For decades, the Cayman Islands has been mentioned in music, movies, and art, such is its proximity to the notion of a tax destination. Even those with a cursory knowledge of investing understand it attracts businesses with its zero corporate tax rate and business-friendly regulations.
This has not happened in a vacuum of course – through long-standing foresight and strong governance, it has become the world’s sixth-largest financial centre, despite its diminutive geographic footprint.
However, the financial world is changing, and international organisations are closely examining offshore financial centres and those who invest in them. In response, the Cayman Islands has taken substantial steps to align with global standards and bolster its reputation as a transparent and responsible financial hub.
A key part of this effort is the introduction of Economic Substance requirements. These rules aim to ensure businesses have a genuine presence in the Cayman Islands, beyond just a performative mailing address.
While these new regulations do not diminish the Cayman Islands’ significant tax advantages, investors and businesses must now consider these new Economic Substance rules. Understanding and following them is key to staying compliant while using the Cayman Islands’ tax-efficient system.
This article explains the Cayman Islands’ Economic Substance requirements, giving investors of all types the information needed to stay compliant while continuing to take advantage of the region’s famously business-friendly attributes.
Cayman Islands Economic Substance Background and Purpose
The Cayman Islands’ Economic Substance rules are part of a global effort led by the OECD and G20 to address tax base erosion and profit shifting (BEPS).
BEPS occurs when companies artificially move profits to low-tax jurisdictions where they conduct minimal business. This practice became widespread as firms sought to reduce their tax liabilities, often cutting effective tax rates to single-digit levels.
While this strategy boosted shareholder returns and competitive advantage, it also depleted government revenues derived from corporate tax. The OECD and G20 launched their BEPS project in 2013 to counter these practices. Their aim is to ensure companies pay taxes where they generate profits and create value.
In 2017, the EU ramped up these efforts by publishing a list of non-cooperative tax jurisdictions. To maintain their standing, many offshore financial centres, including the Cayman Islands, pledged to implement Economic Substance requirements. The Cayman Islands’ Economic Substance Law, also known as the International Tax Co-operation (Economic Substance) Law of 2018, came into effect on January 1, 2019.
For investors, these changes offer enhanced stability and risk mitigation. They can now operate in the Cayman Islands with the assurance that their activities meet stringent international criteria. This regulatory alignment not only safeguards against potential legal issues but also cements the Cayman Islands’ role as a leading financial hub for years to come.
Entities Subject to Economic Substance Requirements
The Cayman Islands’ Economic Substance Law applies to many entities, but not universally.
Entities Covered by the Law
- Cayman companies
- Limited Liability Companies (LLCs)
- Limited Liability Partnerships (LLPs)
- Foreign companies registered in the Cayman Islands
Notable Exemptions
- Investment funds and entities through which they invest or operate
- These entities must still file an annual Economic Substance Notification
- Entities tax resident outside the Cayman Islands
- Must provide robust evidence of foreign tax residency
- Entities which carry out business locally as a partnership or company
Special Considerations
- Cayman trusts: Not directly subject to the law, but trustees must consider their own obligations
Relevant Activities
To give further context, the Economic Substance Law doesn’t apply to all business operations in the Cayman Islands. Rather, it focuses on specific activities deemed ‘relevant’ under the legislation.
The law identifies nine categories of relevant activities:
- Banking business
- Distribution and service centre business
- Financing and leasing business
- Fund management business
- Headquarters business
- Holding company business
- Insurance business
- Intellectual property business
- Shipping business
Key points to consider:
- Entities must carefully assess their operational activities to determine if they fall within these categories
- The Cayman Islands Tax Information Authority (TIA) has provided detailed guidance on each category, however, it is best to have a trusted partner like InCorp to provide clarification
- An entity may conduct more than one relevant activity and must comply with the requirements for each
Implications for businesses:
- Entities conducting relevant activities must satisfy the Economic Substance Test
- The test requirements may vary depending on the specific relevant activities conducted
- Entities not currently engaged in relevant activities should still monitor their operations, as future changes could bring them within the law’s scope
Related Read: British Virgin Islands (BVI) vs the Cayman Islands: What’s Your Best Choice?
The Economic Substance Test
The Economic Substance Test is the fundamental cog in the Cayman Islands’ Economic Substance Law. This test establishes the criteria entities must meet to demonstrate genuine economic presence in the jurisdiction.
