The Caribbean tax haven—Cayman Islands is a pre-eminent offshore jurisdiction for hedge funds. In 2017, it was reported that around 85 percent of the world’s hedge funds were domiciled in the Cayman Islands, driving the jurisdiction to outperform its offshore peers as the top destination. In the same year, another report pointed out that close to 11,000 funds were registered with the local regulator. This constituted more than 60 percent of global hedge funds in terms of numbers and net assets. It appears that nearly 70 percent of those funds were managed by the US managers and about a third were administered by the US administration.
Carlyon Knight-Evans, who is an Assurance Asset Management Partner at PwC told International Finance, “You could look at it from a statistical perspective. I mean it is one of the leading offshore jurisdictions purely by numbers. There are more than ten thousand hedge funds registered in the Cayman Islands. If we go beyond that, why have so many hedge funds used Cayman? There is the logic that success breeds success. It is a jurisdiction which is offshore and tax neutral. But it is also a jurisdiction which is very friendly in terms of legal support. You will find that Cayman law firms have established themselves with a presence in North America, Europe and Asia. They have travelled to be in the markets where people are running funds. If you look at the core concentration of hedge funds in Asia, they are in Hong Kong and Singapore; For Europe, it is London; and North America, it is in the east coast and west coast; and New York is probably the biggest centre.”
A tax haven has unexpected costs
Following the work of the EU Code of Conduct Group on Business Taxation, the council adopted the EU list of non-cooperative jurisdictions for tax purposes. This was set out in an Annex that not only comprised blacklist jurisdictions but also a grey list in line with the EU Code of Conduct Group. The Cayman Islands in response to the situation had closely engaged with the EU and adopted a host of legislative measures. An example of that is the Cayman International Tax Co-operation, also known as the Economic Substance Law in 2018. Nevertheless, the Cayman Islands was added to the EU’s list of non-cooperative jurisdictions for tax purposes on February 18, 2020, because it “does not have appropriate measures in place relating to economic substance in the area of collective investment vehicles,” the Annex states.
Over the years, the efforts of Cayman Islands in becoming a successful hedge fund jurisdiction has been quite remarkable. The EU removed Cayman Islands from its blacklist of non-cooperative jurisdictions last October. In truth, “It was not the Cayman Islands alone that was looked at, but British Virgin Islands (BVIs), Bermuda and others. They also looked at Hong Kong, Singapore and other jurisdictions. They look at a regime to see whether it is in compliance with the EU standard. If that is not the case, then they issue a warning,” Florence Yip, who is PwC’s Asia Pacific Asset and Wealth Management Tax Leader and China Private Equity Tax Leader, told International Finance. “And if you do not make changes before the warning expires, they would put you on the blacklist. The problem of when a jurisdiction appears on the blacklist is it would affect lots of investors and also managers.”
In the investment world, many investors have their own bylaws. Some of them such as pension funds would prohibit them from investing in a jurisdiction which is listed in the EU blacklist. So this is quite problematic if a jurisdiction is on the blacklist. “Cayman Islands actually was on the blacklist because it missed a certain deadline by a couple of days, so it is quite unfortunate,” Yip explained. “But on the other hand, it also shows that the EU can be very stern by imposing penalties and placing jurisdictions in the blacklist.”
The common practice for Cayman funds
As outlined above, having legal capabilities on the ground in North America, Europe and Asia has meant that the Cayman Islands has been able to readily promote itself as an attractive jurisdiction for hedge funds. It is a common law jurisdiction that people are familiar with. By practice, hedge funds established in the Cayman Islands will take the form of a company, a limited partnership, or a unit trust, and they can be managed by a management entity operating from anywhere in the world. It is reported that the fund managers for a majority of Cayman funds do not have a presence in the Cayman Islands because there is no requirement per se for them to be domiciled there.
“Simply what it means is that if a company or a legal entity is set up in the Cayman Islands, proclaiming to carry out certain activities is important. For example, fund managers would need to have a commercial substance to support the claim that they are carrying out fund management business activities in the Cayman Islands,” Yip said. “To support the claim, you need to have people, an office, the right infrastructure and platform to carry out the business. Now, we all do know that in the Cayman Islands they do have their own residents, but very few fund managers operate from there. Of course there are a few, but many international fund managers actually work and live in cities of their choice, like New York, London, Hong Kong or Singapore.”
Yip further explained that there was a significant trend among fund managers, particularly those from Asia, in setting up a Cayman fund manager entity and entering into a fund management agreement with a Cayman fund. Then the Cayman fund manager entity would sub contract some or all of its services to a local investment advisor, for example, in Hong Kong. The Cayman fund would pay two percent management fee to the Cayman fund manager, which in turn would pay a portion to the local investment advisor.
In turn, that allows the Cayman fund manager to keep a good profit margin, while in the past such profit margins kept in the Cayman Islands were not commonly subject to tax anywhere in the world. “So this is something that the EU had to combat and wanted to stop. In January 2019, many of the tax havens such as the Cayman Islands, BVIs and Isle of Man have implemented their own versions of Economic Substance Law to tell the world that they are operating up to the EU standard, and are not collaborating with tax evasion and tax avoidance activities,” Yip said. Now, all the explanations are leading up to the fact that before 2019, there were many Cayman fund management companies. Because of this change, many of the Cayman fund managers have either been closed or downgraded from being a manager to an advisor—while some of them have changed their roles to holding companies.
