Cayman Web3 Digital Fund Topic: Comparison of Tax Risk Analysis that is Easy to Overlook

**Depth | Author | TaxDAO&**Precision Fund Services

As a world-renowned offshore financial center, the Cayman Islands is also the world’s largest offshore fund establishment, with more than 85% of offshore funds registered in the Cayman Islands. At the same time, Cayman provides a very favorable tax policy, the fund does not need to pay income tax, capital gains tax, dividend tax, etc. in the Cayman Islands, and it has also signed tax information exchange agreements with the United Kingdom, the United States, Australia and other countries. According to the Cayman Islands Monetary Authority (CIMA), at the end of 2020, there were 26,351 regulated open-end funds and 9,857 regulated closed-end funds in the Cayman Islands, with total assets of more than US$2 trillion. There are countless exempt funds set up in Cayman.

Registering funds in Cayman has become an important way to invest across borders, and setting up private equity funds to invest in digital assets is gradually favored by Web3 investors. This article mainly introduces the three types of structures for setting up offshore funds for investment in Cayman, and analyzes the tax risks designed under the LP (Limited Partnership) structure.

1 Three Typical Organizational Forms of a Cayman Fund

There are several types of funds that are exempt from Cayman regulation: Exempted Company (EC) and Exempted Limited Partnership (ELP). In this paper, we first select three typical fund structures for analysis.

1.1 Stand-Alone Fund Structure

There are two entities in a single fund, where the fund entity is usually set up in the form of an exempted limited partnership, and the investment team subscribes for the participating shares of the fund (with the right to dividends, but not the right to vote). At the same time, the investment team establishes a fund management company in the British Virgin Islands (BVI) as the managing shareholder of the fund (does not participate in dividends, but has the right to vote at shareholders’ meetings), and the rights of the day-to-day decision-making and operation of the fund are vested in the board of directors of the fund, which is served by the investment team.

1.2 Segregated Portfolio Company (SPC) Structure

Segregated Portfolio Company (SPC) is a special case in the EC structure and a unique form of Caymanian law. In the SPC structure, the SPC, as an exempted entity, can set up up up to 25 Segregated Portfolios (SPs), and the assets and liabilities of these portfolios are completely independent. Operating multiple different funds under an SPC is similar to setting up multiple individual funds, so SPCs are more cost-effective in terms of cost. The following figure shows the SPC architecture.

1.3 Exempted Limited Partnership (ELP) Structure

The ELP structure is mainly divided into three steps, one of which is that the investor first establishes a GP (general partner) company in Cayman/BVI as the general partner of the ELP. The second is to set up an ELP fund entity with individual investors, the GP company established in the first step, and the investment entity SLP (limited partners) controlled by the GP team. The ELP then sets up an SPV (Special Purpose Entity) to carry out investment business. Among them, the GP has the management and control over the affairs of the ELP fund, and is responsible for the operation, management, control and conduct of the fund business of the ELP fund.

SPV under a fund entity refers to a subsidiary or sub-partnership established by a fund entity to invest in a certain project, usually in the form of an ELP, with the fund entity acting as a general partner or limited partner, and the project party acting as a limited partner or general partner. The ELP architecture can bring the following benefits:

• Take advantage of the Cayman Islands’ preferential tax policies to avoid double taxation and exchange controls.
• According to the characteristics and needs of different projects, flexibly design the investment strategy, income distribution, exit mechanism, etc. of the SPV, and protect the interests of investors and project parties.
• Like SPC, ELP can also account for the risks and benefits of different projects separately to avoid mutual influences and improve transparency and efficiency.

2 Selection of SPV locations under ELP architecture

Under the ELP structure, the fund entity achieves investment in downstream enterprises through the SPV, and the SPV can be independently liquidated to protect the rights and interests of shareholders and achieve risk isolation. In practice, SPVs generally choose to be located in Hong Kong or Singapore, which is not only convenient for carrying out financial activities, but also allows them to obtain low tax rates in both places. This article analyzes the impact of four factors: interest, dividends, property gains and stamp duty on the choice of SPV location, as shown in the table below.

