Substance on the Cayman Islands

Substance on the Cayman Islands represents a legal regime under which separate corporate structures are obliged to confirm real business activity in the jurisdiction. For investors, the owners of holdings, financial companies and asset managers, this question determines the stability of an international structure and its correspondence to the requirements of the Tax Information Authority. A company may be duly established, have a registered office and a local director, yet fail the economic substance test if the strategic decisions are taken, and the employees and income-generating functions are located, outside the limits of the islands.

The material will disclose which persons and types of activity fall under the action of the regime, as well as by which criteria economic presence on the Cayman Islands is assessed. Separate attention will be paid to the management of the company, the core income-generating activity, outsourcing, the special rules for holding structures and structures working with intellectual property, the procedures of the notification of economic presence and the submission of the declaration of economic presence. 

Substance on the Cayman Islands: the Legal Basis, the Concept and the Regulators

The Cayman legal regime is formed with regard to the international standards aimed at the prevention of the artificial transfer of profit into jurisdictions with preferential taxation. The main goal of the procedures consists in the confirmation of the fact that the commercial income of the organisation is generated at the expense of the conduct of real activity in the jurisdiction. Economic presence, or substance on the Cayman Islands (Economic Substance), is not a fixed status, but a permanent obligation to prove the lawfulness of the extraction of profit.

The main source of regulatory control is the consolidated International Tax Co-operation Act in the revised edition. The mechanism of the application of these rules is detailed by special subordinate acts establishing the technical regulations of declaring. International groups need to take into account that the current requirements of substance on the Cayman Islands cover not only the fact of passing the standard registration, since the departmental inspectors check the real distribution of commercial functions.

The official regulation is carried out by the Tax Information Authority. At the executive level, the powers are delegated to the directors of the Department for International Tax Cooperation. This body administers the electronic portals, requests the internal documentation of firms and issues penalty rulings.

The basis for the audit is served by the financial reporting of the firm, confirming the transparency of the transactions. The current law on substance excludes the automatic recognition of compliance (correspondence to the rules) on the basis of the purchase of a legal address. Today, the rules of economic presence on the Cayman Islands require of the management the maintenance of detailed document flow for the protection of the structure from state claims. 

Economic Presence on the Cayman Islands: Which Companies Fall Under the Rules

The obligation to perform the tests arises far from all enterprises. At the preliminary stage, the lawyers need to establish whether the organisation belongs to the category of relevant entities. The list includes exempted joint-stock companies, limited liability companies (LLC) and all types of partnerships, including foreign branches. In order to sort out who needs substance on the Cayman Islands, it is necessary to compare the legal form and the type of income.

The classification of subjects by the status of substance

A large-scale exception is provided for investment funds regulated by the Monetary Authority. They are fully taken out from under the action of the law, however their licensed managers are obliged to confirm economic presence on the Cayman Islands. The end operational enterprises into which the funds are invested are assessed independently.

Analogous rules apply to persons who have declared a foreign fiscal status. In order to remove from itself the obligation on substance on the Cayman Islands, the organisation provides the Department for International Tax Cooperation with residency certificates or declarations. 

Substance on the Cayman Islands for Relevant Types of Activity: When the Economic Substance Test Arises

The obligations before the regulator are tied to the conduct of specific commercial operations and the receipt of gross income from them. The legislation singles out nine mobile sectors of business subject to mandatory control. If an organisation combines several directions, the economic substance test on the Cayman Islands is conducted for each of them fully independently.

The list of controlled spheres includes the banking, insurance, shipping business, as well as the management of funds. The inspectors check distribution centres, headquarters and operations with connected structures. Assessing the types of activity for substance on the Cayman Islands, the department studies in detail the real distribution of commercial functions:

• financing and leasing — the provision of any loans to associated companies for a remuneration (interest);

• distribution and service centres — logistics, the storage of goods and consulting for the foreign enterprises of the group;

• the activity of headquarters — centralised management and the taking of strategic risks for subsidiary branches;

• the shipping business — international sea carriage, with the exception of the operation of private pleasure yachts.

The largest number of errors is connected with the issuance of intra-group credits. Any loan automatically transfers the organisation into the financing sector, requiring the confirmation of full-fledged substance for a company on the Cayman Islands.

The Requirements for Substance on the Cayman Islands: Management, CIGA and the Income-Generating Functions

The confirmation of the reality of the business is built on the successful passing of a triune test of economic presence. The organisation is obliged to prove that the core income-generating activity (Core Income-Generating Activities) is physically carried out in the territory of the islands. Simultaneously with this, adequate management of the company from within the jurisdiction and the sufficiency of the resources involved are assessed.

The first element of the check concerns the system of corporate governance. The board of directors is obliged to gather for meetings on the islands with a frequency adequate to the level of the decisions being taken. A quorum of directors physically present must be ensured at such meetings, and the original minutes are subject to storage in the local office. Formal appointment of a nominee director without real participation in the management leads to the failure of the test.

