CAYMAN ISLANDS: Responding to the Global Push to Regulate Offshore.

As published on caymancompass.com, Sunday November 3, 2019.


The Cayman Islands is caught in a maelstrom of international regulatory activity. The flurry of new laws and legislative amendments coming out of the Ministry of Financial Services can at times give the impression that government is being pulled into every conceivable direction by international standard setters.

Economic substance, beneficial ownership registers, harmful tax practices, anti-money laundering, the financing of terrorism and the proliferation of nuclear weapons, anti-corruption and tax information exchange, both automatic and on request, are only some of the buzzwords connected to an alphabet soup of international organisations, forums and initiatives.

It is difficult to untangle the various demands made of international financial centres like Cayman by the European Union, the G-20, the Organisation for Economic Co-operation and Development (OECD) or the Financial Action Task Force (FATF), as well as individual countries like the US or the UK.

Alex Cobham, chief executive of campaign group Tax Justice Network, recently described the developments as “potentially existential” for Cayman’s financial services industry. In an article in the New York Times in October, he was quoted as saying: “I think it does start to look like it could be a perfect storm for Cayman.”

Ask Dax Basdeo, the chief officer in the Ministry of Financial Services, what is government’s priority for responding to international regulatory demands and he replies: “All of it.”

So far this year, the ministry has released about two dozen draft bills and legal amendments, following an equally busy 2018. It is the part of government that generates by far the most legislation.

This pace of draft bills and legal amendments will continue unabated through the end of this year, Basdeo says.

Most laws and amendments passed by the Legislative Assembly this year relate to anti-money laundering and the countering of terrorism financing.

The Caribbean Financial Action Task Force found gaps in Cayman’s AML/CTF regime, according to its analysis released in March, based on an evaluation conducted in December 2017. The CFATF is a regional affiliate of FATF, the global standard-setting body in the anti-money laundering sphere.

The CFATF determined that, at the time of its evaluation, Cayman needed to develop a better understanding of all its anti-money laundering and terrorist financing risks.

Businesses that carry out certain financial activities had to implement more robust countermeasures. The task force called for non-financial businesses and professions like accountants, lawyers, jewellers, realtors and property developers to face stricter rules and supervision.

And public sector bodies, including the Royal Cayman Islands Police Service, Customs and Border Control, the Financial Reporting Authority and the Cayman Islands Monetary Authority, had to make amendments to their processes and procedures to ensure better coordination and cooperation, in response to the CFATF recommendations.

Basdeo says his ministry has finished most of the heavy lifting on the issue, with only two or three technical matters left to be resolved. The emphasis is shifting now to implementing changes at the relevant authorities.

All this must happen quickly because Cayman was given only 12 months, until February 2020, to respond to the evaluation. Failure to take the correct measures and adapt its laws, regulations and practices is not really an option as it could see Cayman blacklisted, with the FATF imposing a remediation plan – a situation that would hamper most financial transactions involving the jurisdiction.

For many businesses, the changes mean an additional burden and sometimes costs. Cayman funds, for instance, now need to have dedicated anti-money laundering compliance and reporting officers. And exempted persons, such as investment managers who act solely on behalf of a handful of sophisticated investors, are subject to a different registration arrangement, with a more stringent anti-money laundering regime.

With all the legal amendments and new requirements, questions about overregulation are sometimes raised by the private sector. But Basdeo says there is a real issue. “Gone are the days where we have 100,000 companies and we don’t know what is going on.”

Not only did government not know enough, the private sector did not know either, he says.

The level of regulation was the price to pay for not having an income tax system. The right balance must be struck, Basdeo adds, but that was the reason why there is so much industry consultation and why Cayman follows a risk-based approach, which simply means that the regulatory scrutiny increases with the level of risk.

Traditionally, the dominant topic in connection with international financial centres has been transparency around tax issues.

Since the OECD released its first study of harmful tax competition in 1998, it has aimed to identify and eliminate harmful preferential tax regimes in OECD-member countries and get ‘tax havens’ to commit to tax transparency and the exchange of tax information.

Leaders from the G-20 largest economies referenced the OECD’s work when they released a tax transparency blacklist in 2009 that included Cayman and forced the jurisdiction to ultimately sign three dozen tax information exchange agreements. These bilateral agreements formed the basis for the cross-border exchange of tax information on request through regulated channels in narrowly defined circumstances.

