Cayman Web3 Digital Fund Special: Analysis and Comparison of Overlooked Tax Risks

Author: TaxDAO & Precision Fund Services

As a globally renowned offshore financial center, the Cayman Islands is also the largest offshore fund establishment location in the world, with over 85% of offshore funds registered there. At the same time, the Cayman Islands offers very favorable tax policies, with funds not required to pay income tax, capital gains tax, or dividend tax; it has also signed tax information exchange agreements with countries such as the UK, the US, and Australia. According to data from the Cayman Islands Monetary Authority (CIMA), by the end of 2020, there were 26,351 regulated open-ended funds and 9,857 regulated closed-ended funds in the Cayman Islands, with total assets exceeding two trillion dollars. The number of exempt regulated funds established in the Cayman Islands is countless. Registering funds in the Cayman Islands has become an important way for multinational investments, and establishing private equity funds for digital asset investments is gradually 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 LP (Limited Partnership) structure.

1 Three Typical Organizational Forms of Cayman Funds

Cayman exempt regulated funds mainly exist in the following organizational forms: Exempted Company (EC) and Exempted Limited Partnership (ELP), among others. This article first selects three typical fund structures for analysis. 1.1 Stand-Alone Fund Structure In a stand-alone fund, there are two entities, where the fund entity is usually established in the form of an exempt limited partnership, and the investment team subscribes to the participating shares of the fund (which have dividend rights but no voting rights). At the same time, the investment team establishes a fund management company in the British Virgin Islands (BVI) as the managing shareholder of the fund (which does not participate in dividends but has voting rights at the shareholders' meeting), while the daily decision-making and operational rights of the fund belong to the board of directors of the fund, which is composed of the investment team. 1.2 Segregated Portfolio Company (SPC) Structure The Segregated Portfolio Company (SPC) is a special case within the EC structure and a unique form of Cayman law. In the SPC structure, as an exempt entity, the SPC can establish up to 25 independent portfolios (Segregated Portfolio, SP), and the assets and liabilities between these portfolios are completely independent. Operating multiple different funds under the SPC has a similar practical effect to establishing multiple stand-alone funds, making SPC more cost-effective. The specific SPC structure is shown in the figure below. 1.3 Exempted Limited Partnership (ELP) Structure The ELP structure mainly consists of three steps. First, the investor establishes a GP (General Partner) company in the Cayman Islands/BVI as the general partner of the ELP. Second, the ELP fund entity is formed by the individual investors, the GP company established in the first step, and the investment entity controlled by the GP team, SLP (Limited Partner). Then, the ELP establishes an SPV (Special Purpose Vehicle) to carry out investment activities. Among them, the GP has management and control rights over the ELP fund affairs, responsible for the operation, management, control, and business activities of the ELP fund. The SPV under the fund entity refers to a subsidiary or sub-partnership established by the fund entity for investing in a specific project, usually also in the form of an ELP, with the fund entity as the general partner or limited partner and the project party as the limited partner or general partner. The ELP structure can bring the following benefits:

• Utilize the favorable tax policies of the Cayman Islands to avoid double taxation and foreign exchange controls.
• Flexibly design the investment strategy, profit distribution, exit mechanism, etc., of the SPV according to the characteristics and needs of different projects, while protecting the interests of investors and project parties.
• Like the SPC, the ELP can also separate the risks and returns of different projects for accounting purposes, avoiding mutual influence and improving transparency and efficiency.

2 Choosing SPV Locations under the ELP Structure

Under the ELP structure, the fund entity invests in downstream enterprises through the SPV, which can independently liquidate, ensuring shareholder rights and achieving risk isolation. In practice, the choice of SPV location generally falls in Hong Kong or Singapore, which facilitates financial activities and allows for low tax rate benefits in both locations. 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.

