Cayman Web3 Digital Fund Special Topic Comparing Easily Overlooked Tax Risks Analysis

Insights on Overlooked Tax Risks in the Digital Fund Industry A Comparative Analysis of Cayman Web3

Author: TaxDAO & Baishun Fund Services

As a globally renowned offshore financial center, the Cayman Islands is also the largest jurisdiction for offshore fund formation, with over 85% of offshore funds registered there. Additionally, the Cayman Islands offers highly favorable tax policies, with no income tax, capital gains tax, or dividend tax on funds registered there. Furthermore, it has signed tax information exchange agreements with countries like the UK, US, and Australia. According to data from the Cayman Islands Monetary Authority (CIMA), as of the end of 2020, there were a total of 26,351 regulated open-ended funds and 9,857 regulated closed-ended funds in the Cayman Islands, with total assets exceeding 20 trillion US dollars. The number of exempted and regulated funds established in the Cayman Islands is countless.

Setting up funds in the Cayman Islands has become an important means of international investment, and establishing private equity funds for digital asset investments is increasingly favored by Web3 investors. This article mainly introduces three typical structures for setting up offshore funds in the Cayman Islands for investment, and analyzes the tax risks associated with the Limited Partnership (LP) structure.

1 Three Typical Organizational Forms of Cayman Funds

Exempted ComLianGuainy (EC) and Exempted Limited LianGuairtnership (ELP) are the main organizational forms of exempted and regulated funds in the Cayman Islands. This article first selects three more typical fund structures for analysis.

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1.1 Stand-Alone Fund Structure

There are two entities in the stand-alone fund structure. The fund entity is usually established as an exempted limited partnership, and the investment team subscribes to participating shares of the fund (with dividend rights but no voting rights). At the same time, the investment team establishes a fund management company in the British Virgin Islands (BVI), acting as the management shareholder of the fund (without participating in dividends but with the right to vote at shareholder meetings). The rights of daily decision-making and operation of the fund are vested in the fund board of directors appointed by the investment team.

1.2 Segregated Portfolio ComLianGuainy (SPC) Structure

Segregated Portfolio ComLianGuainy (SPC) is a special case in the EC structure and a unique form under Cayman law. In the SPC structure, the SPC, as an exempted entity, can establish up to 25 segregated portfolios (SP), and the assets and liabilities between these portfolios are completely independent. Operating multiple different funds under the SPC has a similar effect to establishing multiple stand-alone funds, making it more cost-effective. The specific SPC structure is shown in the following diagram.

1.3 Exempted Limited LianGuairtnership (ELP) Structure

The ELP architecture can be divided into three steps. First, the investor establishes a GP (General Partner) company in the Cayman Islands/BVI as the general partner of ELP. Second, the investment entity SLP (Limited Partner) is formed by the individual investor, the GP company established in the first step, and the GP team. The SLP is majority controlled by these parties. The SLP entity then establishes an SPV (Special Purpose Vehicle) to conduct investment activities. The GP has management and control rights over the ELP fund and is responsible for its operations, management, control, and fund business.

The SPV under the fund entity refers to a subsidiary or joint venture established by the fund entity to invest in a specific project. It usually takes the form of an ELP, with the fund entity acting as the general or limited partner, and the project party as the limited partner or general partner. The ELP architecture offers the following benefits:

1. Takes advantage of the favorable tax policies in the Cayman Islands to avoid double taxation and foreign exchange controls.
2. Allows for flexible design of SPV investment strategies, profit distribution, and exit mechanisms based on the characteristics and needs of different projects, while protecting the interests of investors and project parties.
3. Similar to SPC (Segregated Portfolio Company), ELP allows for separate accounting of risks and returns for different projects, avoiding mutual interference and improving transparency and efficiency.

2. Choosing the Location of SPV in ELP Architecture

In the ELP architecture, the fund entity invests in downstream enterprises through SPV. SPV can be independently liquidated to safeguard shareholders’ rights and achieve risk isolation. In practice, the choice of SPV location generally falls on Hong Kong or Singapore, as it facilitates financial activities and offers low tax rate incentives in both places. This article analyzes the impact of four factors – interest, dividends, property income, and stamp duty – on the choice of SPV location, as shown in the table below.

