Cayman Islands

Economic Substance (ES) Requirements

The Economic Substance Act (ES Act) in the Cayman Islands, which was modified by the International Tax Cooperation (Economic Substance) (Amendment) Act of 2020, became effective on January 1, 2019. This legislation was introduced following Cayman’s partnership with the OECD’s Forum on Harmful Tax Practices and the European Union Commission Services to adhere to the criteria regarding substantial activities.

Deadlines:

• Prior to January 31st annually: Every organization is required to file an Economic Substance Notification with the Registrar of the Cayman Islands.

• Within 12 months following the end of the financial year: Relevant Entities engaged in one or more Relevant Activities must submit an Economic Substance Return to the TIA.

• Within 12 months following the end of the financial year: Entities asserting tax residency outside of the Islands and engaged in one or more Relevant Activities must submit a Tax Resident Outside (TRO) Form for Economic Substance Return to the TIA.

The legislation mandates that every legal entity established or registered in the Cayman Islands must submit an annual notification (referred to as an Economic Substance Notification or ESN). This notification should indicate whether the entity conducted one or more activities outlined in a specific list (Relevant Activities) in the preceding year. If such activities were carried out, the entity must disclose its financial year end date, tax residency status outside of the Cayman Islands, and provide certain identification and contact details. Entities falling within the scope (Relevant Entities) and engaged in any Relevant Activity are obliged to undergo an economic substance test (ES Test) relevant to those activities. The specifics of the ES Test requirements vary based on the conducted Relevant Activities, and each Relevant Entity must file an annual report (referred to as an Economic Substance Return) to facilitate the assessment of their compliance with the ES Test requirements. The responsibility for evaluating whether a Relevant Entity has met the ES Test lies with the TIA.

The Act distinguishes between legal entities other than pure equity holding entities and pure equity holding entities.

Relevant Entities

Relevant Entities encompass all entities registered or domiciled in the Cayman Islands, such as companies (including foundation companies), LLCs, LLPs, registered foreign companies, and various forms of partnerships (including exempted limited partnerships, general partnerships, limited partnerships, and foreign limited partnerships), with the following exceptions:

a. Investment funds or entities used for the direct or indirect investment or operation of investment funds.
b. Entities that are tax residents outside the Cayman Islands (including, under specific conditions, entities disregarded for US income tax purposes).
c. Entities authorized for local business operations in the Cayman Islands as domestic companies or local partnerships.

Currently, Cayman Islands trusts are not subject to this legislation. Consequently, they are not obligated to provide annual notifications or comply with the economic substance test. However, trustees should evaluate whether they themselves are required to submit annual notifications and meet the economic substance test.

Entities engaging in Relevant Activities during the reporting year and claiming tax residency outside the Cayman Islands must submit an annual return stating their tax residency jurisdiction and furnishing documentary proof of their residency outside the Cayman Islands. This return should also detail the entity’s immediate parent, ultimate parent, and ultimate beneficial owner. Information provided by such entities to the TIA will be shared with tax authorities in their claimed residence jurisdiction and the jurisdictions of their immediate parent, ultimate parent, and ultimate beneficial owner.

Entities meeting the Act’s definition of an investment fund, including the fund itself or entities used for direct or indirect investment or operation of investment funds (which typically includes the general partner of an investment fund), are not considered Relevant Entities and are exempt from the economic substance test. However, they must still file an annual Economic Substance Notification to inform the TIA of their classification as an investment fund and provide relevant fund registration details.

The ES Test

Relevant Entities engaged in a Relevant Activity must fulfill the Economic Substance (ES) Test. If a Relevant Entity conducts multiple Relevant Activities, it must meet and report on its compliance with the ES Test for each activity individually. To meet the ES Test for a specific Relevant Activity, a Relevant Entity must:

a. Conduct its “core income generating activities” related to that Relevant Activity within the Cayman Islands.
b. Be “directed and managed” appropriately in the Cayman Islands concerning that Relevant Activity.
c. Considering the level of relevant income derived from the Relevant Activity conducted in the Cayman Islands:

i. Incur an adequate amount of operating expenditure in the Cayman Islands.
ii. Maintain an adequate physical presence (which may involve maintaining a place of business or possessing plant, property, and equipment) in the Cayman Islands.
iii. Employ an adequate number of full-time employees or other personnel with suitable qualifications in the Cayman Islands (outsourced personnel may be included, provided they are situated in the Cayman Islands).

A Relevant Entity may meet the requirement for its core income generating activities to be carried out in the Cayman Islands if these activities are performed by another party, and the Relevant Entity can oversee and control these activities. In other words, Relevant Entities can engage in suitable outsourcing arrangements with service providers in the Cayman Islands. However, core income generating activities should not be outsourced to providers outside of the Cayman Islands. Whenever an entity outsources core income generating activities, the outsourced service provider must verify specific information regarding the outsourcing arrangement to the TIA.

The concept of holding company business (which is one of the nine Relevant Activities) applies solely to Relevant Entities that exclusively hold equity participations in other entities and solely earn dividends and capital gains (referred to as Pure Equity Holding Companies). A Pure Equity Holding Company is subject to a simplified ES Test, which is met by confirming compliance with all relevant filing requirements under applicable Cayman Islands legislation and having adequate human resources and premises in the Cayman Islands for holding and managing equity participations in other entities. Typically, a Pure Equity Holding Company can fulfill the simplified ES Test by appointing a reputable registered office in the Cayman Islands.