Key Components of the Economic Substance Test
- Core Income Generating Activities (CIGA)
- Entities must conduct their CIGA in relation to relevant activities in the Cayman Islands
- CIGA are activities central to generating income from the relevant activity
- Direction and Management
- The entity must be appropriately directed and managed in the Cayman Islands
- This includes holding board meetings with adequate frequency in the Cayman Islands
- Adequate Physical Presence, Expenditure, and Personnel
- Entities must maintain adequate physical presence in the Cayman Islands
- They must incur adequate operating expenditure in the Cayman Islands
- They must employ an adequate number of qualified full-time staff in the Cayman Islands
Additional Considerations
- The test requirements may vary depending on the type of relevant activity
- Pure Equity Holding Companies are subject to a reduced substance test
- High-risk intellectual property business faces a higher burden of proof
Outsourcing Arrangements
- Entities may outsource their CIGA to service providers in the Cayman Islands
- The entity must monitor and control the outsourced activities
- Outsourcing CIGA to providers outside the Cayman Islands, however, is not permitted
Compliance Timeline and Reporting Requirements
Key Reporting Obligations
- Economic Substance Notification (ESN)
- Required annually from all legal entities registered in the Cayman Islands
- Due by 31 January each year
- Relates to the entity’s financial year that began in the previous calendar year
- Economic Substance Return
- Required for Relevant Entities conducting Relevant Activities
- Due within 12 months of the end of the entity’s financial year
- Includes detailed information on compliance with the Economic Substance Test
- Tax Residency Return (TRO Form)
- For entities claiming tax residency outside the Cayman Islands
- Due within 12 months of the financial year-end
- Requires documentary evidence of foreign tax residency
Record Keeping and Penalties
Record-keeping Requirements
- Relevant Entities must maintain records for six years
- These records must demonstrate compliance with the Economic Substance Test
- Records should include information provided in Economic Substance Returns
Penalties for Non-compliance
Financial penalties:
- Failure to satisfy the Economic Substance Test: Up to CI$10,000 (approximately US$12,195)
- Subsequent failures to satisfy: Up to CI$100,000 (approximately US$121,950)
- Failure to file Economic Substance Return: Up to CI$5,000 (approximately US$6,098)
- Continued failure to file: Additional CI$500 (approximately US$610) per day
Penalties for Providing Inaccurate Information
- Up to CI$10,000 (approximately US$12,195)
- Possible imprisonment for up to two years
Additional Consequences
- Potential strike-off from the Cayman Islands company register
Practical Implications for Businesses
The Economic Substance Law significantly alters the operational landscape for companies in the Cayman Islands. Many organisations find value in partnering with corporate service experts to navigate these new regulations effectively.
Key areas of focus for businesses:
- Activity Assessment:
- Firms must accurately determine if their operations fall under the law’s scope
- Expert guidance can prevent costly misclassifications
- Operational Adjustments:
- Some entities may need to enhance their Cayman presence to meet requirements
- Advisors can propose tailored solutions that align with business objectives
- Governance Refinement:
- Companies may need to modify their board practices
- Professional input helps create compliant governance structures
- Information Management:
- Robust data collection and storage systems are now essential
- Many firms adopt specialised tools recommended by their advisors
- Reporting Compliance:
- Timely and accurate submission of required reports is crucial
- Expert assistance often proves invaluable in meeting these obligations
- Risk Oversight:
- Regular compliance checks should become standard practice
- Working with specialists can identify potential issues proactively
While these new regulations present challenges, they also reinforce the Cayman Islands’ commitment to global standards, which is undeniably the way forward for all modern investors. With the right support, businesses can continue to enjoy the jurisdiction’s benefits while meeting new regulatory demands.
Handling economic substance compliance in-house is possible but rarely advisable. Most companies find that working with a trusted advisor is not just common practice, but essential for effective compliance, unless they possess substantial internal resources and expertise.
Where to Next With InCorp
The Economic Substance rules in the Cayman Islands mark a considerable change in how offshore finance works for investors of all types. These new rules bring fresh challenges, but they also show that Cayman is serious about being a trustworthy hub for global business. In essence, this is the new paradigm, and all investors must be on board.
Given the complexities of these new regulations, many companies find that partnering with experienced corporate service providers is the most efficient way to assure compliance.
InCorp’s team are experts, with on-the-ground experience with the nuances of the Economic Substance Law and can provide tailored guidance to help your business operate within these requirements. Stay compliant and contact InCorp today to understand how we can support your Cayman Islands operations in this new regulatory paradigm.
FAQs about Compliance in the Cayman Island
- The Cayman Islands Economic Substance requirements are rules that ensure certain entities have genuine economic presence in the jurisdiction, beyond just a mailing address.
- Most Cayman companies, LLCs, LLPs, and registered foreign companies are subject to these rules, with some exceptions like investment funds and entities tax resident elsewhere.
- The Economic Substance Test requires entities to conduct core income-generating activities in the Cayman Islands, be directed and managed there, and have adequate physical presence, expenditure, and personnel.
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