The Cayman Islands’ new Economic Substance Law, which targets multinational using strategically placed subsidies to lessen taxation, is impacting Hong Kong hedge funds, according to lawyers the legislation, which came into force in this year after concerns were expressed by the European Union, targets large companies that move their IP to subsidiaries located in low-tax jurisdictions.
The new law will affect various business entities differently depending on registration, activities and structure. Hong Kong hedge funds specifically have become tangled up in the new law as a result of using Cayman investment managers, which tend to be less popular with European fund managers.
“Most offshore funds utilised in Asia are registered in the Cayman Islands,” says Fiona Chan, a Hong Kong-based partner at Appleby. “As a result, the Cayman ES legislation is attracting much interest and queries from the funds industry.”
And while the law wasn’t created to target hedge funds specifically, Caymans investment managers that work with Hong Kong clients will have to be careful moving forward. “In short, the new ES legislation will impact on the fund industry in Hong Kong to the extent any offshore entities are utilised. All relevant entities will need to undertake internal review to analyse whether compliance with ES requirements is applicable and how they would demonstrate substance in Cayman,” Chan says.
Marc Parrott, partner, and Mirza Manraj, counsel at Harneys’ Hong Kong office, say that lawyers will need to work with clients to determine the classification of companies or other vehicles incorporated or registered in the Cayman Islands.
“It is necessary to identify each relevant entity, and to determine whether such entity is conducting a relevant activity, whether the relevant entity is tax resident overseas and/or what steps the relevant entity needs to take to meet the economic substance test, if applicable. Legal analysis will very likely be required by relevant entities to clarify these questions and they should contact their Cayman Islands legal counsel for the appropriate advice,” they explain.
TIMELINE IMPORTANT
Additionally, Parrott and Manraj add that careful consideration should also be given to the reporting cycle, noting that relevant entities that existed before Jan. 1 this year, and that were carrying on relevant activities on that date must comply with the economic substance test from July 1.
They break down the timeline further: “Relevant entities established after 1 January 2019 must comply with the requirements from the date on which they start carrying on the relevant activity. From January 2020, all entities registered or formed in the Cayman Islands will be required to include a statement in the annual return that is filed by their registered office service provider as to whether they are carrying on relevant activity. As such, entities must get classified with the help of their Cayman Islands legal counsel in order for them to know whether they are in scope or out of scope of the economic substance regime and assuming they are in scope, whether they need to report to the local competent authority,” they note.
While Parrott and Manraj make the distinction that investment funds “are neither relevant entities nor carrying on relevant activity. Accordingly, there is unlikely to be any impact on hedge funds themselves”, they note that “Hong Kong hedge fund managers that have interposed a Cayman Islands management company between their Cayman Islands domiciled fund and their SFC-licensed Hong Kong management company will need to consider whether they wish to keep that Cayman Islands management company in the structure.”
“If so, there might be options to restructure that management company in certain ways to minimize the impact of the economic substance regime. As such, it is very important that entities obtain appropriate advice from Cayman Islands legal counsel with specific expertise in investment fund structuring,” they add.
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