Economic Substance (Cayman) | China Tax & Investment Consultants Ltd

Cayman Islands

[1] Background of the ES Law [read]

[2] Entity Falling under Scope of Economic Substance Test [read]

Whether an entity complies with the ES test
Defining a relevant entity

[3] Core Income Generating Activities (Cayman Islands CIGA) [read]

[4] Economic Substance Test [read]

Timing for compliance with the ES test
Requirement of being directed and managed in the Islands
Reduced level of compliance test for pure equity holding entity

[5] Notification and Reporting [read]

[6] Tax Information Authority's Function [read]

Determination whether relevant entity satisfies ES test
Monitoring compliance with the ES Law
Spontaneous exchange of information on non-compliance

[1] Background of the International Tax Cooperation (Economic Substance) Law

Base erosion and profit shifting (BEPS) refers to tax planning strategies used by multinational enterprises that exploit gaps and mismatches in tax rules to avoid paying tax. An instance of these gaps and mismatches is one between full taxation and a preferential tax regime under which income is either tax-exempted in whole or in part, or taxed at a reduced rate. Most countries that impose corporate income tax establish preferential tax regimes to promote trade and investment. This changed with the creation of the OECD BEPS 15-point Action Plan, including the publication in 2015 of the Action 5 - 2015 Final Report: "Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance". In the wake of the Action 5 Final Report, countries that already have the preferential regime must comply with the economic substance requirement. In contrast, traditional offshore jurisdictions offering no or only nominal tax treatment, also referred to as the tax haven jurisdictions, do not impose any economic substance requirement on the same activities as those under the preferential tax regime. The existence of mismatches gives rise to BEPS concerns in that it creates the opportunity for tax avoidance.

The mismatches between tax rules not only create the opportunity for tax avoidance but also pose risks to the tax base of the host country that has the preferential regime in place. To address the level playing field issue arising from the different requirement for the economic substance, the Inclusive Framework agreed to apply the substanital activities to no or only nominal tax jurisdictions, in the same way as those having preferential regimes. Subsequently, members of the OECD Inclusive Framework including the Cayman Islands, have introduced legal rules to impose the substance requirement on entities that are engaged in prescribed geographically mobile activities. In this regard, the International Tax Co-operation (Economic Substance) Law, 2018 and its subsidiary regulations 2018 and 2019 came into force on 1st January 2019. [collectively referred to hereafter as "the ES Law"]

[2] Whether an entity falling under the scope of Economic Substance test [section III.A.1 of the Guidance]

(a) Compliance with the ES Test

A relevant entity is subject to the International Tax Co-operation (Economic Substance) Law, 2018 (the ES Law) from the date on which the relevant entity commences the relevant activity unless the relevant entity was in existence prior to 1 January 2019 in which case it must comply with the ES Law by 1 July 2019. This means that, from the applicable date, a relevant entity must satisfy the ES Test in relation to the relevant activities which it is carrying on.

A relevant entity satisfies the ES Test in relation to a relevant activity, if the relevant entity -

(a) conducts Cayman Islands core income-generating activities in relation to that relevant activity;

(b) is directed and managed in an appropriate manner in the Islands in relation to that relevant activity; and

(i) has an adequate amount of operating expenditure incurred in the Islands;

(ii) has an adequate physical presence (including maintaining a place of business or plant, property and equipment) in the Islands; and

(iii) has an adequate number of full-time employees or other personnel with appropriate qualifications in the Islands.

There is a reduced ES Test for pure equity holding companies, as described in The Schedule: Sector Specific Guidance, Section VII.A.1 below headed “Pure equity holding company”.

(b) Defining a "relevant entity"

A “relevant entity” means -

(a) a company, other than a domestic company, that is -

(i) incorporated under the Companies Law (2018 Revision); or

(ii) a limited liability company registered under the Limited Liability Companies Law (2018 Revision);

(b) a limited liability partnership that is registered in accordance with the Limited Liability Partnership Law, 2017;

but does not include -

(i) an investment fund; or

(ii) an entity that is tax resident outside the Islands.

