top of page

Economic Substance in Cayman


Introduction

The Cayman Islands Economic Substance Rules represent a significant regulatory framework implemented by the Cayman Islands Government in response to the Organisation for Economic Co-operation and Development’s (OECD) Base Erosion and Profit Shifting (BEPS) Action 5 initiative. These rules, which form part of the jurisdiction’s commitment to international tax cooperation standards, aim to ensure that entities conducting certain business activities in the Cayman Islands demonstrate adequate economic substance in relation to those activities.


The “Economic Substance Rules” require certain entities incorporated or registered in the Cayman Islands to maintain appropriate levels of economic substance in relation to their “relevant” income-generating activities. These requirements were developed to address concerns about profits being artificially shifted to jurisdictions with low or no tax rates, without corresponding economic activity taking place in those jurisdictions.


As a leading international financial center, the Cayman Islands’ implementation of these rules demonstrates its commitment to maintaining the highest standards of international tax cooperation while preserving its attractive business environment. The rules apply to fiscal years beginning on or after January 1, 2019, requiring affected entities to assess their obligations and ensure compliance with the new regulatory framework.


Legal Framework


The International Tax Co-operation (Economic Substance) Act (the “Act”) provides the primary legislative framework for economic substance requirements in the Cayman Islands. The Act came into force on January 1, 2019, establishing mandatory economic substance requirements for relevant entities carrying on relevant activities. On June 30, 2021, significant amendments to the Act were implemented to enhance alignment with international standards and provide additional clarity on compliance requirements.


The Act operates in conjunction with accompanying regulations and guidance notes issued by the Cayman Islands Tax Information Authority. These supporting materials provide detailed interpretation of the Act’s requirements and practical guidance for implementation. The framework requires relevant entities to demonstrate adequate economic substance in the Cayman Islands through various prescribed tests and reporting obligations.

The legal framework places specific obligations on entities regarding their physical presence, management, and operational activities within the Cayman Islands. These requirements are designed to ensure that entities claiming tax residency in the Cayman Islands maintain a genuine economic connection to the jurisdiction, rather than existing as mere “letter box” companies.


"Relevant Entities"

Under the Economic Substance Rules, a “Relevant Entity” includes Cayman Islands companies, limited liability companies (LLCs), limited liability partnerships (LLPs), and foreign companies registered in the Cayman Islands.


The following entities are specifically excluded from the definition of a Relevant Entity:

  1. Investment funds, including entities through which investment funds directly or indirectly invest or operate;

  2. Entities that are tax resident outside the Cayman Islands (subject to providing satisfactory evidence of foreign tax residence);

  3. Domestic companies that are centrally managed and controlled in the Cayman Islands, carrying on business primarily in the Cayman Islands;

  4. Limited partnerships without separate legal personality.

Each Relevant Entity must determine whether it conducts any Relevant Activities and, if so, must satisfy the Economic Substance Test in relation to each such activity. This determination must be made on an annual basis as part of the entity’s compliance obligations under the Economic Substance Rules.


"Relevant Activities"


Under the Economic Substance Rules, a “Relevant Activity” means any of the following nine categories of business activities:


  1. Banking Business - Activities that require a banking license under the Banks and Trust Companies Act;


  2. Distribution and Service Center Business - Material procurement, storage, and distribution activities;

  3. Financing and Leasing Business - Providing credit facilities for consideration;

  4. Fund Management Business - Securities investment and portfolio management activities;

  5. Headquarters Business - Provision of senior management, strategic or operational control;

  6. Holding Company Business - Pure equity holding activities;

  7. Insurance Business - Activities requiring a license under the Insurance Act;

  8. Intellectual Property Business - Exploitation of intellectual property assets; and

  9. Shipping Business - Operation of ships in international traffic.

Any Relevant Entity conducting one or more of these Relevant Activities must satisfy the Economic Substance Test in relation to each such activity. The determination of whether an entity is conducting a Relevant Activity is based on the actual activities being performed, regardless of any licensing or registration status. Entities must carefully assess their business activities against these categories to determine their obligations under the Economic Substance Rules.

 

5. Economic Substance Test

The Economic Substance Test requires that all “Relevant Entities” conducting “Relevant Activities” must satisfy three key criteria to demonstrate adequate economic substance in the Cayman Islands:


  1. First, entities must conduct their “Core Income Generating Activities” (“CIGA”) within the Cayman Islands. CIGA refers to the essential and commercially significant activities that generate the entity’s relevant income. These activities must be performed within the jurisdiction, though certain activities may be outsourced to local service providers under appropriate supervision.