As seen, Singapore has more cost advantages than Hong Kong in terms of dividends and stamp duty. The dividend tax exemption in Singapore is more generous, and its stamp duty regulations are simpler and lower-cost. However, transaction costs are just one aspect of the SPV location consideration. The specific location choice should also be made based on different industries, architectural considerations, and the corresponding policies in both places.

3. The Three Phases of Investment in ELP Architecture and Analysis of Tax Risks

3.1 Taxation in the Investment Phase

The investment phase mainly consists of three steps: building an overseas structure, establishing a domestic asset management company and a Wholly Foreign-Owned Enterprise (WOFE), and acquiring project companies. There are fewer tax issues involved in this phase.

Building an overseas structure can be roughly divided into two options: Option one is a simplified Cayman structure, where a holding company is established in the Cayman Islands, then investments are made in overseas or domestic project companies or special purpose vehicles through this company. Option two is the BVI/Cayman – Cayman structure, where a holding company is established in the Cayman Islands, a subsidiary holding company is set up in the British Virgin Islands (BVI) or Cayman, and then investments are made in overseas or domestic project companies or special purpose vehicles through the subsidiary holding company.

The advantage of Option 1 is its simple structure, low cost, and easy management. You only need to register and maintain a holding company in the Cayman Islands, without having to register and maintain another holding company in BVI. At the same time, you can also enjoy tax benefits in the Cayman Islands. However, its disadvantages are higher risks, poor confidentiality, and lower flexibility. If the Cayman holding company directly invests in projects in other countries, it may be subject to restrictions or regulations of the laws of those countries. If the Cayman holding company goes public, it may expose the information of its investors and investment projects. There are also additional costs involved if the Cayman holding company needs to change its investment strategy or exit projects.

The advantage of Option 2 is lower risks, better confidentiality, and higher flexibility. By setting up subsidiary holding companies in BVI or the Cayman Islands, you can isolate the risks between the Cayman holding company and the investment projects. This structure also provides higher confidentiality, as there is no need to disclose information about directors, shareholders, beneficial owners, etc. By setting up subsidiary holding companies in BVI, you can flexibly design the investment strategy, profit distribution, exit mechanism, etc. of SPVs according to the characteristics and needs of different projects, while protecting the interests of investors and project parties. The disadvantages are a more complex structure, higher costs, and more management troubles. You need to register and maintain two holding companies in two different regions, which increases compliance risks and management difficulties.

3.2 Taxation in the production and operation process

The production and operation process is the direct source of profits and the main channel to control tax risks. Generally speaking, Hong Kong’s tax policy is simpler and imposes a lower tax burden on businesses. Singapore has higher tax rates for certain tax-related items, such as bank interest income and cross-border interest payments. The tax regulations for different tax-related items in Hong Kong and Singapore are shown in the following table.

3.3 Taxation in the capital exit process

In the capital exit process, Option 1 and Option 2 face different tax issues. Generally, there is not much difference in tax between the two exit options, except that Option 2 has an additional layer of BVI subsidiary holding company, but this has little impact on taxation.

As shown in the table below, in the Cayman Islands, there is no need to pay any taxes or fees when disposing of the holding company or special purpose vehicle. When exiting investments in Hong Kong, only the disposal of the listed Cayman holding company and SPV is subject to stamp duty, and the rate is relatively low, with both the buyer and the seller bearing 0.1%. No taxes or fees need to be paid for other types of disposals. When exiting investments in Singapore, only the disposal of the SPV is subject to stamp duty, which is borne by the buyer at 0.2%. No taxes or fees need to be paid for other types of disposals.

4 Cayman Fund Risk Expansion and Discussion

4.1 Risk of Separation between the Actual Management Location and the Registration Location

Offshore funds often establish their actual management entities in Hong Kong or Singapore. Due to the inconsistency between the location of the management entity and the registration location, corresponding tax risks arise. Considering that the Cayman Islands, Hong Kong, and Singapore have not signed any DTA agreements, the actual tax situation will be even more complicated.

