of a wait-and-see with the BVI. They haven’t implemented the economic substance law as other countries have. You could run the risk of redomiciling only to have to redomicile back to Cayman in a year or so, and then pay twice the fees for restructuring. I think it’s a bit of a wait and see on BVI as a jurisdiction.
Deadline for the ES Return
Most managers, the first year they would’ve been in scope. If the entity was in existence for a number of years, the first year they would’ve been in scope would’ve been 2020. And assuming 31st of December year end, they have within 12 months to file the return. The detailed return will be filed by the end of December this year. The 2020 financial year will be filed before the end of 2021.
Conclusion & Acknowledgments
Thank you, Niall. And just to recap, that Niall and Darragh, they have each of them have shared. Give us an overview of each of the CIGA components and what are the topical items that we came across often. And of course, Darragh has shared a full solution that Waystone can offer.
And I know we have other questions we didn’t get a chance to address this morning, but we’ll reach out as usual to each of you to address those questions individually, and also sharing this webinar recording and presentation slides with all of you. And thank you Niall and also Darragh for your evening time joining us. I know it’s evening in your time, so it was really appreciated for your sharing and also input. And I wish the rest of you guys who dial in this morning, have a god rest of the day. Thank you.