Economic substance requirements: overview

Introduction
Overview
Key dates
Penalties

Introduction

Along with its fellow Crown dependencies and overseas territories and other international financial centres, the Cayman Islands now has comprehensive legislation and regulations requiring Cayman-domiciled or registered legal entities which carry on certain activities to have demonstrable substance in the Cayman Islands.

The International Tax Cooperation (Economic Substance) Act reflected the Cayman Islands' commitment to its obligations as a member of the Organisation for Economic Cooperation and Development's global Base Erosion and Profit Shifting Inclusive Framework and corresponding EU requirements for no or nominal tax jurisdictions.

This article summarises the key elements of the International Tax Cooperation (Economic Substance) Act, which has been subject to various updates since its introduction, and draws upon guidance issued by the Tax Information Authority (TIA), which has responsibility for the supervision and implementation of the act.

Overview

The International Tax Cooperation (Economic Substance) Act requires that all legal entities domiciled or registered in the Cayman Islands must make an annual notification as to whether they were in scope in the prior year and whether 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 were conducting a relevant activity must meet an economic substance test in respect of those relevant activities. The requirements of the economic substance test vary depending on the relevant activities conducted and each relevant entity must make an annual report in order to enable its compliance with the requirements of the economic substance test to be assessed. The TIA is responsible for determining whether a relevant entity has satisfied the economic substance test.

Relevant entities
Relevant entities include all Cayman companies (including foundation companies), limited liability companies, limited liability partnerships and registered foreign companies except:

• investment funds or entities through which investment funds directly or indirectly invest or operate;
• entities which are tax resident outside the Cayman Islands (including, subject to certain conditions, entities which are disregarded entities for US income tax purposes); and
• entities which are authorised to carry on business locally in the Cayman Islands as a domestic company.

Cayman Islands exempted limited partnerships and trusts are not subject to the International Tax Cooperation (Economic Substance) Act and, as such, are not subject to the requirements to make annual notifications or any requirements to meet the economic substance test.

Entities which claim tax residency outside the Cayman Islands must submit an annual return declaring their relevant activities (if any) and providing documentary evidence of their tax residency outside the Cayman Islands. This return also includes information on the entity's immediate parent, ultimate parent and ultimate beneficial owner. All information submitted by such an entity to the TIA will be shared with tax authorities in the jurisdiction in which they are claiming residence and the jurisdictions of their immediate parent, ultimate parent and ultimate beneficial owner.

Relevant activities
The relevant activities are:

• fund management;
• banking;
• insurance;
• finance and leasing;
• distribution and service centre business;
• headquarters business;
• IP business; and
• holding company business.

The guidance issued by the TIA provides detailed information and sector-specific examples regarding the scope of each of these relevant activities and, other than investment funds, all entities must consider their operational activities carefully in order to determine whether they may be conducting a relevant activity.

As an illustration, the guidance provides extended definitions and examples of financing and leasing business. The guidance explains that the activity of providing credit facilities for any kind of consideration is considered to be in scope, subject to certain exceptions detailed in the guidance. As such, an entity which provides credit facilities to customers and charges an interest rate or a lending fee is considered to be conducting a relevant activity, as is an entity which makes an interest-bearing intragroup loan.

Economic substance test
Relevant entities that carry on a relevant activity must satisfy the economic substance test. Where a relevant entity carries on more than one relevant activity, they must satisfy, and report on their compliance with, the economic substance test in respect of each such relevant activity. To satisfy the economic substance test in relation to a particular relevant activity, a relevant entity must:

• carry on its core income-generating activities in relation to that relevant activity in the Cayman Islands;
• be directed and managed in an appropriate manner in the Cayman Islands in relation to that relevant activity; and
• having regard to the level of relevant income derived from the relevant activity carried out in the Cayman Islands:
  • have an adequate amount of operating expenditure incurred in the Cayman Islands;
  • have an adequate physical presence (including maintaining a place of business or plant, property and equipment) in the Cayman Islands; and
  • have an adequate number of full-time employees or other personnel with appropriate qualifications in the Cayman Islands (these may include outsourced personnel provided that they are located in the Cayman Islands).

A relevant entity may satisfy the requirement that its core income-generating activities be carried out in the Cayman Islands if those activities are conducted by any person and the relevant entity can monitor and control the carrying out of the core income-generating activities by that other person (ie, it is permissible for relevant entities to implement appropriate outsourcing arrangements with service providers in the Cayman Islands). Core income-generating activities should not be outsourced to service providers outside the Cayman Islands. Wherever an entity outsources core income-generating activities, the outsourced service provider must verify certain information regarding the outsourcing arrangement to the TIA.

The concept of holding company business (see above) is limited to relevant entities that hold only equity participations in other entities and earn only dividends and capital gains (known as 'pure equity holding companies'). Pure equity holding companies are subject to a reduced economic substance test which is satisfied if they confirm that they have complied with all applicable filing requirements under relevant Cayman legislation and have adequate human resources and premises in the Cayman Islands for holding and managing equity participations in other entities. Counterintuitively, pure equity holding companies which expand their activities will generally find that they are no longer classified as conducting the relevant activity of holding company business.

