Hong Kong hedge funds have found themselves in the crosshairs of the new laws introduced in the Cayman Islands targeting companies firms that shift their intellectual property to subsidiaries in low or zero-tax jurisdictions to lower liabilities, Bloomberg reported.
The Economic Substance Law, effective 1 January 2019, requires firms involved in a range of activities including funds management, banking, finance and leasing, to maintain a level of operational substance that is effectively commensurate with their income-generating activities. Similar laws were also introduced in other offshore jurisdictions like the British Virgin Islands and Bermuda.
The Cayman Economic Substance rule was not designed to target hedge funds. But funds' Cayman investment managers are caught by it, and will have to comply.
It captures Hong Kong firms more than elsewhere "because offshore management companies have been used less by European managers in recent years," according to Paul Hale, the global head of tax affairs at London-based Alternative Investment Management Association.
Many Hong Kong hedge funds use Cayman investment managers (while the Hong Kong firms are designated ‘investment advisers') because it's easier to get regulatory approval to set up in the offshore center. Using a Cayman investment manager as an umbrella, they can also more easily add offices elsewhere, and it has tax advantages for certain investors.
Failure to comply to the new rules could result in a fine of around $12,000 for first offenders. That could increase 10-fold in subsequent years, according to Alice Molan, a Hong Kong-based partner with Cayman law firm Walkers, who spoke to Bloomberg.
To comply with the requirements, they either have to set up an office there or outsourcing their income-generating activities covered by the rules to service providers in the Cayman Islands.
Entities will have annual reporting obligations to the Cayman tax information authority in respect of their compliance to the new rules from 2020. According to KPMG, there are heavy penalties for failing to satisfy economic substance requirements - the fine starts at $10,000 in the first year, and goes up to $100,000 in subsequent years. Entities may also be struck off the Register of Companies.