Then, in 2013, the US Foreign Account Tax Compliance Act (FATCA), came into force, which dictated that foreign financial institutions globally must identify the account holdings of US citizens to the US Internal Revenue Service. Institutions that do not report the information face a 30% withholding tax on certain transactions involving the US.

The initiative showed for the first time that tax information exchange could be automatic, rather than be limited to isolated cases. In 2014, the OECD approved its Common Reporting Standard (CRS) and the signing, by almost 100 jurisdictions, of the Multilateral Competent Authority Agreement that connects the CRS to the Multilateral Convention on Mutual Economic Assistance in Tax Matters.

As a result, taxpayers who maintain bank accounts abroad have to provide information on where they are tax resident to their banks and other financial services providers, so that these can report regularly and automatically financial details to the tax authorities in their clients’ home countries.

This ensures that tax authorities have a broader view of their taxpayers’ assets, significantly limiting the ability to evade tax by not declaring income earned or assets held abroad.

Arrangements to provide tax information to authorities overseas have become part of Cayman’s framework for international cooperation. Cayman had to introduce legislation and establish portals for the exchange of tax information. It is also a member of the OECD’s Global Forum on Transparency and Exchange of Information for Tax Purposes, and Cayman’s tax-exchange regime has been subject to international reviews.

Basdeo notes that about five years ago, government started to seek a different form of engagement with standard setters that involved dropping the hitherto defensive mindset and taking a confident stance on the international stage through participation in the relevant bodies, mainly on tax issues with the OECD.

“After two or three years, we could see just how much it had changed, because we engage through the OECD Forum [and] because we have built stronger relationships,” Basdeo says.

“We know what we stand for, we know what we are doing, and we add to an intelligent conversation. It has had an impact.”

The biggest challenge is that Cayman’s economic model is not well understood by foreign lawmakers who have a difficult time accepting that offshore financial centres can add value.

“A large part of the conversation when we are discussing these issues internationally is trying to explain why the things we do are the way they are and why it is beneficial,” Basdeo adds.

The lack of visibility of who the real owners of offshore businesses are also has been a persistent criticism of financial centres like Cayman. While offshore centres defended the status quo with references to privacy rights, campaign groups and onshore legislators used it to label them ‘secrecy jurisdictions’.

Identifying companies’ beneficial owners is a requirement of the FATF anti-money laundering standards, albeit one of the most poorly implemented ones.

In the wake of the Panama Papers, the UK pushed hard for making public the owners of companies in its overseas territories and Crown dependencies. The territories to agreed a mechanism to give law enforcement and tax authorities in the UK access to this information, and Cayman created a centralised register.

But UK lawmakers ignored both the agreements and the sovereignty of the overseas territories over devolved matters by inserting a clause last year into the UK Sanctions and Anti-Money Laundering Act, which called for public beneficial ownership registers in the UK’s territories.

The move strained relations between Cayman and the UK. Government and industry defended their existing regime of service providers ensuring that beneficial ownership information is collected and verified. They argued they would make beneficial ownership public only if it were to become a public standard.

In a surprise announcement last month, Premier Alden McLaughlin said that time had arrived, and Cayman would set up a public register of company owners as soon as European Union countries establish their own public registers. Corresponding legislation is expected in 2022.

With global tax transparency becoming the norm, the attention of governments and standard-setting bodies like the OECD has moved on to other measures that have historically reduced tax revenues raised around the world. Namely: tax avoidance by multinational corporations.

The OECD, with support from the G20, started a project to deal with the erosion of tax bases and the ability of multinationals to shift profits to low- or no-tax jurisdictions to reduce their tax bill.

The Base erosion and profit shifting (BEPS) initiative targets tax planning techniques that exploit gaps and mismatches in national tax rules to make profits ‘disappear’ for tax purposes or to shift profits to locations where there is little or no real activity but taxes are low, so that little or no corporate tax is paid.

In contrast to tax evasion, these tax avoidance techniques are technically not illegal, but violate the spirit of the law by exploiting loopholes in the interaction between national tax systems or by artificially separating taxable income from the activities that generate it.

The BEPS initiative covers 15 action points. For the time being, country-by-country reporting, which provides a template for multinationals to report annually for each tax jurisdiction they do business in, is one of the few standards that concerned this jurisdiction.