Relevant Entities engaged in “high-risk intellectual property business” face a greater burden of proof in demonstrating adequate economic substance in the Cayman Islands. High-risk intellectual property business generally involves situations where an entity did not create the intellectual property it holds and now generates income from that intellectual property by licensing it to other group entities or as a result of the activities of other group entities. To meet the ES Test, an entity engaged in high-risk IP business must provide the TIA with evidence showing a high level of control over the development, exploitation, maintenance, protection, and enhancement of relevant IP assets, exercised by a sufficient number of full-time employees with the required qualifications permanently residing and/or working within the Cayman Islands.

The TIA’s Guidance offers further clarification on the meaning of “adequate” and “appropriate” for the purposes of the ES Test. Importantly, this guidance acknowledges that adequacy or appropriateness for each Relevant Entity depends on the specific circumstances of the entity and its business activities. It requires the directors (or equivalent) of each Relevant Entity to make a good faith determination on these matters.

Primary revenue-generating activities

The legislation defines “core income generating activities” (CIGA) as activities pivotal to a Relevant Entity in terms of generating relevant income (i.e., income derived from the Relevant Activity) and mandates that these activities be carried out in the Cayman Islands. The Act offers examples of core income generating activities for each Relevant Activity. For instance, in the case of financing and leasing business, CIGA encompass:

i. Negotiating or establishing funding terms
ii. Identifying and acquiring assets for leasing
iii. Establishing the terms and duration of financing and leasing
iv. Monitoring, revising financing or leasing agreements, and managing associated risks

These enumerated CIGA are not exhaustive, and it is not obligatory for a Relevant Entity engaged in the Relevant Activity to perform all listed CIGA. However, if the Relevant Entity does undertake the relevant CIGA, it must be carried out in the Cayman Islands. Additionally, it’s essential to note that if a Relevant Entity contracts to conduct a CIGA, it will be deemed to be performing such an activity irrespective of any delegation arrangement.

Important dates

The Act and its associated regulations establish a schedule for compliance, notification, and reporting:

a. Compliance: The Relevant Entity must meet the ES Test requirements from the commencement of the Relevant Activity until either it ceases the activity or it no longer qualifies as a Relevant Entity.

b. Notification: By January 31st of each calendar year, all legal entities registered or domiciled in the Cayman Islands must submit an Economic Substance Notification to the TIA. This notification informs the TIA whether the entity engaged in any Relevant Activities during its financial year that began in the preceding calendar year. The submission is made through the entity’s registered office to the Cayman Islands Registrar. While the deadline is January 31st, penalties are only imposed if the notification remains outstanding by March 31st. Additionally, any legal entity intending to terminate, migrate to another jurisdiction, deregister as a foreign company, or undergo merger or consolidation with other entities must file a notification for the current year before deactivation by the Cayman Islands Registrar occurs.

c. Reporting for Relevant Entities: Each Relevant Entity involved in a Relevant Activity must furnish an Economic Substance Return to the TIA within 12 months after the conclusion of its financial year. This report details the entity’s compliance with the ES Test throughout the financial year and includes various financial, ownership, and other relevant data. Furthermore, any Relevant Entity engaged in a Relevant Activity must also supply its financial statements or books of account for the corresponding financial year.

d. Reporting for entities claiming tax residency outside of the Islands: Entities conducting a Relevant Activity but exempted from being a Relevant Entity due to their tax residency outside the Cayman Islands must submit a TRO Form to the TIA within 12 months following the end of their financial year. This submission entails presenting documentary evidence of tax residency outside the Islands and furnishing information regarding the entity’s immediate parent, ultimate parent, and ultimate beneficial owner, as previously mentioned.

Keeping Records

A Relevant Entity obligated to meet the ES Test for a Relevant Activity must preserve records pertaining to the information required for submission to the Authority for six years following the conclusion of its financial year.

Penalties

Unless eventual changes to be carried out by local related Authorities, the penalty for not meeting the ES Test for a Relevant Activity in a specific financial year can reach up to US$12,195. In subsequent financial years following an initial notice of non-compliance, this penalty can increase to as much as US$121,950. Additionally, the Registrar is mandated to apply to the Grand Court for an order directing the Relevant Entity to take specific actions or face being struck off.

Moreover, if a Relevant Entity fails to fulfill its annual reporting obligations alongside the ES Test requirements, the TIA may impose a penalty of up to US$6,098, with an additional daily fine of up to US$610 for each day of continued non-compliance. Furthermore, failure to provide requested information to the TIA, assuming the information is within the entity’s control, could result in a penalty of up to US$12,195, imprisonment for up to two years, or both.

The Enforcement Guidelines specify that if the TIA discovers that an entity has misclassified itself under the Act, leading to failure to submit the required Economic Substance Return for a reporting period, the entity will be deemed to have missed the reporting deadline. In such cases, the entity will have a 30-day grace period to submit the Economic Substance Return. Failure to meet this extended deadline will result in the entity being considered to have failed the ES Test and facing the maximum penalties outlined above. Similarly, if an entity fails to respond to a request from the TIA for clarification or additional information, the TIA will assess whether the entity is obligated to satisfy the ES Test based on the provided information, potentially facing maximum penalties if the TIA determines non-compliance with the ES Test.