Cayman government enacts bills for hedge fund regulation
Last February, the government enacted two bills aimed at regulating private funds and subsequently enhancing the regulation of hedge funds in the Cayman Islands. The Private Funds Bill 2020 and the Mutual Funds Law (Revised) of the Cayman Islands will bring private and hedge funds with less than 15 investors under the regulatory oversight of the Cayman Islands Monetary Authority. With that, all Cayman investment funds will be fully regulated by the Cayman Islands Monetary Authority, except select investment vehicles that will be regulated under the Mutual Funds Law.
By definition, the Private Funds Bill applies to any close-ended fund that is established in the Cayman Islands. The bill also exempts non-fund arrangements which include securitisation of special purpose vehicles, joint ventures, proprietary vehicles, holding vehicles and preferred equity financing vehicles among others. That said, the amendment of the Mutual Fund bill will affect open-ended funds that were previously exempt from Cayman Islands Monetary Authority regulations.
“With the new enactments, the fund managers are very alert to the potential future amendments to the Cayman law, including the economic substance law that could be changed due to the EU requirements,” Yip explained. “For now, all the investment funds in the Cayman Islands are exempt from the Economic Substance Law. So hedge funds are performing alright. However, one would need to wait and see, because in the Cayman Islands or other tax havens, usually most directors of GP of such fund vehicles are not residents in Cayman or BVI.”
“The European Parliament adopted a resolution on 21st January 2021 setting out certain proposed changes to the criteria used to draw up the EU blacklist. An example of such proposed changes is for the European Council to include the automatic listing of non-EU jurisdictions with a zero percent corporate tax rate or with no taxes on companies’ profits as a stand alone criterion. So one needs to be careful to monitor the development of the Cayman Economic Substance Law and the EU’s rules. Of course, from the operator point of view, the players would hope that it would be a stable regime because they would like to minimise the cost of compliance and risk of non-compliance,” she added.
A highly conducive offshore financial centre for investors
Although the Cayman Islands is not the only offshore financial centre with tax exemptions, it has become vital to the US hedge fund industry, mainly attributable to its geographical advantages that have enabled it to provide services to the US market. It has a pronounced legal and judicial system that is based on English common law, and more importantly, its public and private sectors have closely engaged with each other since the 1990s to build a constructive regulatory regime for hedge funds.
“There is a very clear tax exemption treatment for its funds regime,” Yip said. “People do not need to worry about taxation in the Cayman Islands. Of course, separately we have to think about taxation elsewhere. But as far as the Cayman Islands is considered, the fund vehicle itself will definitely be tax exempt. That is very important. The other thing is, because the Cayman fund vehicles have been in existence for many years, it is run well with very good and experienced service providers and quite familiar with international investors and regulators.”
This makes the Cayman Islands quite suitable for many investors and fund managers, in addition to becoming a cost efficient destination to set up and run a company. “However, I want to point out that the Cayman Islands has no avoidance of double taxation treaty with any country or any jurisdiction in the world. So people who use Cayman vehicles are not really looking for tax treaty protection; however, they are looking for efficiency, streamline and simplicity of the Cayman fund regime,” Yip said.
A regulated approach for unregulated funds
But there were a few issues from a regulatory standpoint. “One of those was around which funds were captured by the regulations and what were not. Historically, hedge funds were captured and so they needed to be regulated, and there was an exemption for funds with a small number of investors (15 or less). But the bigger concern was what was not captured, which was all the private equity and real estate funds that were used in the Cayman Islands. Those have now needed to be registered,” Carlyon explained.
For that reason, more than 10,000 private equity and real estate funds were registered in 2020 which were previously not subject to any regulatory oversight—a situation that had shaped up to be one of the EU’s key concerns. Although the legal framework is robust, in Carlyon’s view, “It is a common law legal system with good strong cause and lots of precedents that help protect investors and other stakeholders, it was those funds that were not previously captured by the regulatory regime that had become the rising concern with Cayman Islands funds.”
For the unregulated funds, the number has now dropped dramatically with the new reforms, which Carlyon reasons out with an example. The private equity and real estate funds are close-ended and now captured under the private funds law in the Cayman Islands. So they have had to register with the Cayman Island Monetary Authority. “While there are some exceptions, these generally relate to where there is a single investor and the need for investor protection is very different or more to do with factors such as special purpose vehicles that are designed for a singular purpose.”
In this context, what is essentially done is that “the previously unregulated funds have been swept in and captured in the net—that is now the Cayman regulated fund framework,” he said. The second aspect around this is that it could lead to increasing cost. Being regulated funds, they naturally will incur additional costs, not only in terms of registration in the Cayman Islands, but also in compliance and dealing with audit and other tax related matters.
Another interesting fact that Carlyon states is that the new reforms have brought those funds into a safe non-blacklisted environment. “They are now considered regulated funds rather than unregulated. The cost of doing business in the Cayman Islands has increased, but it does not mean that investors might start looking at other jurisdictions. At this phase, the Cayman Islands is the dominant jurisdiction [for hedge funds] and I don’t expect that to change anytime soon.” However, “the new audit requirement of private equity funds and other closed end funds registered with the Cayman Island Monetary Authority might also cast some operating or practical issues because of the additional time and cost associated with audit work to be done in the Cayman,” Yip said.