It can be seen that in terms of dividends and stamp duty, Singapore has more cost advantages as an SPV location compared to Hong Kong: Singapore's dividend tax exemptions are more lenient; its stamp duty regulations are also simpler and lower in cost. However, transaction costs are just one aspect of the SPV location consideration; the specific location choice must also be judged based on different industries, structures, and corresponding policies in both locations.

3 Three Stages of Investment under the ELP Structure and Tax Risk Analysis

3.1 Taxation in the Investment Stage The investment stage mainly consists of three steps: building an offshore structure, establishing a domestic asset management company and a Wholly Owned Foreign Enterprise (WOFE), and acquiring the project company. There are relatively few tax issues involved in this stage. Building an offshore structure can be roughly divided into two plans: Plan One is a simplified Cayman structure, which involves establishing a holding company in the Cayman Islands and then investing in overseas or domestic project companies or special purpose entities through that company; Plan Two is the BVI/Cayman ------ Cayman structure, which involves establishing a holding company in the Cayman Islands and a subsidiary holding company in the British Virgin Islands (BVI) or Cayman, and then investing in overseas or domestic project companies or special purpose entities through the subsidiary holding company. The advantage of Plan One is its simple structure, low cost, and ease of management. It only requires registering and maintaining one holding company in the Cayman Islands, without needing to register and maintain another holding company in the BVI, while also enjoying the tax benefits of the Cayman Islands. However, its disadvantages include higher risks, poorer confidentiality, and lower flexibility. If the Cayman holding company directly invests in projects in other countries, it may be subject to restrictions or regulations under the laws of those countries. If the Cayman holding company goes public, it may expose information about its investors and investment projects. If the Cayman holding company needs to change its investment strategy or exit a project, there are also corresponding additional costs. The advantage of Plan Two is lower risk, better confidentiality, and higher flexibility. By establishing a subsidiary holding company in the BVI or Cayman, it can isolate the risks between the Cayman holding company and the investment projects; this structure also provides higher confidentiality, as it does not need to disclose information about its directors, shareholders, beneficial owners, etc. By establishing a subsidiary holding company in the BVI, it can flexibly design the investment strategy, profit distribution, exit mechanism, etc., of the SPV according to the characteristics and needs of different projects, while protecting the interests of investors and project parties. Its disadvantages include a complex structure, higher costs, and troublesome management. It requires registering and maintaining two holding companies in two regions, increasing compliance risks and management difficulties.

3.2 Taxation in the Production and Operation Stage Production and operation are the direct sources of profit and the main channel for controlling tax risks. Overall, Hong Kong's tax policies are simpler, resulting in a lower tax burden for businesses. Singapore has higher tax rates on certain taxable items, such as bank interest income and cross-border interest payments. The tax regulations for different taxable items in Hong Kong and Singapore are shown in the table below.

3.3 Taxation in the Capital Exit Stage In the capital exit stage, Plan One and Plan Two face different tax issues. Overall, there is not much difference in taxation between the two exit plans, except that Plan Two has an additional layer of BVI subsidiary holding company, which does not significantly affect taxation. As shown in the table below, in the Cayman Islands, whether disposing of a holding company or a special purpose entity does not require any tax payment. When exiting investments in Hong Kong, only the disposal of the publicly listed Cayman holding company and SPV requires stamp duty, and the rate is low, with each party bearing 0.1%. Other types of disposals do not require tax payment. When exiting investments in Singapore, only the disposal of the SPV requires stamp duty, which is borne by the buyer at 0.2%. Other types of disposals do not require tax payment.

