Cayman Islands: Asian Firms Face Growing Offshore Compliance Risks

Imagine a scenario in which a Hong Kong-based hedge fund manager establishes and appoints an offshore management company to provide investment management services for its fund. On one hand, the fund's structure ensures a clear operational base. But at another level, key governance procedures are often neglected. These tasks include maintaining a certain number of offshore directors, opening and maintaining a bank account, holding regular board meetings in the offshore jurisdiction, and keeping a balance of non-onshore directors.

Such neglect could come at a steep price and expose the fund manager to tax liabilities in the manager's onshore jurisdiction. This is especially true in today's environment, in which regulators and tax authorities everywhere are taking a closer look at the substance of offshore management companies in relation to corporate governance.

By substance, we mean maintaining a proper operational structure that keeps the fund manager's operations outside of the tax framework of the onshore entity. In other words, the offshore company should be a real, living, breathing entity and not a mere shell.

Hong Kong-based managers are no doubt aware of this increased scrutiny, as over the past few years, the Inland Revenue Department (IRD) has been delving into this very matter. The IRD is increasing its investigations for the same reasons regulators everywhere are
looking more closely at offshore fund management structures – to consider what activities being provided by investment managers are to be taxed in Hong Kong.

How to mitigate risk

So, how does a Hong Kong investment manager minimise its exposure to tax risk? Merely setting up a fund manager in an offshore jurisdiction such as the Cayman Islands is not a sufficient structure to ensure tax compliance and minimise the risk. Regulators have highlighted the risk of the approach.

First, ongoing questions from tax authorities point to concerns about central management and control issues regarding the fund, as well as the need to properly demonstrate that there is real substance to the offshore business structure. Some of the questions that the Hong Kong-based asset manager should look to address include: Can the asset manager show trade activity being reviewed, approved or ratified offshore? Does the offshore management company have dedicated directors or employees based in the offshore jurisdiction? Can the manager show payments being processed offshore?

Additionally, tax authorities must be satisfied that the directors of the Cayman fund manager are located offshore and that the board consists of a majority of non-onshore directors. There should also be proof that the board meets regularly and does so in the offshore jurisdiction in which the management company is established or a jurisdiction other than the onshore jurisdiction.

The directors should also operate independently and not simply rubber-stamp decisions of the executives in the onshore jurisdiction.
Other pertinent considerations include whether the Cayman fund manager has had regular involvement in the fund's management and in the realisation of the fund's investment objective, policies and strategy. Questions regarding where and by whom agreements of the Cayman fund manager are executed are also looked into and whether the offshore directors of the Cayman fund manager are regularly reviewing reports and actively monitoring the fund's returns.

Good corporate governance helps minimize tax risks

These inquiries represent only a fraction of the facts which, if considered thoughtfully, would mitigate the risk of tax liability being assessed on income earned by the offshore Cayman fund manager.

Hong Kong-based fund managers should take other precautionary steps to ensure that their Cayman fund manager is operating with the required level of offshore substance so as not to attract tax penalties.

In addition, managers must ensure that the flow of fees earned from the offshore fund truly represent what is noted in the underlying agreements between the Cayman fund manager and its offshore fund.

An imperative to getting the substance right

With governments around the world casting their tax nets far and wide, it's an opportune time for Hong Kong fund managers to carefully assess their offshore structures and ensure that there is substance to them.

Not addressing the corporate governance and operations of the offshore management company is a far riskier proposal today than it ever was. The good news is, there's no need to run this risk. Asset managers have plenty of opportunities to step up their guidance and oversight and ensure they use their Cayman structures to achieve operational efficiency, meet compliance requirements and avoid unnecessary tax liabilities.

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.

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