[3] Cayman Islands core income generating activities (Cayman Islands CIGA)

“Cayman Islands core income-generating activities” means activities that are of central importance to a relevant entity in terms of generating ~~income and that are being carried out in the Islands including~~ relevant income and must be carried on in the Islands including; [amended by Subsidiary Legislation SL 20 2019 and SL 33 of 2019 under section 15(1)(b) of the International Tax Cooperation (Economic Substance) Law, 2018]

(a) in relation to banking business -

(i) raising funds, managing risk including credit, currency and interest risk;

(ii) taking hedging positions;

(iii) providing loans, credit or other financial services to customers;

(iv) managing capital and preparing reports or returns, or both, to investors or the Cayman Islands Monetary Authority, or both;

(b) in relation to a distribution and service centre business -

(i) transporting and storing goods, components and materials;

(ii) managing stocks;

(iii) taking orders;

(iv) providing consulting or other administrative services;

(i) negotiating or agreeing funding terms;

(ii) identifying and acquiring assets to be leased;

(iii) setting the terms and duration of financing or leasing;

(iv) monitoring and revising financing or leasing agreements and managing risks associated with such financing or leasing agreements;

(d) in relation to fund management business -

(i) taking decisions on the holding and selling of investments;

(ii) calculating risk and reserves;

(iii) taking decisions on currency or interest fluctuations and hedging positions;

(iv) preparing reports or returns, or both, to investors or the Cayman Islands Monetary Authority, or both;

(e) in relation to headquarters business -

(i) taking relevant management decisions;

(ii) incurring expenditures on behalf of Group entities;

(iii) co-ordinating Group activities;

(f) in relation to insurance business -

(i) predicting or calculating risk or oversight of prediction or calculation of risk;

(ii) insuring or re-insuring against risk;

(iii) preparing reports or returns, or both, to investors or the Cayman Islands Monetary Authority, or both;

(g) in relation to intellectual property business -

(i) where the intellectual property asset is a -

(A) patent or an asset that is similar to a patent, research and development; or

(B) non-trade intangible (including a trademark), branding, marketing and distribution

(ii) in exceptional cases, except if the relevant activity is a high risk intellectual property business, other core income generating activities relevant to the business and the intellectual property assets, which may include –

(A) taking strategic decisions and managing (as well as bearing) the principal risks related to development and subsequent exploitation of the intangible asset generating income;

(B) taking the strategic decisions and managing (as well as bearing) the principal risks relating to acquisition by third parties and subsequent exploitation and protection of the intangible asset;

(C) carrying on the underlying trading activities through which the intangible assets are exploited leading to the generation of income from third parties;

(h) in relation to shipping business -

(i) managing crew (including hiring, paying and overseeing crew members);

(ii) overhauling and maintaining ships;

(iii) overseeing and tracking deliveries;

(iv) determining what goods to order and when to deliver them, organising and overseeing voyages; or

(i) in relation to holding company business, all activities related to that business.

[4] Economic Substance Test

(a) Timing for the compliance with the ES Test [section III.A.1 of the Guidance]

A relevant entity is subject to the ES Law from the date on which the relevant entity commences the relevant activity unless the relevant entity was in existence prior to 1 January 2019 in which case it must comply with the ES Law by 1 July 2019. This means that, from the applicable date, a relevant entity must satisfy the ES Test in relation to the relevant activities which it is carrying on.

(b) Directed and Managed in the Islands [section III.A.5. of the Guidance]

A relevant entity complies with the requirement to be directed and managed in an appropriate manner in the Islands in relation to a relevant activity if -

(a) its board of directors, as a whole, has the appropriate knowledge and expertise to discharge its duties as a board of directors;

(b) meetings of the board of directors are held in the Islands at adequate frequencies given the level of decision making required;

(d) the minutes of those meetings record the making of strategic decisions of the relevant entity at the meeting; and

(e) it keeps all such director meeting minutes and appropriate records in the Islands.

