Article by Mr Ian Ashman and Mr Julian Black
The Cayman Islands are one of the world's leading financial centres and are a major provider of services for the purposes of structured finance transactions. The financial services industry in the Cayman Islands has developed over nearly four decades and has in place a framework of commercial legislation which is both modern and flexible to be able to meet the requirements of innovative financing structures. As a jurisdiction, the Cayman Islands offer efficiency, stability and professionalism. They have a constitutional relationship with the United Kingdom (being a British Overseas Territory), as a result of which the Cayman Islands enjoy an AAA sovereign risk rating and have autonomy in respect of domestic matters such as taxation and financial regulation.
Along with stability, the Cayman Islands are committed to maintaining the highest possible business standards. They comply in full with the minimum standards and core principles of banking supervision adopted by the Basle Committee on Banking Supervision. In 1986, the Cayman Islands entered into the Mutual Legal Assistance Treaty with the United States, providing a highly effective form of anti-money laundering legislation. During the course of the last year, substantial amounts of new legislation have been enacted in co-operation with the Financial Action Task Force, to strengthen the jurisdiction further against money laundering, and the Cayman Islands now have one of the tightest anti-money laundering regimes in the world.
The Cayman Islands have a robust judicial system through the Grand Court, which has ultimate appeal to the Privy Counsel of the House of Lords. This results in a level of predictability in relation to Cayman Islands law and inspires confidence. All of the top five accountancy firms are represented in the Cayman Islands. The jurisdiction also boasts top flight independent SPV Administrators including, amongst others, Deutsche Bank (Cayman) Limited, HSBC Financial Services (Cayman) Limited and BNP Paribas Private Bank and Trust (Cayman) Limited who are active in the structured finance arena.
Jersey practitioners, in seeking to pitch for London-based work, are quick to emphasise proximity to London and time zone advantages over the Cayman Islands. However, market participants are increasingly focusing on the benefits of having their offshore lawyers available in the evening/night which is often the time at which large structured finance transactions are closing. During these hours, the Cayman Islands' five hours time lag to the U.K. proves to be a huge value added. This, coupled with the fact that the two leading Cayman Islands law firms have offices in London, enables the Cayman Islands documentation to be worked on around the clock, providing a much more complete time zone coverage than the product offered by Jersey.
The Cayman Islands have a modern and flexible framework of commercial legislation. While certain statutory provisions may differ from English law providing greater flexibility, the central issues of corporate power, directors' fiduciary duties, corporate personality, limited liability and corporate benefit are, in all substantive respects, the English common law. At the same time, the Cayman Islands' commercial legislation has proved to be less cumbersome in many areas that have caused difficulty under the corresponding English statutes. This flexibility makes it possible for Cayman Islands structures to meet the varying requirements of increasingly innovative Arrangers.
Three aspects of Cayman Islands law of direct application to structured finance transactions deserve specific mention. The Companies Law provides that shares are redeemable not only out of profit but also from the credit balance on the share premium account, enabling an equity instrument to have much of the economic substance of debt.
In certain transactions, particularly where the debtor is bound by a negative pledge, it is helpful to use contractual subordination rather than security upon which to hinge the priority of payments of a transaction. Under English law, the effectiveness of contractual subordination arrangements is not definitively established either in statute or in case law, though the first instance decision in Re: Maxwell Communications Corporation Plc (1993) is helpful. Under the Companies Law, contractual subordination is statutorily enshrined, which means that a priority of payments settled by a Cayman Islands issuer would be enforceable by creditors, even if those creditors lacked the benefit of an associated security interest.
Under English law it is unlawful for a company to directly or indirectly provide finance for the acquisition by a third party of its own shares, pursuant to Section 151 of the English Companies Act 1985. Financial assistance in the Cayman Islands is not unlawful, though the directors must ensure that the transaction is demonstrably for the material benefit of the company, a position that is reinforced by the judgment of Prospect Property Limited (in liquidation) –v- McNeill (1991) (CILR).
The basic off-balance sheet financing structure for an issue of debt securities or repackaging requires a company owned by a charitable trust or a STAR trust (the latter operates such that any residual profit of the company would be held on trust for the benefit of the noteholders). The suitability of Cayman Islands' SPVs for structures such as these is well established. The share capital of a Cayman Islands' company may be denominated in any currency (including Euro) to simplify the accounting requirements, and there are no minimum requirements in respect of issued or paid up capital.
