New Offshore Economic Substance Rules Could Spell Significant Concern for PE Funds and Bermuda/Cayman/BVI-Based Structures

by Orrick, Herrington & Sutcliffe LLP

Orrick, Herrington & Sutcliffe LLP

Traditionally, in the world of international tax planning, it has not been uncommon to see corporate structures utilizing entities organized in offshore jurisdictions that do not impose an income tax on corporate earnings – jurisdictions such as the Cayman Islands.  These structures are often effective to permit a multinational group to manage its overall effective tax burden.  For U.S.-based multinationals operating through controlled foreign subsidiaries, the benefit of this type of planning had already been significantly reduced under the new Global Intangible Low-Taxed Income (GILTI) regime, which in the majority of cases ensures that a certain amount of foreign earnings is taxed in the U.S. irrespective of whether the income is repatriated or not. The recent introduction of new economic substance rules in offshore jurisdictions indicate that certain offshore structures may now come with attendant costs of maintaining economic substance in the relevant jurisdiction.

In response to increasing pressure from international organizations such as the EU and OECD, many offshore jurisdictions, including the Cayman Islands, Bermuda, and BVI, have now imposed so-called "economic substance rules" for certain entities organized under the laws of such jurisdictions.  The concept is relatively straightforward – an affected offshore entity is now required to have adequate premises, employees, local activities, locally-generated income, and locally-generated expenses – i.e., a piece of paper and a mailbox will no longer suffice. 

This step is the latest in a worldwide focus on curbing abusive tax practices known collectively as "BEPS" (Base Erosion and Profit Shifting). For the better part of the last decade, the OECD has helped spearhead the so-called "BEPS movement" to foster the multilateral promulgation of laws designed to prevent taxpayers from setting up structures that have the effect of moving income into low or no-tax jurisdictions. For years, the OECD, the EU, and other organizations had been threatening to place any of these offshore jurisdictions that refuse to impose such laws (or ones similar to it) under "blacklist" status, which could subject such jurisdictions to punitive measures. 

It seems that the threatening message has been effective, and widespread action is being taken by offshore jurisdictions. The list of offshore jurisdictions enacting these new economic substance rules is rapidly on the rise, and in most cases the new laws are effective as of January 1, 2019, or will be phased into effect during 2019.  Accordingly, many taxpayers may already be subject to these requirements without even knowing it.  Private equity funds and multinational groups alike would therefore be well-served to review their structures immediately with local jurisdiction (offshore) counsel to ensure compliance, and, where needed, to begin any possible remedial action.  

Under the new rules, "relevant entities" organized in an offshore jurisdiction that carry on "relevant activities" are required to maintain an "adequate" level of "substance" in that jurisdiction (e.g., board meetings held in the offshore jurisdiction, local employees, locally-sourced income and local operating expenses). Failure to do so will potentially subject the relevant entity to large fines and penalties.  In some cases, even criminal liability (including imprisonment) could be on the table, as well as the possibility that the offshore government may simply de-register the offending relevant entity. 

Compliance will generally be assessed on a yearly basis based on reporting requirements imposed on the offshore entities subject to the rules.  In the case of the Cayman Islands, Bermuda, and BVI, this will take the form of a special informational return which must be filed beginning in 2020.

What Types of Entities Are Subject to These New "Economic Substance" Rules?

Generally speaking, the new rules apply to "relevant entities" conducting "relevant activities."  Depending on the specific laws of the applicable offshore jurisdiction, "relevant entities" could include corporate/incorporated entities, limited liability companies, locally registered foreign companies, or even limited partnerships organized under the laws of the offshore jurisdiction that have seperate corporate legal personality.

"Relevant activities" include banking, insurance, shipping, fund management, finance/leasing, holding company activities, IP holding activities, and service center or distribution center activities.

It is important to note there are subtle, albeit extremely meaningful differences in the application of these laws among different offshore jurisdictions, underscoring the need for taxpayers to consult with local counsel to quantify precisely what the new rules mean for them.  As an example, the Cayman Islands legislation does not apply to "investment funds," which may allow many private equity funds to avoid having to worry about these rules at all, while the BVI and Bermuda provide no such exemption.   

Some of these potential jurisdictional differences are highlighted below.