  2. Second, entities must be directed and managed in an appropriate manner in the Cayman Islands. This requirement includes:

    1. holding regular board meetings in Cayman with adequate frequency given the level of decision-making required;

    2. ensuring that a quorum of directors is physically present in Cayman for such meetings;

    3. keeping meeting minutes documenting strategic decisions in Cayman; and

    4. maintaining all corporate records in Cayman.

  3. Third, entities must demonstrate adequate operating expenditure, physical presence, and qualified employees or other personnel in the Cayman Islands, proportionate to the level of relevant activity carried on in Cayman. The assessment of what constitutes “adequate” will depend on the nature and scale of the relevant activity but must be sufficient to effectively perform the CIGA.


Failure to meet any component of the Economic Substance Test may result in penalties and enforcement actions by the Tax Information Authority. Entities should maintain detailed documentation evidencing their compliance with these requirements.


Reporting Requirements

All entities registered in the Cayman Islands must comply with annual reporting obligations under the Economic Substance Rules. The reporting process consists of two main filings:


  1. The “Economic Substance Notification” (“ESN”) must be filed annually by all Cayman Islands registered entities, prior to filing their annual return. The ESN requires entities to confirm whether they are conducting relevant activities and whether they are claiming any exemptions from the economic substance requirements.

  2. The “Economic Substance Return” is required only for entities conducting relevant activities. This detailed return must be submitted within twelve months after the end of each financial year. The return requires entities to demonstrate how they meet the economic substance test, including detailed information about their Core Income Generating Activities, direction and management, operating expenditure, physical presence, and employees in the Cayman Islands.

All filings must be submitted through the Department for International Tax Cooperation’s online portal. Failure to file either the ESN or Economic Substance Return by the applicable deadline may result in penalties. The Tax Information Authority may request additional documentation or clarification to verify the information provided in these filings.


Virtual Asset Service Provider (VASP) Entities

Virtual Asset Service Providers ("VASPs") operating in the Cayman Islands are subject to economic substance requirements if they conduct any of the nine Relevant Activities. Simply being registered as a VASP does not automatically trigger economic substance obligations - the determining factor is whether the entity engages in relevant activities.

VASPs conducting Relevant Activities must comply with the same economic substance requirements as other entities, including maintaining adequate physical presence in the Cayman Islands, conducting Core Income Generating Activities in the jurisdiction, and demonstrating appropriate levels of operating expenditure and qualified employees based in the Cayman Islands. Additionally, they must file annual Economic Substance Notifications and, where applicable, Economic Substance Returns.


The Tax Information Authority ("TIA") provides specific guidance for VASPs regarding how to assess whether their activities fall within scope of the economic substance requirements. VASPs are advised to carefully evaluate their business activities and seek professional advice to determine their obligations under the economic substance regime.


Enforcement and Penalties

The TIA is the designated authority responsible for monitoring and enforcing compliance with the Economic Substance Rules in the Cayman Islands. The TIA has broad powers to determine whether a Relevant Entity has satisfied the economic substance test and to impose penalties for non-compliance.


The TIA may impose penalties in the following circumstances:

  1. For failure to satisfy the economic substance test, penalties include CI$10,000 in the first year of non-compliance, increasing to CI$100,000 in subsequent years. For failure to provide required information or for providing inaccurate information, the TIA may impose a penalty of CI$10,000, with an additional penalty of CI$1,000 for each day the failure continues.

  2. The TIA also has the authority to exchange information on non-compliant entities with tax authorities in the relevant jurisdictions where the entity’s immediate parent, ultimate parent, and ultimate beneficial owners are located. In cases of continued non-compliance, the TIA may apply to the Grand Court for an order requiring the entity to take action to satisfy the economic substance test or face potential strike-off from the Cayman Islands register.


Entities have the right to appeal against any determination or penalty imposed by the TIA within 30 days of receiving notice of such determination or penalty.


NXT Steps

Compliance with the economic substance requirements is essential for entities operating in the Cayman Islands. Entities conducting business in the Cayman Islands should be very careful to consider whether they are a Relevant Entity and whether any new business processes or products will cause them to engage in Relevant Activity to ensure they meet all economic substance requirements applicable to their activities.


bottom of page