Government has released draft legislation that will have far-reaching consequences for parts of the offshore finance industry in the Cayman Islands.

The bills, developed after consultation with Cayman’s financial services industry and regulators, the OECD and the European Union, require certain Cayman-registered companies to meet new economic substance standards.

For a business to qualify as tax resident in Cayman, entities must have substantial business activity locally; for example, in terms of staffed offices and management decisions made on island.

The new legislation comes in response to the threat of a blacklisting by the European Union as part of the EU’s process of assessing whether countries are deemed cooperative or uncooperative in tax matters. According to the EU Council, Cayman has fallen foul of a fair tax criterion aimed at tax regimes that facilitate offshore structures which attract profits without real economic activity.

To avoid an immediate blacklisting and potential punitive measures, Cayman’s government made a written commitment last year to introduce new substance requirements into legislation by the end of 2018.

The Ministry of Financial Services said the new requirements “could be fulfilled by activities such as hiring staff and having physical business locations; or outsourcing these activities to a local service provider.”

The International Tax Co-operation (Economic Substance) Bill 2018 affects banking, insurance, fund management and shipping companies; entities functioning as headquarters or distribution and service centers; and businesses engaged in financing and leasing or holding intellectual property.

“If a Cayman entity is conducting relevant business activities in one or more of these categories; and if that entity is not tax resident in another jurisdiction, the bill would require the entity to have ‘economic substance’ in the Cayman Islands,” the ministry said in a press release.

Substance test

Under the proposed legislation, companies will pass the economic substance test if they conduct core income-generating activities on island; incur an adequate amount of operating expenditure in Cayman; have a physical presence locally; and have an adequate number of full-time staff locally.

In addition, the company must be directed and managed from Cayman with regular board meetings held and minutes of strategic decisions kept on island.

Details will be defined in corresponding regulations issued by Cabinet, according to the draft bill.

The proposed legislation contains even more rigorous requirements for so-called “high risk intellectual property” businesses. These include companies that hold intellectual property they did not create and acquired either from an entity in the same group or another entity outside of Cayman, and then license the intellectual property to related entities.

They also encompass intellectual property businesses that do not undertake research and development, branding or distribution as part of their local core income-generating activities.

High risk intellectual property businesses are presumed to have failed the substance test, even if they carry out core income-generating activities on island, unless they can demonstrate that they historically maintained control over the development, exploitation, maintenance, enhancement and protection of the intangible property asset. This would have to be exercised by an adequate number of full-time employees with the necessary qualifications that permanently reside and perform their activities in Cayman.

These types of businesses must provide detailed business plans which demonstrate the commercial rationale for holding the intellectual property assets in the islands; employee information, including level of experience, type of contracts, qualifications and duration of the employment; and evidence that decision making is taking place within the islands.

Equity holding companies are subject to a “reduced” economic substance test under the proposed legislation. They would satisfy the substance test if they have complied with all applicable filing requirements under the Companies Law and if they have “adequate human resources and adequate premises in the islands for holding and managing equity participations in other entities.”

The draft bill is scheduled for debate in the Legislative Assembly later this month and is expected to take effect by Jan. 1, 2019.

The Cayman Islands government is expected to issue guidance notes for consultation in the near future.

Cayman Finance

Cayman Finance, the association representing Cayman’s financial services organizations, said in a statement: “We anticipate that our sophisticated clients will adapt as required and take this in their stride.”

Cayman Finance described the draft legislation as the latest in a series of steps by the Cayman Islands to meet its 2017 commitment as an Inclusive Framework member under the OECD’s global Base Erosion and Profit Shifting (BEPS) initiative and, in particular, BEPS Action 5, which focuses on preferential tax regimes that attract geographically mobile income.

The bill also reflected Cayman’s commitment to meet the European Union requirements, which are modeled on BEPS Action 5.

“It is worth noting that all of Cayman’s main competitor jurisdictions are in a similar position as BEPS Inclusive Framework members,” the financial services association said.

“Those who establish Cayman structures do not do so to engage in base erosion and profit shifting activity; they do so because Cayman is an efficient neutral hub with key expertise in handling complex transactions,” Cayman Finance added. “Cayman and its service providers are used to constantly evolving to meet global requirements and we are confident that this latest development will be no different.”

The association said it encourages its members “to familiarize themselves with the bill and, once the final form is passed into law, we recommend that our members seek Cayman Islands legal advice on what it means for them and their clients.”

Minister for Financial Services Tara Rivers said representatives from more than 15 financial services and commerce associations have participated in the government consultation on the new legislation.

“This breadth allowed government to ensure that our legislation is appropriate for both financial services and local business,” she said.

Minister Rivers acknowledged that government had taken some time to publish the bills but said “the breadth and depth of consultation was necessary in order to develop the best framework for Cayman while also fulfilling our global responsibilities as an international financial center.”

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