The second element requires an assessment of the adequacy of the resources: operational expenses, the office and the staff. The department applies the concept of subjective adequacy, comparing the resources with the gross income. The presence of million-dollar turnovers in the absence of expenses on personnel guarantees the failure of the check. 

For the optimisation of the costs, it is permitted to engage certified local providers. The transfer of income-generating functions to outsourcing is allowed if the organisation fully controls the hired specialists. The double accounting of resources is prohibited: the contractor distributes the time of the employees individually. The service provider is obliged to confirm the data on the portal of the department within 30 days. 

Reduced and Increased Substance on the Cayman Islands: Holdings, IP Structures and Outsourcing

The existing supervisory practice divides the rules of compliance by levels of complexity, singling out special regimes for various types of corporate assets. For pure holdings, passively holding shares and receiving only dividends or capital gains, reduced substance on the Cayman Islands is provided for. The simplified audit obliges the enterprise to timely submit reporting under the law on companies, to have sufficient premises and human resources for the management of the interests. The named criteria are usually closed through the services of local licensed registration agents. If, however, the holding firm issues a loan or provides paid services, it is transferred to the standard level of control.

A diametrically opposite approach is applied to objects of intellectual property of the high-risk group. Here belong situations when an organisation acquires patents or trademarks from connected persons and then extracts royalties from their use within an international group. For such structures, a legislative presumption of the non-observance of the rules applies. In order to successfully pass substance for an IP company on the Cayman Islands, the management is obliged to provide a detailed commercial business plan. To refute the claims of the department is impossible without the hiring of local full-time specialists permanently residing on the islands for the performance of the functions of the development and protection of the intangible assets. 

When transferring functions to third-party performers, it is necessary to separate the auxiliary processes and the actions directly connected with the formation of income:

• auxiliary functions — technical IT support, the calculation of salaries and the legal back office may be transferred to contractors outside the limits of the jurisdiction;

• income-generating operations — risk management, the signing of contracts and strategic management is allowed to be delegated only to local providers under the rigid control of the directors.

The engagement of external contractors has clear boundaries. If the main decisions are taken by foreign specialists, the outsourcing (the transfer of functions) is recognised as invalid. A competently built-up substance for a business on the Cayman Islands protects a transnational group from accusations of the evasion of duties. 

Substance on the Cayman Islands: the Check of the Structure, the Reporting, the Timeframes and the Responsibility

For ensuring the long-term security of the business, international groups need to build up a regular system of internal control. A comprehensive check of substance on the Cayman Islands must be conducted by the management of the company within the framework of a step-by-step algorithm, covering all the stages of the activity of the structure.

The algorithm of the legal check of a company:

• Step 1. The precise determination of the organisational and legal form of the person according to the up-to-date registration documents.

• Step 2. The check of the company for the presence of criteria of exclusion from the category of relevant entities.

• Step 3. The analysis of the actual commercial transactions and the detection of all the relevant types of activity.

• Step 4. The determination of the exact sum of the gross income obtained from each controlled direction.

• Step 5. The identification of the core income-generating functions performed by the employees on the islands.

• Step 6. The audit of the system of corporate governance, including the check of the quorum and the frequency of the local meetings of the board of directors.

• Step 7. The assessment of the adequacy of the operational expenses, the staff number of the personnel and the office areas on the Cayman Islands.

• Step 8. The legal audit of the outsourcing agreements and the verification of the registration of the contractors on the portal of the department.

• Step 9. The check of the history of the submission of the annual notifications and the completeness of the financial reports.

• Step 10. The assessment of the risks of the automatic cross-border exchange of information with foreign fiscal bodies.

The interaction with the department is divided into two mandatory stages. The first step is the sending of the annual electronic notification (ESN) before 31 March. The second stage is the submission of a full-fledged declaration within twelve months after the end of the financial year of the firm with the attachment of the accounting balance sheet. 

The non-submission of the declaration within the established term leads to an automatic fine in the amount of 5,000 Cayman Islands dollars, to which is added a penalty of 500 dollars for each subsequent day of delay. The first detection of the non-observance of the criteria of presence is punished by a levy of 10,000 Cayman Islands dollars. A repeated failure of the check in the following period entails a sanction of 100,000 dollars, after which the Registrar initiates the compulsory striking off of the firm from the register. 

Conclusion

Substance on the Cayman Islands has ceased to be a formal tick in legal questionnaires and has turned into a central element of the long-term survival of a foreign business. Today the Department for International Tax Cooperation assesses not beautiful formulations in contracts, but the real infrastructure of the company: the qualification of the directors, the physical conduct of meetings on the islands, the substantiation of the local expenses and the direct connection between the actions of the employees and the generation of gross income.