It can be seen that in terms of dividends and stamp duty, Singapore has more cost advantages than Hong Kong as an SPV location: Singapore SPVs have more relaxed dividend tax deductions, and their stamp duty regulations are more concise and low-cost. However, transaction costs are only one of the aspects to consider in the landing of SPVs, and the specific landing options will be judged separately according to different industries, structures and corresponding policies of the two places.

3 Three Aspects of ELP Structure Investment and Tax Risk Analysis

3.1 Taxation of Investment

The investment process is mainly divided into three steps: building an overseas structure, setting up a domestic asset management company and a wholly foreign-owned enterprise (WOFE), and acquiring a project company. There are fewer tax issues involved in this session.

Setting up an overseas structure can be broadly divided into the following two options: the first is a simplified Cayman structure, i.e., setting up a holding company in the Cayman Islands, and then investing in an offshore or onshore project company or special purpose entity through the company, and the second is a BVI/Cayman-Cayman structure, i.e., setting up a holding company in the Cayman Islands and setting up a sub-holding company in the British Virgin Islands (BVI) or Cayman, and then investing in an offshore or onshore project company or special purpose entity through the sub-holding company.

The advantages of scheme 1 are simple structure, low cost and convenient management. It is only necessary to register and maintain one holding company in Cayman, and there is no need to register and maintain another holding company in the BVI, while also enjoying the tax benefits of Cayman. However, its disadvantages are higher risk, less confidentiality, and less flexibility. If a Cayman holding company invests directly in a project in another country, it may be restricted or regulated by the laws of another country. If a Cayman holding company goes public, it may expose information about its investors and investment projects. If the Cayman holding company needs to change its investment strategy or exit the project, there are also corresponding additional costs.

The advantages of option 2 are lower risk, better confidentiality and higher flexibility. By setting up a subsidiary holding company in the BVI or Cayman, the risk between the Cayman holding company and the investment project can be isolated, and this structure also provides a high level of confidentiality without the need to disclose information about its directors, shareholders, beneficial owners, etc. By setting up a sub-holding company in the BVI, the SPV can flexibly design the investment strategy, income distribution, exit mechanism, etc., according to the characteristics and needs of different projects, and protect the interests of investors and project parties. Its disadvantages are complex structure, high cost, and troublesome management. The need to register and maintain two holding companies in two regions increases compliance risks and management difficulties.

3.2 Taxation of production and operation

Production and operation are the direct source of profits and the main channel for controlling tax risks. Overall, Hong Kong’s tax policy is more concise and the tax burden on businesses is lower. Singapore has a higher tax rate on certain tax-related items, such as bank interest income and cross-border interest payments. The tax regulations of Hong Kong and Singapore for different tax-related items are shown in the table below.

3.3 Taxation of capital exit

In terms of capital exit, Option 1 and Option 2 face different tax issues. Overall, there is not much difference in taxation between the two exit options, except that option 2 has an additional layer of BVI sub-holding company, but this does not have much impact on taxation.

As shown in the table below, there are no taxes to be paid in the Cayman Islands, either for the disposal of a holding company or a special purpose vehicle. In the case of investment exit in Hong Kong, only the disposal of the listed Cayman holding company and SPV is subject to stamp duty, and the proportion is relatively low, with the buyer and seller each bearing 0.1%. Other types of disposal are not subject to taxes. When exiting an investment in Singapore, only the disposal of the SPV is subject to stamp duty, which is 0.2% for the buyer. Other types of disposal are not subject to taxes.

4 Risk Development and Discussion of Cayman Funds

4.1 Risk of separation of the location of the actual management institution from the place of registration

The actual management institution of an offshore fund is often set up in Hong Kong or Singapore, and the location of the management institution is inconsistent with the place of registration, resulting in corresponding tax risks. Considering that the Cayman Islands has not signed DTA agreements with Hong Kong and Singapore, the actual tax situation will be more complicated.

The main tax risk of a Cayman offshore fund is that it may be deemed to be a tax resident or have tax source income in the place where it is actually managed, and therefore be subject to income tax or other taxes in the jurisdiction. The risk treatment mainly depends on the tax laws and regulations of the location of the actual management agency, and different regions may adopt different judgment standards and taxation principles. Therefore, when choosing the location of the actual management institution, the offshore fund should fully understand and compare the tax laws and regulations of these regions, so as to choose the most favorable region, or take corresponding measures to avoid or reduce tax risks.

