Improving the Cayman Islands product: FATCA and the adoption of third party rights
Article by Mark Matthews From Maples and Calder Updated July 29 2015
Over the past year, a number of legislative measures have been adopted to ensure that the Cayman Islands remains the leading jurisdiction of choice for structured finance and capital markets transactions and for secured lending transactions generally. This article focuses on two recent key legislative developments. The first is the introduction of a framework of new laws and guidelines to implement the intergovernmental agreements that the Cayman Islands has agreed in order to enable entities and financial institutions in the jurisdiction to comply with the US Foreign Account Tax Compliance Act (FATCA) and its UK equivalent highlighting the Cayman Islands’ continued commitment to meeting international regulatory and tax transparency standards. The second is the adoption of the Contracts (Rights of Third Parties) Law, 2014 on May 21, 2014, which now gives third parties (where provided for under a contract governed under Cayman Islands law) a statutory right to enforcement in their own right, even where they are not themselves party to that contract. This underscores the jurisdiction’s continued commitment to improving the Cayman Islands offering from a legal perspective.
THE CAYMAN ISLANDS ADVANTAGE – A RECAP
Before taking a closer look at these legislative developments, it is worth considering some of the reasons enabling the Cayman Islands to become, and continuing to be, a leading financial centre for banking and finance. Over the past 30 years or so, successive Cayman Islands governments have implemented and refined the country’s financial services legislation so as to meet the demands of multinational companies, fund managers, investment banks and other key financial institutions in order to provide a jurisdiction in which transactions can be structured to meet the complex demands of an international investor base, whilst complying with tax and securities laws applicable to banks, businesses, managers and investors in multiple jurisdictions. The result is a tax neutral jurisdiction with a creditor-friendly and robust legal system, a strong regulatory framework and a sophisticated and well-regulated professional work force, underpinned by a stable political and economic environment.
Key factors that make the Cayman Islands a compelling jurisdiction for finance and banking transactions include:
An English-based legal system which is flexible and creditor-friendly together with a well-established and credible judiciary.
Political and economic stability, with low country risk.
Appropriate regulation by the Cayman Islands Monetary Authority (CIMA). The International Monetary Fund and other international organisations have assessed compliance as being in line with required international prudential, regulatory, cooperation and anti-money laundering standards.
A sophisticated and well developed financial services industry with an experienced and relatively large professional workforce.
Tax neutrality, which ensures that the Cayman Islands does not add additional layers of tax to those already paid by investors in their own jurisdictions.
No foreign exchange controls.
Quick and simple establishment of Cayman Islands entities (e.g. companies, partnerships or trusts).
Relatively low cost of establishment and maintenance of Cayman Islands entities.
Limited restrictions on dividends and redemption payments.
Simple and effective insolvency laws, including the absence of administration, Chapter XI type moratorium or stand-still provisions.
Bankruptcy remote structuring in Cayman Islands special purpose entities internationally recognised and accepted by rating agencies.
Recognition of separate corporate personality.
Innovative statutory developments including, amongst other things, the creation of segregated portfolio companies, the introduction of user-friendly merger and continuation provisions, statutory recognition of non-petition covenants and statutory recognition of set-off and netting, both pre and post-insolvency, as well as between multiple parties.
COMMITMENT TO MEETING INTERNATIONAL STANDARDS ON TAX TRANSPARENCY
In order to strengthen the Cayman Islands product and meet the demands of both the business and international community, the Cayman Islands was one of the first non-Organisation for Economic Co-operation and Development (OECD) jurisdictions to sign up to the OECD’s Global Forum on Taxation in 2000, when it committed to adhere to the OECD’s principles on transparency and exchange of information. Since then, the Cayman Islands has signed 33 bilateral Tax Information Exchange Agreements (TIEAs) which provide for the provision of tax information through the Tax Information Authority (TIA), the competent authority established for tax co-operation by the Cayman Islands under the TIA Law (2005 Revision). TIEAs have been signed with a broad array of countries including France, the Netherlands, Italy, Sweden and the UK in Europe; China and Japan in Asia; and within the US, Canada and Brazil in North and South America, respectively. Since 2005, the TIA has also administered 27 bilateral agreements with EU Member States which provide for the automatic reporting of information on savings income. Not surprisingly, therefore, the Cayman Islands are also on the OECD’s ‘white list’ of compliant jurisdictions that meet international tax and transparency standards.
