With an estimated 75% of the world’s hedge funds now domiciled in the jurisdiction, the Cayman Islands are continuing to strengthen their position as the world’s number one offshore domicile for hedge funds. This comes as no great surprise given the Cayman Islands’ well established and highly favourable regulatory and professional environment and the common perception in many quarters that it is now hard to justify why a hedge fund should be established elsewhere. It is certainly true that success breeds success.

However, there is also now a relatively new factor at play which has unexpectedly helped burgeon the Cayman Islands’ already healthy hedge fund industry. This comes in the shape of the European Union Savings Directive (commonly referred to as the "EUSD Directive") which came into effect on 1 July 2005 and which, generally speaking, applies to savings income payments made in one EU Member State to a person residing in another EU Member State by institutions (so called "Paying Agents") located in those EU Member States. The EUSD Directive also applies to such payments made by Paying Agents located in certain (but not all) overseas territories of those EU Member States and in certain other third countries (such as Switzerland) which have all signed up to the EUSD Directive. The Paying Agents being under an obligation (depending in which EU Member State, applicable EU Member State territory or applicable third country they are located) to either disclose the payment to the appropriate revenue authority or to apply a withholding tax. The EUSD Directive was drafted widely enough to potentially cover payments made by Paying Agents to EU residents investing in investment funds such as hedge funds. The EUSD Directive was also drafted to extend to, amongst other places, the Caribbean territories of the EU Member States (such as the Cayman Islands) which, along with the other applicable overseas territories and applicable third countries, have all since voluntarily enacted legislation implementing the EUSD Directive into their respective legal systems.

The initial reaction in the Cayman Islands to the news that the EUSD Directive would extend to their jurisdiction was one of trepidation. How would the industry react ? Would it lead to a mass exodus of hedge funds to other offshore centres which were not party to the EUSD Directive ? Those other offshore centres began to rub their hands with glee thinking of the rich spoils which no doubt lay ahead. However, by what at the time seemed like a twist of fate but now appears to be the result of skilled negotiation on the part of those intent on protecting their respective interests when the EUSD Directive was still on the drawing board, the complete opposite has happened. Rather than hedge funds emigrating to those other offshore centres as was originally feared there has, in fact, been an influx of hedge funds to the Cayman Islands from those other offshore centres. Why has this happened ?

This influx has primarily been down to one of the exemptions contained in the EUSD Directive and how this is being interpreted in each EU Member State, applicable overseas territory and applicable third country. This exemption basically states that the EUSD Directive will only apply to payments made to EU Residents by Paying Agents on behalf of investment funds which are recognized as Undertakings for Collective Investments in Transferable Securities funds (or "UCITS funds" for short) under another European Directive (commonly referred to as the "UCITS Directive") or funds recognized as their equivalent. The UCITS Directive governs how investment funds can be marketed in the EU and is designed to allow cross border sales of investment funds to investors of different nationalities provided, amongst other things, that the investment fund invests within defined parameters (such as with regard to the use of leverage) and meets local marketing rules of the country in which it is being marketed. The corollary of this is that payments made to EU residents by Paying Agents on behalf of investment funds which are considered as non-UCITS equivalent funds fall outwith the scope of the EUSD Directive altogether.

Most (if not all) EU Member States, applicable territories and applicable third countries have adopted the same interpretation of the exemption in question and have allowed each EU Member State, applicable territory and applicable third country (though its own implementing legislation) to determine what does or does not constitute a non-UCITS equivalent fund. This interpretation is commonly referred to as the "home country approach". The Cayman Islands have determined that the vast majority of its hedge funds are non-UCITS equivalent funds and therefore fall outwith the scope of the EUSD Directive altogether.

Investment funds established in countries or territories which are not party to the EUSD Directive and which have a Paying Agent in an EU Member State, applicable territory or applicable third country and which make payments to EU residents will possibly be caught by the EUSD Directive as they are located in jurisdictions which currently do not have any corresponding legislation determining what a non-UCITS equivalent fund is from their point of view. It is down to this uncertainty that many investment funds have decided to take the safe option and redomicile to the likes of the Cayman Islands.

With certainty comes comfort and stability and the fact that the Cayman Islands has been able to offer the certainty that investment funds strive for whilst question marks still hang over the status of other offshore centres and how their investment funds will be treated in light of the EUSD Directive has lead to a significant number of investment funds upping sticks from the likes of Bermuda (which incidentally is a British territory but is not technically in the Caribbean) and The Bahamas (which has been independent from the U.K. since 1973) to the Cayman Islands. So much so, that whilst initially glad of not being involved, many of those jurisdictions are now scrambling to sign up to the EUSD Directive themselves. However, it may, to a certain extent, be too little too late and the damage may already have been done.

Our firm has just recently registered the 10,000th investment fund to be registered in the Cayman Islands and it is appropriate to say that this is a well established hedge fund which, due to the EUSD Directive, decided that Bermuda was no longer the place to be.

Nick Reid is a Senior Associate at Solomon Harris and specializes in investment funds. He has recently completed several redomiciliations of hedge funds to the Cayman Islands.

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