Implications of Cayman’s Economic Substance Law on red-chip structures

The International Tax Co-operation (Economic Substance) Law 2018, passed by the Cayman Islands on 17 December 2018, and to be enforced by the Cayman Islands Tax Information Authority, took effect from 1 January 2019. As the Cayman Islands has become a preferred place of choice for Chinese companies to seek US dollar-denominated funding and implement overseas IPO plans using red-chip structures, how the Economic Substance Law (ESL) may affect use of red-chip structures deserves our attention.

A so-called “red-chip structure” is a shareholding structure whereby a Chinese company holds or controls any onshore assets either directly or indirectly (variable interest entity, or VIE structure) through use of any offshore special purpose vehicles incorporated outside the PRC.

Many users of red-chip structures, being Chinese companies, seek US dollar-denominated funding through their Cayman Islands entities before implementing their overseas IPO plans with the Cayman Islands entities as issuers.

In an existing red-chip structure, typically the primary business assets of the group entities are based in China. Does the ESL raise any new compliance requirements to red-chip structures? The authors will analyze this first by looking at the scope of application of the ESL.

SCOPE OF APPLICATION

The ESL requires “relevant entities” that carry on “relevant activities” to have demonstrable “economic substance” in the Cayman Islands.

Relevant entities. “Relevant entities” include Cayman Islands companies (including foreign-funded companies incorporated in the Cayman Islands), limited liability companies and limited partnerships incorporated under the Companies Law (2018 Revision), the Limited Liability Companies Law (2018 Revision) and the Limited Liability Partnership Law 2017. Generally, Cayman Islands companies established to take advantage of red-chip structures are exempt companies incorporated in the Cayman Islands, to which the new ESL applies.

Relevant activities. According to the ESL, a relevant entity that carries on a “relevant activity” is required to fulfil relevant reporting duties and satisfy the economic substance test in relation to that relevant activity. The “relevant activities” as defined in the ESL include nine categories of activities, such as headquarters business and equity holding business.

If a Cayman Islands vehicle in a red-chip structure is identified as a pure equity holding company under the ESL, the implementation of the ESL will have minimal impact on the vehicle’s fulfillment of compliance duties. However, in practice, Cayman Islands companies (the potential issuers) could also be affected by the ESL.

These Cayman Islands companies are incorporated by Chinese companies as financing platforms before implementation of their overseas IPO plans. When providing funding to these companies in US dollars, investors will sign or develop a series of transaction documents with the existing shareholders, including a shareholder agreement and a restated and amended articles of association for the Cayman Islands companies, as well as documents setting out a range of preferred rights to which the investors are entitled, including without limitation, right of first refusal, pre-emptive right, board composition, veto power (protective clause), priority of liquidation, conversion right, registration right, redemption right, anti-dilution right, and right of receiving dividends.

These preferred rights enable investors to control management activities of the group companies, either directly or indirectly. Moreover, at the Cayman Islands company level, employee stock option plans are put in place, or will be established by the group companies.