THE NEXT STEP – FATCA IMPLEMENTATION
In 2010, the US introduced FATCA as a means to reduce tax evasion by US citizens outside the US. FATCA effectively applies extraterritorially by requiring financial institutions outside of the US to report information on financial accounts held by their US customers to the US Internal Revenue Service (IRS) and to close accounts of US customers who do not provide the requisite information mandated by FATCA. In order to ensure compliance, the US Treasury and IRS can impose a 30% withholding tax on any US source income of non-complying financial institutions. The UK then adopted legislation to mirror the US approach with the implementation of a UK styled FATCA for reporting equivalent information to the UK’s tax authority, Her Majesty’s Revenue and Customs (HMRC), by financial institutions in the UK’s Overseas Territories (of which the Cayman Islands is one) and Crown Dependencies. In order to incentivise countries to comply with FATCA, the US developed two forms of intergovernmental agreements (IGAs) – Model 1 and Model 2 IGAs, which deal with various legal impediments to adopting FATCA and which also lessen, in certain respects, the burden of implementing FATCA.
As part of its continued commitment to meet international standards on tax transparency and in order to comply with FATCA, the Cayman Islands signed Model 1B (non-reciprocal) IGAs with the UK and US on November 5, and November 29, 2013, respectively. As part of this process, the Cayman Islands updated its primary tax information exchange legislation, the TIA Law, in 2013, to provide for the entry into the IGAs and to enable the TIA to comply with its automatic exchange of information requirements with the IRS and HMRC. Detailed rules and regulations dealing with the implementation in the Cayman Islands of the US and UK IGAs followed with the adoption on July 4, 2014 of the Tax Information Authority (International Tax Compliance) US Regulations, 2014 (US Regulations) and the Tax Information Authority (International Tax Compliance) UK Regulations, 2014 (UK Regulations) collectively known as the “Regulations”. The legislation and Regulations set forth the requirements under Cayman Islands law for Cayman Islands financial institutions (“FIs”) to report US and UK tax resident accountholders to the TIA in the Cayman Islands which will then pass that information along to the IRS and HMRC, respectively, as part of the automatic exchange of information provided for under the TIA Law. Furthermore, the Cayman Islands published Guidance Notes (GNs) on July 22, 2014 to assist with compliance with the Regulations. The GNs provide practical assistance to the industry in interpreting the legislation, helping Cayman entities determine their status as either an FI or as a non-financial foreign entity (NFFE) and also to provide clarification on areas of uncertainty under the IGAs.
HOW DOES FATCA WORK IN THE CAYMAN ISLANDS?
A Cayman Islands entity will need to determine its status. Generally, FIs will fall into one of four categories as follows:
Custodial Institutions: Any FI that holds financial assets for other parties.
Depository Institutions: Any FI that takes deposits in the ordinary course of banking or similar business.
Investment Entities: Includes most types of funds as well as collateralised loan obligations (CLOs) and certain structured finance issuers.
Specified Insurance Companies: Any FI that issues cash value or annuity contracts.
All Cayman Islands FIs will be ‘Reporting FIs’ unless they fall within an exemption, as provided in Annex II to the IGAs or under the GNs, in which case they will be ‘Non-Reporting FIs’. Although Non-Reporting FIs will still need to provide certain documentation to withholding agents to confirm their status, in most cases there should be none of the additional requirements that FIs have to undertake as set out under the Regulations. Reporting FIs will need to adhere to or comply with the following:
Registration requirements with the IRS under the US Regulations.
Notification of status to the TIA in the Cayman Islands by March 31, 2015.
Identification of reportable financial accounts.
Due diligence requirements, both initially and on-going, as well as meeting the specified timeframes for reporting.
Reporting of financial accounts by May 31, annually; with first reports due by May 31, 2015.
Any Cayman Islands entity that is not an FI will be treated as an NFFE, of which there are two sub-categories, active-NFFEs and passive-NFFEs. Either way, an NFFE has no registration or reporting obligations to the TIA although it will need to determine its FATCA status and, in certain circumstances, certify that status to any FI with which it holds a financial account. In certain circumstances, persons who control passive-NFFEs may also be required to provide a self-certification as to their status. Notwithstanding that NFFEs have no reporting obligations, they still can, in certain circumstances, elect to be ‘direct reporting NFFEs’ or ‘sponsored reporting NFFEs’.
HOW IS FATCA ENFORCED IN THE CAYMAN ISLANDS?
