On March 12, government and the financial sector awaited with bated breath the outcome of the European Union’s evaluation of Cayman’s tax regime. The EU process of listing countries as either cooperative or uncooperative in tax matters started in 2017 and saw Cayman escape a blacklisting only after making some last-minute written commitments to amend its legislation by the end of 2018.

The EU claimed that Cayman and several other offshore financial centres had infringed a somewhat arbitrary fair tax criterion by facilitating offshore structures that attract profits with little or no economic activity locally.

The EU Code of Conduct Group, which was tasked with assessing third countries, used the country-by-country financial statements of European banks to determine that a full-time employee of a European bank in Cayman generated an average profit of EUR6,298,000 (US$7,070,733) in 2015, whereas the global average was only €45,000 (US$50,520). “The profitability per employee and per country in the Cayman Islands appears to be the highest all over the world,” the 2017 assessment stated.

The Cayman Islands government at the time submitted an analysis by its banking regulator, the Cayman Islands Monetary Authority, which showed Cayman-licensed banks may have employees in other jurisdictions that were not included in the data. These employees could give the Cayman Islands company a permanent establishment in the relevant jurisdiction making it subject to taxation in that jurisdiction.

The CIMA analysis said, “The non-reporting of operating expenses may inflate the profit before taxes analysis artificially and the reporting of taxes at branch level can be misinterpreted as meaning that the Head Office does not pay taxes in circumstances where it actually does pay such taxes – it is just that these taxes are reported at the Head Office level.”

The Code of Conduct Group, however, concluded that the Cayman government had not explained “in a convincing way” how banking subsidiaries in Cayman earned at least €171 million profits in 2015 without any substantial economic presence. The assessment further included a back of the envelope calculation which divided the number of employees on island (40,411 in 2016) by the number of registered companies (92,269 in 2016) to arrive at an average of 0.44 employees per company. “If you divide only employees working in the financial sector, the ratio is 0.14. From our perspective, these disproportionate figures strongly highlight the questions arising in respect of substance,” the assessment found.

The EU also criticised that Cayman legislation ring-fenced the domestic market from exempted companies, which are only allowed to operate locally to the extent that it furthers their international business. The aim of the EU is to stop the granting of tax advantages only to certain companies by ring-fencing them so that they do “not affect the national tax base”.

This, of course, is not the case in Cayman where neither domestic nor non-domestic companies are subject to income tax or any other tax. Nevertheless, the EU Code of Conduct Group argued that Cayman’s ring-fencing legislation was “harmful”.

As a result, it remained unclear for several months how Cayman could rectify the alleged short-comings.

The EU assessment itself appeared to struggle with the notion what exactly Cayman should be asked to change in its legislation.

“The introduction of a [corporate income tax] system or a positive [corporate income tax] rate is not amongst the actions that a third country jurisdiction can be asked to take in order to be in line with the requirements under this test, since the absence of a corporate tax base or a zero or almost zero level tax rate cannot by itself be deemed as criterion for evaluating a jurisdiction as non-compliant,” the initial 2017 Code of Conduct Group assessment of the Cayman Islands stated.

“It remains unclear what exactly we would be asking jurisdictions to amend/introduce in response to their deemed failure under [economic substance] Criterion 3. It might be suggested that a jurisdiction should have a de jure requirement for substance as part of their company law, but it’s not clear what that would entail, i.e., what the test of substance would be, when that test of substance would be applied, what the implication would be of a company failing that test.”

During the course of last year, the EU managed to untie that mental knot by convincing the Organisation for Economic Cooperation and Development to include zero tax jurisdiction, like Cayman, in its framework for harmful preferential tax regimes. This initiative targets narrowly defined parts of a tax system that apply incentives or concessions to certain taxpayers, who are engaged in operations that are purely tax-driven and involve no substantial activity.

This again ignored that Cayman does not have a preferential tax regime at all. All companies are treated equally and are not subject to any tax. But it provided a framework of economic substance rules that Cayman and other financial centres could be forced to introduce in their domestic legislation.