Relevant entities which conduct high-risk IP business are subject to a higher burden of proof in demonstrating that they maintain adequate economic substance in the Cayman Islands. 'High-risk IP business' generally includes scenarios where an entity did not create the intellectual property which it holds and now generates income from that IP either by licensing it to other group entities or as a consequence of the activities of other group entities. In order to meet the economic substance test, an entity conducting high-risk IP business must provide the TIA with materials which demonstrate that there is, and historically has been, a high degree of control over the development, exploitation, maintenance, protection and enhancement of relevant IP assets, exercised by an adequate number of full-time employees with the necessary qualifications that permanently reside or perform their activities within the Cayman Islands.

The guidance issued by the TIA provides further information as to the meaning of 'adequate' and 'appropriate' for the purposes of the economic substance test. Notably, such guidance accepts that what is adequate or appropriate for each relevant entity depends on the particular facts of the relevant entity and its business activity and requires that the directors (or equivalent) of each relevant entity make a determination on these matters in good faith.

Core income-generating activities
The International Tax Cooperation (Economic Substance) Act defines 'core income-generating activities' as activities that are of central importance to a relevant entity in terms of generating relevant income (ie, income derived from the relevant activity) and requires that these be carried on in the Cayman Islands. The act provides examples of core income-generating activities for each relevant activity – for example:

• for fund management business, core income-generating activities include:
  • taking decisions on the holding and selling of investments;
  • calculating risks and reserves;
  • taking decisions on currency and interest fluctuations and hedging positions; and
  • preparing reports or returns, or both, to investors or the Cayman Islands Monetary Authority;
• for financing and leasing business, core income-generating activities include:
  • negotiating or agreeing funding terms;
  • identifying and acquiring assets to be leased;
  • setting the terms and duration of financing and leasing; and
  • monitoring and revising financing or leasing agreements and managing risks associated with such financing or leasing agreements.

These lists of core income-generating activities are not prescriptive and a relevant entity which conducts the relevant activity need not conduct all of the listed core income-generating activities. However, to the extent that the relevant entity does conduct a relevant core income-generating activity, it must be conducted in the Cayman Islands. Where a relevant entity contracts to conduct a core income-generating activity, it will be considered to be doing such an activity notwithstanding any delegation arrangement.

Directed and managed
To be considered to be 'directed and managed' in an appropriate manner in the Cayman Islands requires that:

• the relevant entity's board of directors, as a whole, has the appropriate knowledge and expertise to discharge its duties as a board;
• meetings of the board are held in the Cayman Islands at adequate frequencies given the level of decision making required;
• the minutes of the board of directors record the making of strategic decisions of the relevant entity at the board meetings held in the Cayman Islands; and
• the minutes of all meetings of the board, together with other appropriate records of the relevant entity, are kept in the Cayman Islands.

A meeting will be considered to be validly held in the Cayman Islands for these purposes only if:

• the situation of that meeting would be deemed to be in the Cayman Islands under the constitutional documents of the relevant entity (this is commonly decided by the location of the chair of the relevant meeting); and
• at least that number of directors of the relevant entity constituting a quorum are physically present in the Cayman Islands for the meeting.

Key dates

During the first notification and reporting periods under the International Tax Cooperation (Economic Substance) Act, key dates have shifted regularly. However, in this briefing note, we set out the dates which generally apply. The act and accompanying regulations provide a timetable for compliance, notification and reporting.

• Compliance – all relevant entities must now be in compliance with the act and are expected to be meeting the requirements of the economic substance test to the extent that they are carrying on relevant activities. The economic substance must be satisfied from the date on which the relevant entity commences the relevant activity.
• Notification – by 31 January in each calendar year, all legal entities domiciled or registered in the Cayman Islands must notify the TIA as to whether they conducted any relevant activities and whether they were a relevant entity during their financial year which commenced in the prior calendar year (ie, the notification in 2022 would relate to financial years commenced in 2021, whether that be 1 January 2021 or 1 September 2021, for example). This notification is made via the Cayman Islands registrar. Notwithstanding the 31 January deadline, no penalties accrue unless the notification has not been submitted by 31 March.
• Reporting – each relevant entity conducting a relevant activity (and any entity claiming tax residency outside the Cayman Islands) must submit a report to the TIA within 12 months of the end of its financial year regarding its compliance with the economic substance test during that financial year. This report includes various financial, ownership and other data and relevant entities conducting a relevant activity must also provide their books of account or financial statements for the relevant financial year.

Penalties

The penalty for failure to satisfy the economic substance test for a relevant activity in a given financial year is US$12,200. The penalty for failure to satisfy the economic substance test for a relevant activity in a subsequent financial year can increase to up to US$122,000 and, in addition, the registrar must make an application to the Grand Court for an order for the relevant entity to either take such actions as may be specified or be struck off.

In addition, a penalty of US$6,100 applies for any failure to comply with reporting obligations, with an additional fine of US$610 accruing for each day that the failure to comply continues. Separately, any failure to provide the TIA with information requested (assuming that such information is in the control of the relevant person) can lead to a fine of up to US$12,200, two years' imprisonment or both.

For further information on this topic please contact Dave Sherwin at Ogier by telephone (+1 345 949 9876) or email (dave.sherwin@ogier.com). The Ogier website can be accessed at www.ogier.com.