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Relevant Entity

Relevant Activity



Key Dates


Cayman Islands

  • Cayman exempted companies (Ltd companies)
  • Cayman LLCs
  • Foreign companies registered in the Cayman Islands
  • Fund management
  • Banking
  • Insurance
  • Financing and leasing
  • Distribution and service center businesses
  • Headquarters businesses
  • IP businesses
  • Shipping
  • Holding companies
  • Investment funds (or entities through which investment funds directly or indirectly invest or operate)
  • Entities which are tax resident outside the Cayman Islands
  • Domestic Cayman entities carrying on a Cayman business
  • Cayman exempted LPs and trusts
  • Lesser substance required in the case of holding companies. Greater substance required in the case of certain IP companies
  • US$12,200 for first year of noncompliance
  • $US122,000 for subsequent years
  • Noncompliant entities will be required to apply to the Grand Court of the Cayman Islands for an order requiring remedial action to avoid de-registration
  • Criminal penalties for knowingly making a false economic substance declaration (up to US$10,000 and five years’ imprisonment)
  • Effective 1/1/19
  • Entities in existence prior to 1/1/19 must comply by 7/1/19, with first return due in 2020
  • New entities must comply upon incorporation, with first return due in 2020
  • Typical Cayman LPs used by PE funds appear to be exempt from these rules
  • Appears to target corporate entities used by multinationals for strictly tax purposes


  • All registered entities (includes companies, limited liability companies, and partnerships)
  • Appears to apply to limited partnerships to the extent electing to have “separate legal personality”
  • Fund management
  • Banking
  • Insurance
  • Financing and leasing
  • Distribution and service center businesses
  • Headquarters businesses
  • IP businesses
  • Shipping
  • Holding companies
  • Pure equity holding companies are subject to a reduced substance test (IP companies are subject to an enhanced substance test)
  • Outsourcing of core income generating activities may be possible in certain cases
  • Civil penalties of up to US$250,000, subject to discretion of Bermuda Registrar of Companies
  • Registrar may require court order for remedial action or de-register entity
  • Criminal penalties for knowingly making a false economic substance declaration (up to US$10,000 and two years’ imprisonment)
  • Effective 1/1/19
  • Entities in existence prior to 1/1/19 must comply by 7/1/19, with first return due in 2020
  • New entities must comply upon incorporation, with first return due in 2020
  • Unlike Cayman Islands, appears to potentially implicate PE funds (LPs) themselves. Query what the policy is for applying the rule to flow-through entities


  • Companies incorporated or registered under the BVI Business Companies Act (excluding companies not resident in BVI)
  • Limited partnerships (whether local or foreign) other than nonresident partnerships or partnerships that do not have legal personality
  • Fund management
  • Banking
  • Insurance
  • Financing and leasing
  • Distribution and service center businesses
  • Headquarters businesses
  • IP businesses
  • Shipping
  • Holding companies
  • Pure equity holding companies are subject to a reduced substance test (IP companies are subject to an enhanced substance test)
  • Graduated penalties up to US$400,000 for “high-risk” IP legal entity and up to US$200,000 for all other entities
  • Registrar may de-register the entity
  • Criminal penalties of up to 5 years’ imprisonment may apply in certain cases of noncompliance
  • Effective 1/1/19
  • Entities in existence prior to 1/1/19 must comply by 7/1/19, with first return due in 2020
  • New entities must comply upon incorporation, with first return due in 2020
  • Unlike Cayman Islands, appears to potentially implicate PE funds (LPs) themselves. Query what the policy is for applying the rule to flow-through entities
  • Appears to impose steeper criminal penalties than other jurisdictions. Query whether these may apply in cases of mere noncompliance (as opposed to in cases of false statements)
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What Are the Rules? How Do We Comply?

Generally, compliance with the rules is likely to require some or all of the following to be satisfied:

  • Conducting “core income generating activities” in the offshore jurisdiction
    • Local jurisdiction guidance will generally specify different activities for different types of businesses
    • Fund management businesses may be required to prepare reports for investors in the offshore jurisdiction, versus financing and leasing businesses, which may be required to negotiate funding terms in the offshore jurisdiction
  • Being “managed and directed” in the offshore jurisdiction
    • Having regular board meetings on site in the offshore jurisdiction
    • Maintaining records in the offshore jurisdiction
  • Having a requisite level of income derived from the core income generating activities mentioned above, including
    • Having a certain amount of operating expenses generated in the offshore jurisdiction
    • Having a physical presence in the offshore jurisdiction (e.g. a place of business, plant, property and/or equipment)
    • Having an adequate number of full-time employees or other personnel employed in the offshore jurisdiction, with all possessing the requisite qualifications to do their respective jobs


Given the specificity of local-jurisdiction guidance in this area, the “facts and circumstances” nature of the analysis, the lack of a “one size fits all” answer for all companies, and the brand new status of these rules (and corresponding lack of official guidance as to application), we highly recommend consulting with local counsel in the relevant offshore jurisdiction as to how these rules apply to any given structure. In short, the era of offshore based mere mailbox companies may be over.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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