Collateralised Debt Obligations ("CDOs")
The Cayman Islands are the jurisdiction of choice for incorporating the Issuer on a CDO transaction, be it a balance sheet or arbitrage structure, and whether true sale or synthetic. Since the risk associated with a CDO transaction is parcelled into the junior tranche, it is often the requirements of the holders or potential holders of the junior tranche that drive the structuring of the funding side of the transaction. However, in 1999 the U.S. accounting profession indicated that, pursuant to FASB 125, off balance sheet treatment would not be achieved for a U.S. originator where the junior tranche of a CDO is issued as debt. This has led to a general tendency for the junior tranche to be issued as preference shares, and the preference shares are generally listed either on Luxembourg, Dublin or the Cayman Islands Stock Exchange along with the debt tranches and are occasionally rated.
There is no requirement for the register of members of a Cayman Islands company to be held in the Cayman Islands as a matter of Cayman Islands law, and clearly it is more practical for it to reside with the preference share paying agent to most easily facilitate payments on the preference shares. However, there is a risk associated with adopting this approach arising out of the English law decision Macmillan –v- Bishopsgate (No. 3) [HL]. This case, though not technically binding in the Cayman Islands, held that priorities of competing interests in shares of a company are not necessarily determined in accordance with the law of incorporation of that company and the case suggests that, in certain circumstances, the issue of priority may be determined according to the laws of the jurisdiction where the register of members of the company is situated. Accordingly, keeping the register of members in New York or elsewhere with the preference share paying agent would give rise to a complex conflict of law issue on the transaction, and in order to avoid the need to qualify the legal opinion accordingly, a decision was taken on CSFB's SFA CABS II CDO, Ltd. to keep the register of members in the Cayman Islands.
The situation is further complicated where a transaction combines a U.S. originator (who needs to issue equity for U.S. GAAP purposes) and a European investor in the junior tranche who is unable or unwilling to invest in shares. In these circumstances, a compromise needs to be reached. For some transactions, the Preference Shares of a CDO transaction have been separately repackaged through a further Cayman Islands SPV that issues debt. On others, such as UBS Warburg's North Street Referenced Linked Notes, 2000-3 Trust, and various other transactions, the right result for both originator and investor has been reached by adopting an innovative trust structure. This involves a Cayman Islands administrator acting as trustee of the issue and issuing limited recourse trust interests represented by certificates to investors. This is a route that is increasingly finding favour with arrangers, when the situation arises of incompatibility between US GAAP requirements and those of investors.
A recent transaction, structured through a Dutch B.V. to take advantage of its double taxation treaty with the U.K., attracted an Italian investor who unusually was unable to hold the investment in the form of debt. The debt issued by the Dutch B.V. was repackaged through a Cayman Islands company in order to privately place preference shares with the Italian investor. The transaction was structured so that dividends on the preference shares matched debt payments on the notes of the Dutch B.V., and voting rights attached to the Dutch B.V. notes were effectively passed through to the end investor by imposing an obligation upon the custodian to consult the end investor, prior to voting the notes. Costs were kept to a minimum as the Cayman Islands administrator agreed to act as custodian for the Dutch B.V. notes (which were Euroclear traded) and all documents on the transaction were governed by Cayman Islands law.
The ability of a Cayman Islands' SPV to issue shares that are redeemable out of share premium and out of capital enables transactions to be structured whereby an instrument issued that has the legal characteristics of equity can have the economic substance of debt. This is achieved by arranging for shares to be issued with a par value as a very small proportion of their issue price, thereby ensuring that the majority of the proceeds are entered into the share premium account of the Cayman Islands' SPV. The effect is that it is as easy to provide for preference shares to be "repaid" as it is for debt. Thereafter, the terms of the preference shares provide that they will be redeemed at a specific time in the future, and dividends are tailored to match the notional interest payments. Structuring of this nature is not readily achieved in other offshore jurisdictions where redemption of shares is a more cumbersome activity.
The Cayman Islands provides the natural choice of jurisdiction of incorporation of the Issuer for whole business financings, in a large part due to the clean financial assistance opinion that can be given on such a transaction. Over the past six months, Walkers have been instructed in relation to Deutsche Bank's, THPA Finance Limited, JP Morgan's, RHM Finance Limited and Lehman Brothers' Really Useful Theatres Finance Limited.
Tax Analysis of a Structured Financing Taxation
On a structured finance transaction, it is imperative that there is no tax leakage in the deal. With the huge and increasing size of recent transactions only a small number of basis points of tax can amount to a large overall tax charge. Tax leakage can arise in any one of the following ways:
- Entity level corporation tax in the jurisdiction in which the company is incorporated;
- Entity level corporation tax in any other jurisdiction in which, by virtue of its activities, it is deemed to be doing business;
- Withholding taxes due with respect to payments made by the SPV;
- Withholding taxes with respect to the payments received by the SPV;
- Other relevant taxes e.g. stamp duty.