The directed and managed test is designed to ensure that there are an adequate frequency of board meetings held and attended in the Islands (although it is not necessary for all meetings to be held in the Islands).

What constitutes an adequate frequency of meetings in the Islands will be dependent on the relevant activities of the relevant entity.

The test also looks to ensure that the associated minutes and records are kept in the Islands and that the board is a decision making body with the appropriate knowledge and experience. In the case where there are corporate directors, the requirements will apply to the individual(s) (officers of the corporate director) actually performing the duties.

(c) Reduced Economic Substance Test for Pure equity holding company

A pure equity holding company is subject to a reduced economic substance test.

The term “pure equity holding company” means a company that only holds equity participation in other entities and only earns dividends and capital gains.

A relevant entity that is only carrying on the business of a pure equity holding company is subject to a reduced ES Test which is satisfied if the relevant entity confirms that –

(a) it has complied with all applicable filing requirements under the Companies Law (2018 Revision); and

(b) it has adequate human resources and adequate premises in the Islands for holding and managing equity participation in other entities.

A pure equity holding company maintaining a registered office in the Islands engaging its registered office service provider in accordance with the Companies Law (2018 Revision) may be able to satisfy these reduced substance requirements in the Islands where the pure equity holding company is passively holding equity interests in other entities, depending on the level and complexity of activity required to operate its business. A pure equity holding company is not required to be directed and managed in the Islands. [Per Schedule: Sector-Specific Guidance, Section VII.A.1]

[5] Notification and Reporting

(a) Notification to the Authority [section IV.A. of the Guidance]

Starting in 2020, a relevant entity shall notify the Authority annually of –

(a) whether or not it is carrying on a relevant activity;

(b) if the relevant entity is carrying on a relevant activity, whether or not all or any part of the relevant entity’s gross income in relation to the relevant activity is subject to tax in a jurisdiction outside of the Islands and, if so, shall provide appropriate evidence to support that tax residence as may be required by the Authority; and

The Economic Substance notification (ESN) shall be made at the time specified by the Authority and in the form and the manner approved by the Authority.

The ESN is required as a prerequisite to the entity filing its Annual Return via the General Registry's Corporate Administration Platform, as applicable for the particular type of entity. The deadline for submitting the ESN is the date after which the General Registry can impose penalties for late payment of the Annual Return fees, namely 31 March each year, as per Section IV.A. of the Guidance issued by the Cayman Islands Tax Information Authority.

* The deadline for filing annual returns in 2020 was extended until 30 June 2020 as a result of the coronavirus (COVID-19) pandemic

For the avoidance of doubt, the timing for compliance with the notification obligation is separate from the timing of compliance with the ES Test specified in Section III.A.1 above headed “Compliance with the economic substance test”.

(b) Reporting to the Authority [section IV.B of the Guidance]

A relevant entity that is carrying on a relevant activity and is required to satisfy the ES Test must prepare and submit to the Authority a report for the purpose of the Authority’s determination whether the ES Test has been satisfied in relation to that relevant activity. The report must be made within twelve months after the last day of the end of each financial year of the relevant entity commencing on or after 1 January 2019.

For the avoidance of doubt, the timing for compliance with the reporting obligation is separate from the timing of compliance with the ES Test specified in Section III.A.1 above headed “Compliance with the economic substance test”.

Example timetable for a new relevant entity

In this example, the relevant entity chooses the calendar year as its financial year, commencing on 1^st January 2019 and ending on 31^st December 2019..

