17 December 2019

Cayman Islands economic substance legislation - restructuring considerations for investment managers

Most fund managers in Hong Kong SAR have a Cayman Islands investment manager in their fund structure which is registered as an ‘Excluded Person’ under the SIB Law. If you are in this category and haven’t already done so, you need to act now to either restructure the entity or otherwise ensure it is prepared for compliance with Cayman Islands economic Substance Legislation which is due to directly impact these entities from 15 January 2020.

There are a number of different options available to asset managers, which are summarised below.  None of these options is necessarily better or worse than any other option, and the best outcome for any manager will be driven largely by their internal circumstances; be that investor relations sensitivity, licensing and regulatory compliance, location of investment decision-makers and/or tax and accounting considerations. Whichever option is selected, action needs to be taken and changes need to be made – there is no ‘do nothing’ status quo alternative. 

Introduction to substance legislation

The use of the Cayman Islands-domiciled investment management companies (Cayman IM) as discretionary manager has long been the default for investment fund structures established by Hong Kong-based asset managers. This usage is so widespread that it is unusual to see a structure in Hong Kong without the Cayman IM. 

The introduction of the Cayman Islands International Tax Co-operation (Economic Substance) Law, 2018 and related Regulations (the “Substance Legislation”) has caused the asset management community to rethink these structures. From 15 January 2020, an ‘Excluded Person’ under the Cayman Islands Securities Investment Business Law (“SIB Law”) that carries out discretionary asset management activities, and that is a ‘relevant entity’ for the purposes of the Substance Legislation, will be required to register as a Registered Person, and from the time of such registration, become subject to the requirements of the Substance Legislation.

Asset managers that have not already taken action need to decide quickly whether to register their Cayman IM, and comply with the substance requirements, or to restructure out of scope of the Substance Legislation.

Restructuring options

Broadly speaking, there are two approaches available: firstly, removing the Cayman IM from the structure, and secondly, keeping the Cayman IM in the structure, subject to certain contractual and operational revisions being made.

Removing the Cayman IM from the structure

In this scenario, the Investment Management Agreement (IMA) between the fund and its Cayman IM is terminated and a new IMA is entered into between the fund and the Hong Kong (or other onshore) investment adviser (the onshore adviser). The Cayman IM entity can then be liquidated or repurposed for anther function. 

A permutation of the above has been to repurpose the Cayman IM as the holding company of the onshore adviser, once it ceases providing discretionary investment management services upon the termination of the IMA. This approach removes the requirement for Securities and Futures Commission of Hong Kong (SFC) preapproval of changes of directors and shareholders of an SFC authorised onshore adviser (as any changes are made at the Cayman Islands level). 

Key considerations when removing the Cayman IM from the structure will include ensuring that: (i) the onshore adviser is adequately licensed to provide discretionary management services (particularly acute for private equity managers relying on the intra-group company licensing exemption), (ii) the onshore adviser is aware of and able to comply with its licensing requirements including the SFC Fund Manager Code of Conduct, and (iii) onshore taxation and accounting considerations applicable to the payment of management fees pursuant to the IMA have been fully considered. 

Managers may need to consider updating the fund’s offering documentation to reflect the onshore adviser as the discretionary investment manager (which, for funds registered as mutual funds in the Cayman Islands, is required to be done within 21 days of the change taking effect). Managers will also need to bear in mind the need to explain to investors the reasons for the change and also the any effect on the structure and their interests, which can cause concerns from an investor relations perspective.

Maintain the Cayman IM structure

Asset managers that are reluctant to remove the Cayman IM from the structure, but do not wish to become subject to the substance test (described below) in relation to carrying out a ‘fund management business’, can choose to keep the structure intact, but will need to revise the IMA to ensure that the Cayman IM is either not engaged to provide discretionary asset management services, or is not receiving any fees for the services provided. 

Under the first option above, the amendments to the IMA will generally re-characterise the IMA as a procurement agreement pursuant to which the Cayman IM procures certain services from the onshore adviser on behalf of the fund (including discretionary asset management), and for which the Cayman IM could charge fees. If this approach is pursued, the onshore adviser will be providing discretionary asset management services, and the considerations outlined above would apply.

The second approach is to revise the IMA such that no fees are taken by the Cayman IM. Subject to the provisions of the IMA, this may also be achieved through a waiver of management fees without a formal amendment to the IMA. This approach means that simplified economic substance requirements apply, although the Cayman IM will need to comply with the SIB Law registration requirements as it will be performing the discretionary asset management function. This approach has been favoured by managers that are very sensitive to the investor relations implications of making changes to their fund structure. Managers adopting this approach would need to consider whether the fee disclosures in the fund’s offering documents would need to be revised accordingly.

Note that it is performance of discretionary asset management which triggers the substance requirements. A manager that does not provide discretionary asset management, but which provides other services falling within the definition of ‘Securities Investment Business’ (such as providing investment advice or arranging deals in securities) will still need to register as a Registered Person under the SIB Law (albeit they may not be required to comply with the Substance Test as they may not be carrying on the ‘relevant activity’ of ‘fund management business’).

Substance legislation compliance

It is of course open to those managers falling within the scope of the Substance Legislation to take steps to comply with it. Generally speaking, entities within the scope of the Substance Legislation will need to meet the economic substance test (the “Substance Test”) set out in the Substance Legislation, and adhere to certain notification and reporting obligations.  

Meeting the substance test

The scope of this article does not permit a full exploration of the compliance obligations under the Substance Legislation.  However, by way of high level summary, the Substance Test requires entities carrying out ‘fund management business’ to: (i) conduct Core Income Generating Activities (CIGA) relating to the ‘fund management business’ (see below) from the Cayman Islands; (ii) be directed and managed in an appropriate manner in the Cayman Islands; and  (iii) with regard to the income generated from the ‘fund management business’, have incurred adequate operating expenditure, have an adequate physical presence and an adequate number of full-time employees or other personnel with appropriate qualifications in the Cayman Islands.  In addition such entities must also comply with annual notification and reporting requirements. Compliance with the Substance Test is highly subjective and Cayman IMs within the scope of the Substance Legislation will need to establish a level of economic substance in the Cayman Islands in good faith based on the business activities of the entity.

Outsourcing economic substance

The Substance Legislation also contemplates the outsourcing of CIGA relating to the ‘fund management business’ to persons in the Cayman Islands (such as making investment decisions, making decisions on currency or interest fluctuations and hedging positions, calculating risk and reserves, and preparing reports or returns, or both, to investors or CIMA. This provides a further alternative where managers do not wish to disrupt the fund structure, but are not able to independently comply with the Substance Test. There are a number of service providers in the Cayman Islands to which Cayman IMs may outsource the CIGA relating to ‘fund management business’.

Managers that choose this approach will also need to ensure that the outsourcing arrangements put in place enable them to monitor and control the carrying on of CIGA by the party to which that activity is outsourced, and that CIMA’s “Statement of Guidance: Outsourcing - Regulated Entities”, is complied with. 


Cayman IMs have a number of options available to ensure that they remain compliant with the law when key changes commence on 15 January 2020. It is imperative that action be taken immediately (if not already taken) to ensure that Cayman IMs do not fall foul of either or both of the SIB Law or the Substance Legislation.


An original version of this article was published in the HFM Hong Kong Special Report 2019, December 2019.

© Carey Olsen 2020.


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