In the Cayman Islands, there is no corporation tax on any company carrying out either domestic business or off-shore business, and the fact that there has never been any corporation tax in the Cayman Islands provides the comfort that this will continue to be the case. The professionalism of the Cayman Islands administrators means that Cayman Islands companies are centrally managed and controlled in the Cayman Islands, which helps on-shore tax counsel gain comfort that the SPV will not be taxable in the relevant on-shore jurisdiction (except in certain cases where the Cayman Islands' SPV is purposely tax resident in the United Kingdom or elsewhere). In relation to payments made by a Cayman Islands' SPV, there is no tax withheld by the Cayman Islands government on any payment (of principal, interest or otherwise) made by them.
However, where there would be withholding tax imposed on payments made in relation to the underlying assets of a transaction, it is often prudent for the transaction to be structured to benefit from a double taxation treaty. Accordingly, where U.K. commercial mortgages are being securitised, and U.K. payors would be required to withhold tax on interest payments paid abroad, pursuant to Section 349 of the Taxes Act 1988. The preferred route would be to structure through a Dutch B.V., taking advantage of the UK/Netherlands double tax treaty, even though this would give rise to a corporation tax charge at the level of Dutch B.V.
Stamp duty is not an issue for a carefully structured transaction where the issuer is incorporated in the Cayman Islands. Stamp duty is charged at US$600 on the instrument that creates a security interest, and with that exception the tax is de minimis. Stamp duty only arises in the Cayman Islands where the relevant instrument is physically brought into the Cayman Islands. Usually security documents are executed by power of attorney outside the Cayman Islands. If it is preferred that documents are executed by directors of the relevant Cayman Islands SPV, the documents need to be held in escrow by the directors until the documents have been dispatched out of the jurisdiction.
OECD Forum on Harmful Tax Practices
On 26 June 2000, the OECD published a list of jurisdictions which it perceived had harmful tax practices. The Cayman Islands were not included on the list of over 40 jurisdictions, since it had signed a letter of commitment to eliminate harmful tax practices by 2005.
The Cayman Islands were able to take this robust approach position, since the jurisdiction does not have discriminatory tax treatment between companies carrying out on-shore business and those carrying out off-shore business in the financial sector. All Cayman Islands companies are treated equally with regard to the level of taxation imposed upon them: there is no tax (through direct assessment or withholding) on any type of Cayman Islands company. It was consequently easy for the Cayman Islands to avoid being listed by the OECD as having harmful tax practices.
The Jersey Position
By contrast, the Jersey position is more complex and seemingly more troublesome. Jersey has for over 50 years had a 20% rate of tax on businesses that are resident in Jersey for tax purposes, and has more recently introduced the exempt company with a zero rate of tax for off-shore financial work.
It is principally this discrimination in the tax rate between local and off-shore business that the OECD held to be objectionable. Under pressure from the international community, Jersey has set about seeking to find a tax regime that satisfies both the OECD and the demands of the structured finance industry, which broadly requires no tax leakage on structured finance transactions. One approach that has been pursued by Jersey has been to seek to remodel itself on the Cayman Islands' zero corporation tax position, though this has proven to be politically unacceptable. Currently, a system of having in place trading companies and investment companies is under review, with different rules as to deductibility. On this basis, Jersey's structured finance business going forward would be more akin to that of Ireland and Holland than it would be to that of the Cayman Islands. As Richard Pratt, Director-General of the Jersey Financial Services Commission, was quoted by The Times as saying "It should be that no one pays any tax. That would not be different for non-residents, but then we would have no revenue. A balance must be struck where everybody pays tax somehow". This gives rise to concern for Structured Finance practitioners who are keen not to set up a thirty-year deal where they are unable to quantify the potential tax charge over the life of the deal. International Securitisation Report (May 2001) quotes a senior banker from Jersey as saying: "The OECD review has caused some Investment Banking houses to review whether they want to locate their SPVs in Jersey. Investment Bankers do not want to find themselves in the situation that if withholding tax is applied to SPVs, they need to re-arrange transactions at their own expense". The market response of many market participants has been flight to the stability of the Cayman Islands which does not have these overhanging threats.
In summary, the Cayman Islands continue to offer the structured finance industry a commercial and flexible approach, against a bedrock of stability, especially in relation to the tax analysis of transactions. This, combined with its depth of expertise keeps the Cayman Islands at the head of the field for off-shore jurisdictions for structured finance transactions.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.