Cayman Economic Substance: Requirements and Compliance

Cayman economic substance requirements apply to Cayman companies, LLCs, LLPs, partnerships and registered foreign companies under the International Tax Co-operation (Economic Substance) Act (As Revised). Every entity files an annual economic substance notification, and a relevant entity carrying on a relevant activity must also meet the economic substance test and file an economic substance report.

Key takeaways

• The ES Act covers companies, LLCs, LLPs, general and limited partnerships, exempted limited partnerships, foreign limited partnerships and registered foreign companies.
• Investment funds, entities tax resident outside the Cayman Islands and domestic companies or local partnerships are not relevant entities.
• Nine relevant activities trigger the ES test; holding company business is subject to a reduced test.
• The full test requires core income-generating activities, direction and management, expenditure, premises and people in the Cayman Islands, each adequate to the relevant income.
• Core income-generating activities may be outsourced to a person in the Cayman Islands, provided the entity monitors and controls them.

The legal framework

The economic substance requirements are set out in the International Tax Co-operation (Economic Substance) Act (As Revised) (the ES Act) and regulations issued under it by the Cabinet of the Cayman Islands. The Tax Information Authority (the Authority) has issued Guidance on the ES Act, which explains how its definitions should be construed and gives examples of relevant activity. Bell Rock's Cayman economic substance support applies this framework entity by entity.

Which entities are within the ES Act?

The requirements of the ES Act apply to:

• Cayman Islands companies incorporated under the Companies Act (As Revised) or the Limited Liability Companies Act (As Revised);
• Cayman Islands limited liability partnerships registered under the Limited Liability Partnership Act (As Revised);
• general partnerships and limited partnerships under the Partnership Act (As Revised);
• exempted limited partnerships and foreign limited partnerships under the Exempted Limited Partnership Act (As Revised); and
• non-Cayman companies registered as foreign companies under the Companies Act (As Revised).

Entities that are not relevant entities

The requirements that apply to a particular entity depend on whether it is a "relevant entity" within the meaning of the ES Act. The following are not relevant entities:

• investment funds, including vehicles through which an investment fund invests;
• an entity that is tax resident outside the Cayman Islands; and
• a domestic company or local partnership, as defined in the ES Act.

The investment fund exclusion is relevant to most fund structures; the fund types concerned are described in our overview of Cayman investment fund structures. Fund managers, by contrast, need to consider whether they carry on fund management business, as noted in our guide to setting up a Cayman fund management company.

All entities submit an annual economic substance notification (ESN) to the Registrar of Companies through an online portal. A relevant entity that carries on a relevant activity must also meet the economic substance test and submit an economic substance report to the Authority.

What are the relevant activities?

A relevant entity must satisfy the economic substance test (ES test) if it carries on any of the following relevant activities:

1. banking business;
2. distribution and service centre business;
3. financing and leasing business;
4. fund management business;
5. headquarters business;
6. holding company business;
7. insurance business;
8. intellectual property business; and
9. shipping business.

The scope of each activity is defined in the ES Act. A relevant entity that carries on more than one relevant activity must meet an ES test for each activity.

The economic substance test

A relevant entity that carries on a relevant activity other than holding company business satisfies the ES test if:

• it conducts all core income-generating activities in relation to that activity in the Cayman Islands;
• it is directed and managed in an appropriate manner in the Cayman Islands in relation to that activity; and
• having regard to the level of relevant income derived from the activity carried out in the Cayman Islands, it has incurred adequate operating expenditure in the Cayman Islands, has adequate physical presence in the Cayman Islands (including a place of business, or plant, property and equipment), and has an adequate number of full-time employees or other appropriately qualified personnel in the Cayman Islands.

"Relevant income" is defined as all of the entity's gross income from its relevant activities, recorded in its books and records under applicable accounting standards.

The reduced test for holding company business

A relevant entity that carries on holding company business satisfies the ES test if:

• it has complied with all applicable filing requirements under the Companies Act (As Revised); and
• it has adequate human resources and adequate premises in the Cayman Islands for holding and managing equity participations in other entities.

The Companies Act filings in question are summarised in our article on Cayman company statutory filings.

Directed and managed in the Cayman Islands

A relevant entity required to satisfy the ES test for an activity other than holding company business must be directed and managed in an appropriate manner in the Cayman Islands in relation to that activity. The Guidance provides that this part of the test is met if:

• the board of directors has the appropriate knowledge and expertise to discharge its duties;
• board meetings are held in the Cayman Islands at adequate frequencies, given the level of decision-making the activity requires;
• those meetings are quorate;
• the minutes record the strategic decisions the entity takes; and
• the minutes and other appropriate records are kept in the Cayman Islands.

