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
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…ia-level=”1″>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