The country-by-country reporting measure addresses the lack of corporate tax data that makes it difficult for tax authorities to determine the extent of tax avoidance and correctly price transactions between entities that form part of a group.

Again, Cayman had to pass the underlying legislation and develop a mechanism for reporting.

In 2016, the EU combined a number of initiatives for its list of uncooperative countries in tax matters, aiming to replace its member states’ national tax blacklists with a unified EU-wide approach. EU members agreed that non-EU countries would be assessed by the EU’s Code of Conduct Group on Business Taxation.

In December 2017, the EU published its first blacklist based on criteria around tax transparency, tax fairness and anti-BEPS measures.

Cayman was not included on the list, because it had no issues meeting the tax-transparency criteria and BEPS standards. However, Cayman fell afoul of the hitherto unknown tax-fairness criterion, aimed at tax regimes that facilitate offshore structures which attract profits without real economic activity.

In response, Cayman had to implement economic substance legislation by the end of 2018, to avoid being blacklisted at a later stage.

Because the EU did not specify what exactly Cayman should do until June 2018, legislators had to rush through new economic substance legislation before the end of 2018.

The EU ultimately based its requirements for ‘tax fairness’ on the work of the OECD Forum on Harmful Tax Practices, which seeks to eliminate harmful preferential tax regimes. These are regimes that apply tax incentives or concessions to taxpayers who are engaged in operations that are purely tax-driven and involve no substantial activity.

Even though Cayman’s tax regime does not fulfil the OECD definition of ‘preferential’, because the same income tax rate of zero is applied universally, the OECD, in May 2018, began to apply the economic substance rules designed under BEPS Action 5 to tackle ‘harmful preferential tax regimes’ to all zero- or low-tax countries.

The EU seized on this to tell Cayman to use the rules as a template for its own economic substance legislation.

The economic substance law today requires companies and limited liability partnerships, which are registered and managed locally and generate income in one of nine defined activities, to demonstrate that they have enough economic activity on island to justify the profits they make.

To ensure that profits are taxed where they are generated and economic activity is taking place, the legislation imposes a substance test on banking, insurance, fund management and shipping companies, as well as entities functioning as headquarters or distribution and service centres, and businesses engaged in financing and leasing or holding intellectual property.

Resident companies that generate core income in these fields must pass an economic substance test.

They will pass if they conduct core income-generating activities on island; incur an adequate amount of operating expenditure in Cayman; have a physical presence locally; and have an adequate number of full-time staff. In addition, the company must be directed and managed from Cayman with regular board meetings held and minutes of strategic decisions kept on island.

How many Cayman companies fall under the new rules will become clearer before the end of this year as they will have to file declarations specifying if they conduct relevant operations in Cayman.

So far, Cayman’s economic substance rules have passed muster.

The OECD Forum on Harmful Tax Practices determined Cayman’s tax regime was “not harmful” after a review in June.

The EU also accepted that Cayman’s legislative changes fulfilled the commitment to fair taxation. But it expressed concerns related to economic substance in the area of collective investment vehicles which Cayman should address before the end of this year.

The technical guidance on what those concerns are and what the EU expects from Cayman arrived once again late – in May.

It stated that the EU Code of Conduct Group will scrutinise the legislation for funds in Cayman against four pillars: the authorisation and registration of funds; supervision and enforcement; valuation, accounting and auditing of funds; and depositary rules.

In response, government in October circulated draft bills for consultation in the financial services industry that would require non-mutual funds to be authorised by the Cayman Islands Monetary Authority. As part of the authorisation process, investment funds would have to provide CIMA with basic information about the nature of the fund and the types of assets it will invest in.

The legislation will also prescribe requirements for annual audited accounts, custody arrangements, valuation procedures and fund administration.

The bills will be redrafted based on the industry feedback received before the end of this year.

For Minister of Financial Services Tara Rivers, international scrutiny and ongoing tests to see if Cayman complies with a set of evolving rules is part and parcel of operating as an offshore finance centre.

Cooperation was also central to Cayman’s absence from the EU blacklist.

“The government recognises that we, like all international financial centres, will be assessed for compliance with financial services regulatory standards. We also recognise that those regulatory standards are not static,” she says.

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