On 18 February, 2020, the Council of the European Union (the “EU Council”) added the Cayman Islands to the EU’s official list of non-cooperative jurisdictions, commonly referred to as the “EU blacklist”. While the Cayman Islands government has already initiated the process of attempting to remove the jurisdiction from the blacklist, it is possible that the EU Council’s measure will lead to increased disclosure requirements for Cayman Islands vehicles and their investors to EU tax authorities, and might even – in a worst case scenario - impact the ability of certain funds to repatriate investment proceeds without additional withholding or other adverse tax measures being imposed by relevant EU Member States.
The Cayman Islands were originally on an EU “grey list”, which generally includes “tax regimes that facilitate offshore structures which attract profits without real economic activity”. In 2019, the Cayman Islands government enacted legislation requiring certain entities to have an acceptable level of economic substance in the Cayman Islands. However, according to the EU Council, the legislation did not sufficiently encompass certain investment funds and partnerships. Because the Cayman Islands government did not remediate this alleged weakness within the EU Council’s expected timeline, the EU Council added the Cayman Islands to the EU blacklist.
The purpose of the EU blacklist is to discourage so-called abusive tax practices. Those practices include tax regimes which provide for a low or zero rate of tax without requiring a sufficient degree of substance in the relevant jurisdiction, or which provide inadequate tax reporting information, or lack transparency, or which do not confirm to international standards for profit determination and attribution.
There are not expected to be any immediate tax consequences of the admission of the Cayman Islands to the EU blacklist. While the Cayman Islands are party to a range of tax information sharing and exchange agreements, these fall short of typical double tax treaties, and do not permit the elimination of EU Member State withholding taxes where imposed at the EU-located source of such payments. In that regard, the “blacklisting” might be said to leave a Cayman Islands entity in no worse a position than before. However, the EU Council will encourage EU Member States to introduce administrative measures in relation to transactions involving Cayman Islands entities. These measures might include enhanced country-by-country reporting requirements and more frequent disclosures relating to Cayman Islands entities under the EU’s cross-border mandatory reporting regime, known as “DAC 6”.
In addition, in December 2019, the EU Council recommended that EU Member States implement at least one of four possible “defensive tax measures” by 1 January, 2021 in respect of all jurisdictions (not just the Cayman Islands) classified as non-cooperative for tax purposes. These are, in summary:
(i) increasing withholding taxes on payments of interest, dividends, service fees, royalties and other payments from entities in EU Member States to blacklisted jurisdictions;
(ii) denying tax deductions on payments from entities in EU Member States to blacklisted jurisdictions;
(iii) tightening the CFC legislation in EU Member States by including (in the tax base of an EU Member State taxpayer) the income of an entity or branch located in a blacklisted jurisdiction; and
(iv) denying or reducing the effectiveness of the “participation exemption” relating to profits and dividends distributed from subsidiaries located in blacklisted jurisdictions with provisions going beyond current limitations in the EU’s parent/subsidiary directive and other domestic rules.
To date, the EU Member States have not taken concerted action in accordance with these defensive tax measures, but it is possible that a consensus in that regard may develop as 2021 approaches. Any action in respect of the EU Council’s recommendations of December 2019 relating to defensive tax measures would be a matter for each EU Member State to determine in its own right., owing to the EU Council having only limited authority regarding direct taxation matters. Whether EU Member States actually take collective concerted action in respect of the recommended defensive tax measures listed above, or take unilateral action as separate Member States, or take no action at all, against the Cayman Islands will be driven by several factors including political expediency and domestic tax policy.
Other consequences of the blacklisting are harder to predict.
It is possible that investor perception of the Cayman Islands might be adversely affected by the EU Council’s announcement. This is important given an increasing focus over the last few years by investors and pension funds in considering reputational issues, alongside other economic factors in making investment decisions. Investors may therefore wish to consider, in the medium to long term, whether other alternative investment vehicles, perhaps situated in in the EU or other higher-taxing jurisdictions, might be a better location to form an entity. While it is likely to be premature for sponsors to any Cayman Islands-located fund to commence restructuring of the fund’s structure or securities offerings, fund sponsors should consider disclosure obligations, whether for inclusion in offering documents or as required by relevant side letters. That being said, it is important to remember that the admission of the Cayman Islands to the EU blacklist should not prevent the use of Cayman Islands incorporated financing vehicles under the EU Securitisation Regulation, or prevent a Cayman Islands established fund from being marketed into the European Union in accordance with national private placement rules under the EU’s Alternative Investment Fund Managers Directive (“AIFMD”). This is because the list of non-cooperative jurisdictions referred to in the AIFMD and the EU Securitisation Regulation is a list maintained by the Financial Action Task Force (which is not an EU organization) and which is different from the EU’s list of non-cooperative jurisdictions for tax purposes.
At the very least, however, Cayman Islands incorporated companies and entities are likely to be subject to higher compliance and audit costs, and a greater degree of scrutiny by counterparties and investors. Those costs would have been increased in any event as a result of the Cayman Islands’ introduction of legislation regarding economic substance, and are likely to be augmented as a result of the EU Council’s announcement.
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