Under the Regulations the TIA has enforcement powers which, amongst other things, include the ability to compel the disclosure of information by an FI and to inspect the books and records of an FI so as to ensure that any information provided to the TIA is correct and complete. If any requested information is outside the jurisdiction, an FI is also obligated to take all necessary measures to obtain such information.
The Regulations also provide sanctions for non-compliance, including various vicarious liability provisions for directors and officers. Failure to comply may also result in fines and/or imprisonment for up to two years.
IMPROVING THE LEGAL PRODUCT – THIRD PARTY RIGHTS LAW PROVIDES CONTRACTING PARTIES GREATER FLEXIBILITY
As part of its continuous effort to improve its legal offering, the Cayman Islands adopted the Contracts (Rights of Third Parties) Law, 2014 (CRTPL) on May 21, 2014 in order to broaden the ability of contracting parties under Cayman Islands law to provide enforcement rights for non-contracting third parties. The reason for the new legislation stems from the fact that Cayman Islands law, with respect to third party rights, follows the common law doctrine of privity of contract. Under that doctrine, only the parties to a contract are able to enforce the rights, obligations and liabilities that arise under that contract. Historically, therefore, third parties have not had any direct rights under any agreement to which they are not a contracting party save in very limited circumstances such as where rights, like indemnification or exculpation rights, are provided to third parties under deed poll.
How it works. Under the CRTPL, third parties now have a stand-alone statutory right of enforcement of contractual benefits given to them in a Cayman Islands law governed contract to which they are not a contracting party. Unlike the equivalent UK legislation, on which the CRTPL is very much based, third party rights only arise where the contracting parties ‘opt in’, which is to say, only where the contracting parties expressly provide in writing for the applicable rights to be capable of enforcement by the relevant third party. Importantly for third party beneficiaries, once the contracting parties have opted in, they may not rescind or vary the agreement so as to change or extinguish a third party’s rights without the consent of such third party, unless the contract specifically excludes that entitlement.
Are all agreements covered? It is important to note that the CRTPL does not apply to all forms of contracts. Certain statutory, trade and employment contracts are excluded. Examples of agreements that are not covered under the new legislation include company memoranda and articles of association, promissory notes, bills of exchange and other negotiable instruments, letters of credit, contracts for carriage of goods by air, sea or road and rights of employees under employment contracts.
Effect on existing contracts and scope of enforcement rights. Other points to keep in mind with the new legislation include how it interacts with existing contracts and the scope of enforcement of third party rights. Generally in relation to the first point, the CRTPL does not have retrospective effect. However, where pre-existing contracts contain express written provisions in favour of third parties, those provisions will come into effect upon the date that the CRTPL was brought into force, namely May 21, 2014. Notwithstanding that, however, only actions which accrue on or after May 21, 2014 are capable of enforcement by such third parties. It goes without saying that existing contracts are also capable of amendment post May 21, 2014 to provide for third party rights.
In relation to the breadth of enforcement of third party rights, a third party is only entitled to the same rights under the contract as the contracting party. Furthermore, the CRTPL prohibits double recovery which means that, where a contractual right is enforceable by both the contracting party and third party, a Cayman Islands court may take into account any payments already made to a contracting party when determining any award to a third party claimant.
Not only does the introduction of the CRTPL provide greater flexibility for parties contracting under Cayman Islands law governed documents, but it also brings the Cayman Islands into line with other leading jurisdictions, such as the UK and the US, in terms of providing statutory third party rights for non-contracting third parties. The requirement for an opt-in provision avoids the necessity, as under the equivalent UK statute, of having to opt out on most general commercial contracts, so that the third party rights provisions are only effective where the parties expressly provide for them in writing.
THE CAYMAN ISLANDS – LOOKING AHEAD
The Cayman Islands has consistently adapted and improved its regulatory and legal system to meet the demands of the finance and banking sector and the international business community. Furthermore, it has been pro-active in meeting the OECD’s principles on transparency and exchange of information and is committed to meeting international standards of best practice in this respect as evidenced by its early adoption of legislation to implement US FATCA and its UK equivalent. The government is in continuous dialogue with the private sector in the Cayman Islands to ensure that it keeps abreast of regulatory and legal issues and will continue to improve its offering so as to remain a pre-eminent international financial centre.
Originally published in Global Banking & Financial Policy Review 2014/2015, by Euromoney Institutional Investor.