The number of board meetings held in the Cayman Islands must be included in the economic substance report. Bell Rock's board support and company secretary service covers hosting and minuting meetings in the Cayman Islands.

Core income-generating activities

Core income-generating activities (CIGA) are defined in the ES Act as activities of central importance to a relevant entity in generating income from its relevant activities, which must be carried on in the Cayman Islands. Other than for holding company business, a relevant entity must conduct CIGA to satisfy the ES test.

The ES Act gives examples of CIGA for each activity, but the nature of CIGA for any entity depends on how it conducts its business, and the Guidance confirms that the examples are neither exhaustive nor mandatory.

Banking business

• raising funds and managing risk, including credit, currency and interest risk;
• taking hedging positions;
• providing loans, credit or other financial services to customers; and
• managing capital and preparing reports or returns to investors or CIMA.

Distribution and service centre business

• transporting and storing goods, components and materials;
• managing stocks;
• taking orders; and
• providing consulting or other administrative services.

Financing and leasing business

• negotiating or agreeing funding terms;
• identifying and acquiring assets to be leased;
• setting the terms and duration of financing or leasing; and
• monitoring and revising financing or leasing agreements and managing the associated risks.

Fund management business

• taking decisions on the holding and selling of investments;
• calculating risk and reserves;
• taking decisions on currency or interest fluctuations and hedging positions; and
• preparing reports or returns to investors or CIMA.

Headquarters business

• taking relevant management decisions;
• incurring expenditure on behalf of group entities; and
• coordinating group activities.

Insurance business

• predicting or calculating risk, or overseeing that prediction or calculation;
• insuring or reinsuring against risk; and
• preparing reports or returns to investors or CIMA.

Intellectual property business

• where the asset is a patent or similar asset: research and development; and
• where the asset is a non-trade intangible, including a trade mark: branding, marketing and distribution.

In exceptional cases, and unless the relevant entity carries on high-risk intellectual property business, other CIGA relevant to the business and its intellectual property assets may include:

• taking strategic decisions and managing, as well as bearing, the principal risks related to the development and subsequent exploitation of the intangible asset generating income;
• taking 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; and
• carrying on the underlying trading activities through which the intangible assets are exploited, leading to income from third parties.

Shipping business

• managing crew, including hiring, paying and overseeing crew members;
• overhauling and maintaining ships;
• overseeing and tracking deliveries; and
• determining what goods to order and when to deliver them, and organising and overseeing voyages.

Premises, people and expenditure

Physical premises

For an activity other than holding company business, the relevant entity must have adequate physical presence in the Cayman Islands, including a place of business or plant, property and equipment, having regard to the relevant income from the activity. For holding company business, it must have adequate premises in the Cayman Islands for holding and managing equity participations in other entities.

Employees and staff

For an activity other than holding company business, the relevant entity must have an adequate number of full-time employees or other appropriately qualified personnel in the Cayman Islands, having regard to the relevant income from the activity. For holding company business, it must have adequate human resources in the Cayman Islands for holding and managing equity participations.

Expenditure

For an activity other than holding company business, the relevant entity must incur an adequate amount of operating expenditure in the Cayman Islands, having regard to the relevant income from the activity.

What "adequate" means

The Guidance clarifies that "adequate" means "as much or as good as necessary for the relevant requirement or purpose". What is adequate for each relevant entity depends on its activity and the particular facts of its business.

Outsourcing core income-generating activities

The ES Act expressly allows a relevant entity to outsource its CIGA to any person in the Cayman Islands, provided the entity can monitor and control that person so as to ensure that the CIGA is in fact carried out in the Cayman Islands. The ES Act does not restrict the outsourcing of activities that are not CIGA, such as payroll or human resources, to service providers outside the Cayman Islands.

For the ES test, the activities and resources of the service provider are taken into account, including for the people and premises elements. The service provider's employees can be treated as employees of the relevant entity, but only while they are providing services to it, and this must be evidenced by the relevant entity, for example through timesheets. The Authority also requires service providers to verify the outsourcing information within 30 days of the date on which the relevant entity submits its economic substance report.