1.	Incorporation	Legal rules	1 Feb 2019	Remarks
2.	Commence relevant activities		1 March 2019
3.	Satisfy economic substance test	S4(6), ES Law, 2018 ES Legislations	1 March 2019	The test needs to be satisfied on the day of commencing business
4.	Annual return (1^st) to Registrar		31 December 2019
5.	Registrar to Authority		31 March 2020
6.	Notification to Authority	S7(2), ES Law	30 Sept 2020	Notification is required even if a relevant entity has not been engaged in any relevant activities during a financial year. *
7.	1^st Report to Authority	S7(3) and S7(4), ES Law	31 December 2020	Reporting is also required for a relevant entity that has not carried on any relevant activities during a financial year. *
8.	Authority’s assessment		2021
9.	Spontaneous exchange of information		2021 / 2022

* As per Section III.A.1. of the Guidance to Economic Substance for Geographically Mobile Activities, issued by the Tax Information Authority.

[6] Authority’s Function

The Tax Information Authority is the “Authority” for the purposes of the ES Law. The Authority’s functions under the ES Law include (i) administering the ES Law, determining whether a relevant entity satisfies the ES Test in respect of its relevant activities, monitoring compliance with the ES Law, and (ii) sharing information with other competent authorities.

A. Determination of whether ES Test is satisfied

The Authority shall have the power, in accordance with the ES Law, the ES Regulations and this Guidance, to make a determination as to whether a relevant entity satisfies the ES Test for any financial year in respect of which a report is required under the ES Law.

1. Failure to satisfy ES Test

If the Authority determines that a relevant entity that is required to satisfy the ES Test in relation to a relevant activity has failed to satisfy such ES Test for a financial year, the Authority shall issue a notice to the relevant entity notifying the relevant entity of such determination, giving the reasons, details regarding any penalty, directing any action to be taken to satisfy the ES Test and advising of the relevant entity’s right to appeal.

The Authority shall impose a penalty of ten thousand dollars on a relevant entity for failing to satisfy such ES Test or one hundred thousand dollars if it is not satisfied in the subsequent financial year after the initial notice of failure.

2. Misleading information

It is an offence for a person to knowingly or wilfully supply false or misleading information to the Authority under the ES Law. Such an offence is punishable on summary conviction by a fine of ten thousand dollars or with imprisonment for a term of five years, or both.

3. Offence by officers of a body corporate

Where an offence under the ES Law that has been committed by a body corporate is proved to have been committed with the consent or connivance of, or to be attributable to any neglect on the part of any director, manager, secretary or other officer of the body corporate, or any person who was purporting to act in such a capacity, the officer or any person purporting to act in that capacity, as well as the body corporate, commits that offence and is liable to be proceeded against and punished accordingly. Where the affairs of a body corporate are managed by its members, the foregoing shall apply in relation to defaults of a member in connection with the member’s functions of management as if the member were a director of the body corporate.

B. Share of Information

1. Other Competent Authorities

The Authority will systematically spontaneously exchange information provided to it under the ES Law in accordance with relevant international standards and scheduled agreements under the Tax Information Authority Law (2017 Revision) with other competent authorities in respect of relevant entities that fail to satisfy the ES Test in relation to relevant activities and in relation to high risk IP business. Information will also be shared with the competent authority of the jurisdiction where an entity claims to be tax resident or subject to income tax on its relevant income.

Recipient competent authorities could be in the jurisdiction of residence of the relevant entity’s parent company, ultimate parent company, and ultimate beneficial owner and could also be in the jurisdiction where the relevant entity (or the entity claiming not to be a relevant entity by reason of its tax residence) itself is incorporated or claims to be tax resident, if that is outside the Islands. To activate the exchanges set out above, recipient jurisdictions would need to opt in to receive spontaneously exchanged information.

2. FHTP Monitoring Process

The OECD Forum on Harmful Tax Practices (FHTP) will conduct annual monitoring of the enforcement of the “substantial activities” requirements in practice by no or nominal tax jurisdictions, such as the Cayman Islands, in addition to monitoring of preferential regimes of most other jurisdictions that are members of the Base Erosion and Profit Shifting (BEPS) Inclusive Framework. This monitoring process considers details on the monitoring mechanism to ensure compliance, and statistical data to support this.

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