What followed was a hurried dash to draft and enact the new Economic Substance Law before the end of 2018, amid some advanced tea leaf reading in terms of what the EU would require. Despite the ongoing dialogue with the EU, the outcome was far from certain and risked damaging the local financial services sector, accidentally or otherwise.

How fraught the process was, became apparent on March 12 when the EU Council of finance minister expanded the existing tax blacklist by 10 countries to a total of 16.

While Cayman was not named on the list of non-cooperative jurisdictions, new additions included the likes of Bermuda, which had committed to making similar legal amendments.

With regard to the Bahamas, the British Virgin Islands and Cayman, the EU Council stated that the jurisdiction had engaged in a positive dialogue and remained cooperative, but also that they “would require further technical guidance”.

Collective investment vehicles

This technical guidance referred to a new issue raised by the EU, stating that the three jurisdictions “committed to addressing the concerns relating to economic substance in the area of collective investment funds”.

Cayman and the other offshore centres will have until the end of 2019 to adapt their legislation. But the EU noted that the deadline may be reviewed depending on the technical guidance that will be agreed by the Code of Conduct Group and the ongoing dialogue with the jurisdictions concerned.

Once again, it is entirely unclear what Cayman has committed to.

The EU first referred to collective investment vehicles in a scoping paper in June 2018 but mentioned them in the context of “reduced substance” similar to equity holding companies.

The substance test would include fund managers, the scoping paper said, as this is a mobile activity within the scope. “However, collective investment funds (CIVs) are of a different nature, except in rare circumstances where the manager and the CIV form one legal entity. Therefore, the usual substance requirements cannot automatically be applied to CIVs. Thus, and in part similar to pure equity holding companies, reduced substantial activities requirements adapted to CIVs should apply Requirements in this regard can be paralleled with EU legislation on investment funds, in particular Directive 2011/61/EU on Alternative Investment Fund Managers,” the paper noted.

But the EU then based its economic substance process on the global standard set by the OECD’s Forum on Harmful Tax Practices, which does not consider funds as an economic substance issue.

The Cayman Islands government responded to the EU Council’s findings by saying that the EU has acknowledged that further work will be needed to define acceptable requirements for collective investment vehicles (CIVs) or funds.

“While the government has committed to continuing its engagement and dialogue with the EU on this issue, it should be borne in mind that the global standard requiring economic substance for relevant financial and corporate entities, set by the OECD’s Forum on Harmful Tax Practices, does not include CIVs,” the government said in a statement. “As such, Cayman’s legislation is based on the global standards, and we will continue to adhere to global standards with regard to economic substance requirements for relevant entities.”

Overall, the Code of Conduct Group’s latest assessment of Cayman’s tax regime in early 2019 concluded: “Leaving aside the issue of collective investment funds, the Cayman Islands have implemented their commitment to introduce substance requirements.”

The same document that outlined the Code of Conduct Group’s findings regarding the Cayman Islands for the EU Council said Cayman had introduced substance requirements for companies, limited liability companies and limited liability partnerships.

It outlined that in response to a request by the EU Commission, the Cayman government clarified that there are four types of partnerships in the Cayman Islands: general partnerships, limited partnerships, exempted limited partnerships and limited liability partnerships.

In its submission, Cayman’s government argued that it only considers limited liability partnerships relevant for substance requirements, because only limited liability partnerships are legal persons in their own right, and only limited liability partnerships can hold or own assets and contract in their own right.

The outcome document concluded that the issue “is clarified” and the risk of tax base erosion and profit shifting in this area was “limited”. But the assessment declared, “It however needs to be monitored, in the coming months, whether it is considered necessary to include all partnerships in the scope of substance requirements.”

There are no other unresolved issues according to the document, but the EU may add new criteria may to its listing process. When the new tax blacklist was released, the EU Council invited the Code of Conduct Group to finalise discussions about introducing ultimate beneficial ownership as a future criterion for the blacklist.

Country-by-country reporting has already been confirmed as a new criterion and will be applied to an expanded list of countries in the next round of assessments.