The main tax risk for Cayman offshore funds is that their actual management entities may be considered tax residents or have taxable income in the location where they are situated, thus requiring them to pay income tax or other taxes in that area. The handling of this risk mainly depends on the tax laws and regulations of the actual management location, and different regions may adopt different assessment criteria and tax principles. Therefore, when selecting the actual management location, offshore funds should fully understand and compare the tax laws and regulations of these regions in order to choose the most favorable one or take corresponding measures to avoid or reduce tax risks.

Under Singapore’s tax laws and regulations, whether a company is a tax resident of Singapore primarily depends on whether the company is controlled and managed in Singapore. The control and management refer to the location of the company’s highest decision-making level, usually the meeting place of the board of directors. Therefore, if the actual management entity of the Cayman offshore fund is in Singapore, it may be considered controlled and managed in Singapore, thereby becoming a tax resident of Singapore. Singaporean tax residents are required to pay global income tax in Singapore (tax rate is 17%).

Under Hong Kong’s tax laws and regulations, whether a company needs to pay profits tax in Hong Kong mainly depends on whether its profits come from trade, business, or activities in Hong Kong, i.e. whether there is a substantial connection between its profits and Hong Kong. Therefore, if the actual management entity of the offshore fund is located in Hong Kong, its investment income may also be regarded as “sourced from Hong Kong” and thus subject to profits tax in Hong Kong (tax rate is 16.5%).

In addition to tax risks, regulatory risks and legal risks are also issues of concern in the investment process. Firstly, if the financial regulatory authorities in Hong Kong or Singapore determine that the offshore fund is engaged in financial services activities locally, the fund entity may be required to comply with regional financial regulatory laws and regulations, including but not limited to obtaining the relevant licenses, disclosing relevant information, and undergoing inspections by regulatory authorities. Secondly, the actual management entity needs to comply with relevant laws and regulations in the local jurisdiction and may have to deal with litigation or arbitration under the local legal framework, which requires addressing jurisdiction and governing law issues.

4.2 Risks of Cayman Economic Substance Law for Fund Investments

The Cayman Economic Substance Law is a law enacted by the Cayman government in response to OECD’s requirements for tax transparency and fair competition, particularly in response to the international standards proposed by OECD to combat erosion of the tax base and profit shifting caused by high levels of territorial mobility activities. It was enacted in December 2018 and took effect in January 2019. The law requires relevant entities registered in the Cayman Islands (Relevant Entities) to undergo corresponding economic substance tests for their relevant activities (Relevant Activities). Failure to comply may result in fines or even deregistration risks, and the local tax authorities may exchange information on such relevant entities with the tax authorities in the jurisdictions of the ultimate beneficial owners.

This article summarizes the relevant requirements of the Economic Substance Law for different entities and the risks involved in practical operations as shown in the table below. Among the four types of investment entities, offshore asset management companies, general partner funds, and funds are not subject to economic substance requirements, but there are still risks of operations that could potentially be constrained by economic substance requirements. On the other hand, Cayman holding companies are limited by (reduced) economic substance requirements, only needing to have sufficient personnel and office space in Cayman to hold and manage other entities, and can meet the aforementioned economic substance requirements through their registered agents. The “Economic Substance Risks” in the table refer to the situation where entities become subject to economic substance requirements after certain operations are performed, or are no longer eligible for reduced economic substance test treatments. Therefore, investors should closely monitor these types of risks during the investment process and consult professionals when necessary.

4.3 Discussion and Outlook

The Cayman Economic Substance Law is an undeniable legal risk for investors and managers establishing funds in Cayman. Failure to meet the economic substance requirements may affect the tax status of the fund, increase additional disclosure obligations, and even result in fund deregistration. Therefore, investors and managers need to reasonably choose and design the fund’s structure and operation mode based on their specific circumstances. Meanwhile, it is also necessary to closely follow the Cayman government’s and tax authorities’ further interpretation and implementation of the Economic Substance Law, and timely adjust and optimize their fund strategies.

Establishing funds in Cayman for digital asset investment holds great potential and prospects, but also faces numerous challenges and risks. Therefore, investors and managers need to fully understand the characteristics and rules of digital assets, rationally allocate and manage their digital asset portfolios to achieve long-term stable investment returns.

This article only analyzes and compares three types of fund structures for digital asset investment in Cayman from a tax perspective. In practice, investors and managers also need to consider various factors based on their specific goals and needs, and choose the most suitable fund structure accordingly.

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