Annual notification and reporting

Economic substance notification

All entities submit an ESN to the Registrar of Companies each year through an online portal. In the ESN, the entity states whether it carries on any relevant activity. If it does not, it must confirm whether it is an investment fund. If it does, it must identify the type of relevant activity and confirm whether it is a relevant entity. Further information is required depending on the answers given. Subject to any extension granted, the deadline for submitting the ESN is 31 March each year.

Economic substance report

A relevant entity carrying on a relevant activity prepares and submits an economic substance report for that activity through an online portal. Subject to any extension granted, the report must be filed with the Authority within 12 months of the end of the entity's financial year. Its contents are set out in section 7(4) of the ES Act and in the International Tax Co-operation (Economic Substance) Regulations (As Revised), and include:

• the type of relevant activity;
• the amount and type of relevant income;
• the amount and type of expenses and assets in respect of the relevant activity;
• the number of full-time employees or other appropriately qualified personnel responsible for the relevant activity;
• the name and address of any person other than the relevant entity conducting CIGA for it, and the CIGA conducted;
• for intellectual property business, a declaration of whether it is high-risk intellectual property business;
• details of any MNE Group, as defined in the Tax Information Authority (International Tax Compliance) (Country-By-Country Reporting) Regulations (As Revised), of which the relevant entity is a constituent entity;
• the jurisdiction of tax residence of the relevant entity's immediate parent, ultimate parent and ultimate beneficial owner; and
• a copy of the relevant entity's financial statements or books of account for the financial year.

Other annual reporting regimes, such as FATCA, run in parallel; see our article on Cayman FATCA reporting.

How the Authority assesses the ES test

The Authority has the power to determine whether a relevant entity has satisfied the applicable ES test. The Guidance explains that the assessment takes a principles-based approach. Specific requirements, for example employee numbers for a given level of relevant income, are not prescribed, because every business is treated as unique and the requirements depend on how the entity conducts its business.

In assessing whether an entity satisfies the ES test, the Authority considers a range of factors, including:

• the fluctuation of activities from year to year and its effect on what constitutes an adequate level of employees or personnel;
• the ability of directors to perform CIGA in addition to their fiduciary duties, and the potential for this to remove the need for full-time employees or outsourced work; and
• on request, normal business practices for a relevant activity that are permitted in other jurisdictions, subject to the Forum on Harmful Tax Practices' substantial activities requirements.

Penalties

Failure to submit an economic substance report when required attracts a penalty, together with a further penalty for each day the report is not filed. The amounts are set out in the ES Act, and the current position is published by the Department for International Tax Cooperation.

A relevant entity that fails to satisfy the ES test for a financial year is subject to a penalty. If it fails again in the financial year following the year in which the Authority gave notice of the initial failure, the ES Act provides for a substantially higher penalty.

Where Bell Rock fits

Bell Rock Group is licensed by CIMA as a company manager under the Companies Management Act (As Revised). From its office in the Cayman Islands it provides economic substance support on an outsourced basis: independent directors through named individuals, who act in their personal capacity, management and support personnel, compliance and regulatory support, physical office and meeting facilities, board meeting hosting, company secretarial services, registered office and coordination of the annual ESN and economic substance report. Each entity remains responsible for meeting the ES test.

Frequently asked questions

Do Cayman investment funds have to meet economic substance requirements?

No. Investment funds, including vehicles through which an investment fund invests, are not relevant entities. They still submit the annual ESN, confirming their investment fund status.

What is the reduced test for a Cayman holding company?

A pure holding company satisfies the ES test if it has complied with its Companies Act filing requirements and has adequate human resources and premises in the Cayman Islands for holding and managing its equity participations.

Can a Cayman entity outsource its core income-generating activities?

Yes, to a person in the Cayman Islands, provided the entity can monitor and control that person and evidence the time spent on its behalf.

When is the economic substance report due?

Within 12 months of the end of the relevant entity's financial year, subject to any extension granted.

What happens if a relevant entity fails the ES test?

It is subject to a penalty, and a substantially higher penalty applies if it fails again in the following financial year after notice of the first failure.

Related reading

• Ongoing obligations for Cayman exempted companies
• Cayman family office structuring
• Cayman Enterprise City and SEZ companies
• Cayman AML obligations for relevant financial business
• Cayman Economic Substance: What Entities Must File and Maintain
• How to Demonstrate Economic Substance in the Cayman Islands

For classification, substance arrangements and annual filings, see Bell Rock's economic substance service.