4 Risk Expansion and Discussion of Cayman Funds

4.1 Risks of Separation between Actual Management Location and Registration Location The actual management institutions of offshore funds are often established in Hong Kong or Singapore. Due to the inconsistency between the management location and the registration location, corresponding tax risks arise. Considering that the Cayman Islands has not signed DTA agreements with Hong Kong and Singapore, the actual tax situation will be more complex. The main tax risk for Cayman offshore funds is that they may be regarded as having tax residency or tax source income in the location of the actual management institution, thus needing to pay income tax or other taxes in that region. Risk handling mainly depends on the tax laws of the actual management institution's location, as different regions may adopt different judgment standards and taxation principles. Therefore, when choosing the location of the actual management institution, offshore funds should fully understand and compare the tax laws of these regions to select the most favorable location or take corresponding measures to avoid or reduce tax risks. Singapore's tax laws stipulate that whether a company is a tax resident of Singapore mainly depends on whether it is controlled and managed in Singapore. Here, control and management refer to the location of the company's highest decision-making body, usually the location of the board of directors' meetings. Therefore, if the actual management institution of the Cayman offshore fund is in Singapore, it may be regarded as being controlled and managed in Singapore, thus becoming a tax resident of Singapore. Tax residents in Singapore are required to pay global income tax (at a rate of 17%). Hong Kong's tax laws stipulate that whether a company needs to pay profits tax in Hong Kong mainly depends on whether its profits come from trade, business, or operations in Hong Kong, i.e., whether the company's profits have a substantial connection to Hong Kong. Therefore, if the actual management institution of the offshore fund is located in Hong Kong, its investment income may also be deemed "sourced from Hong Kong," thus requiring payment of profits tax in Hong Kong (at a rate of 16.5%). In addition to tax risks, regulatory and legal risks are also issues that need to be addressed during the investment process. First, 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 local financial regulatory regulations, including but not limited to obtaining the necessary licenses, disclosing relevant information, and undergoing inspections by regulatory authorities. Second, the actual management institution must comply with relevant legal provisions locally and may also have to deal with litigation or arbitration under the local legal framework, which requires addressing jurisdiction and governing law issues. 4.2 Risks Brought by the Cayman Economic Substance Act to Fund Investments The Cayman Economic Substance Act was enacted in December 2018 by the Cayman government to comply with the OECD's requirements for tax transparency and fair competition, particularly in response to the OECD's international standards aimed at combating activities with high territorial mobility that erode tax bases and shift profits. This law came into effect in January 2019. The act requires relevant entities registered in the Cayman Islands to pass corresponding economic substance tests for their relevant activities; otherwise, they may face fines or even deregistration risks, and local tax authorities may exchange information about these entities with the tax authorities in the jurisdictions of the ultimate beneficial owners. This article summarizes the relevant requirements of the economic substance act for different entities and the risk points 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 corresponding risks of being constrained by economic substance requirements. The Cayman holding company is subject to (reduced) economic substance requirements, only needing to have sufficient personnel and office space in the Cayman Islands to hold and manage other entities, and can meet the above economic substance requirements through its registered agent. The "economic substance risk points" in the table refer to situations where an entity changes from being exempt from economic substance requirements to being subject to them after performing certain operations; or where it can no longer enjoy reduced economic substance testing treatment. Therefore, during the investment process, investors should closely monitor such risk points and consult professionals when necessary.

4.3 Discussion and Outlook The Cayman Economic Substance Act poses a legal risk that cannot be ignored for investors and managers establishing funds in the Cayman Islands. Failure to meet economic substance requirements may affect the fund's tax status, increase additional information disclosure obligations, and even lead to fund deregistration. Therefore, investors and managers need to reasonably choose and design the fund's structure and operation methods based on their specific circumstances. At the same time, they need to closely monitor the Cayman government's and tax authorities' further interpretations and implementations of the economic substance act, adjusting and optimizing their fund strategies in a timely manner. Establishing funds in the Cayman Islands for digital asset investments has corresponding potential and prospects, but it also faces numerous challenges and risks. Therefore, investors and managers need to fully understand the characteristics and rules of digital assets, reasonably allocate and manage their digital asset portfolios to achieve long-term stable investment returns. This article only analyzes and compares three structures for establishing funds in the Cayman Islands for digital asset investments from a tax perspective. In practice, investors and managers also need to consider various factors comprehensively based on their specific goals and needs to choose the fund structure that best suits them.