Singapore’s tax laws stipulate that whether a company is a tax resident in Singapore or not depends mainly on whether the company is controlled and managed in Singapore. Control and management here refers to the location of the highest decision-making level of the company, usually the place where the board of directors of the company meets. Therefore, if the de facto management of a Cayman offshore fund is in Singapore, then it may be deemed to be controlled and managed in Singapore, thus becoming a tax resident in Singapore. Tax residents of Singapore are required to pay global income tax in Singapore at a rate of 17%.

Hong Kong’s tax law stipulates that whether a company is required to pay profits tax in Hong Kong mainly depends on whether the company’s profits are derived from trade, business or business in Hong Kong, i.e. whether the company’s profits are substantially connected with Hong Kong. Therefore, if the actual management institution of an offshore fund is located in Hong Kong, its investment income may also be deemed to be “Hong Kong-sourced” and therefore subject to profits tax in Hong Kong (the tax rate is 16.5%).

In addition to tax risks, regulatory risks and legal risks are also issues that need to be paid attention to in the investment process. First, if the financial regulatory authorities in Hong Kong or Singapore determine that an offshore fund is engaged in financial services activities there, the fund entity may be required to comply with regional financial regulatory regulations, including but not limited to obtaining appropriate licenses, disclosing relevant information, and being subject to inspections by regulatory authorities. Second, the de facto authority needs to comply with the relevant legal provisions locally, and may also respond to litigation or arbitration within the local legal framework, which needs to deal with jurisdictional and applicable law issues.

4.2 Risks to Fund Investments under the Cayman Economic Substance Act

The Cayman Economic Substance Act is a law enacted by the Cayman Government in December 2018 and entered into force in January 2019 in response to the OECD’s requirements for tax transparency and fair competition, in particular in response to the OECD’s international standards to combat base erosion and profit shifting from geographically highly mobile activities. The Act requires Relevant Entities incorporated in Cayman to pass the appropriate Economic Substance test in relation to their Relevant Activities or risk being fined or even deregistered, and the local tax authorities may exchange information about such entities with the tax authorities in the jurisdiction where the ultimate beneficial owner is located.

This article summarizes the relevant requirements of the Economic Substance Act for different entities and the risk points in practice, as shown in the following table. Among the four types of investment entities, overseas asset management companies, general partner funds and funds are not subject to the economic substance requirement, but there are corresponding risk operations that may be subject to the economic substance requirement. A Cayman holding company, on the other hand, is subject to the (reduced) economic substance requirement and is only required to have sufficient personnel and office space in Cayman to hold and manage other entities, and can satisfy the above economic substance requirements through its registered agent. The “economic substance risk point” in the table refers to the fact that after performing certain operations, the entity changes from being exempt from the economic substance requirement to being subject to the economic substance requirement, or is not entitled to the reduced economic substance test treatment. Therefore, investors should pay close attention to such risk points during the investment process and consult professionals if necessary.

4.3 Discussion and outlook

The Cayman Economic Substance Act is a legal risk that cannot be ignored for investors and managers setting up funds in Cayman. Failure to comply with the economic substance requirements may affect the fund’s tax status, impose additional disclosure obligations, or even lead to the deregistration of the fund. Therefore, investors and managers need to choose and design the structure and operation of the fund reasonably according to their own specific circumstances. At the same time, it is also necessary to pay close attention to the further interpretation and implementation of the Economic Substance Act by the Cayman government and tax authorities, and adjust and optimize their fund strategies in a timely manner.

While setting up a fund in Cayman to invest in digital assets has corresponding potential and prospects, it also faces many challenges and risks. Therefore, investors and managers need to fully understand the characteristics and laws of digital assets, and reasonably allocate and manage their digital asset portfolios in order to achieve long-term and stable investment returns.

This article only analyzes and compares the three structures for setting up a fund in Cayman to invest in digital assets from a tax perspective. In practice, investors and managers also need to choose the most suitable fund structure according to their specific goals and needs, taking into account various factors.

References

[1] ZHANG Zhijin, WANG Weiwei, JIANG Jiahong. (2023). Introduction to Typical Fund Structures and Digital Asset Funds.