The Cayman Islands: a nexus for Chinese capital flow

Wednesday, 18 January 2012 19:15

By Adam Skuse

Spiraling government debt, borrowing difficulties, growing unemployment and calls to increase tax. While such stories come as no surprise when talking about Greece, Italy and the other ailing economies of the old world, few would expect to find the sandy shores of the Cayman Islands - a name synonymous with wealth - troubled by similar problems.

However, the debt of the Cayman Islands government is expected to reach around $600 million by June next year, up nearly 500 percent from a decade ago; while this year will be the third time in four years that it will face a budget shortfall - expected to be around $4.5 million. At the same time, unemployment is on the rise.

While these figures are tiny compared to the scale of the problems faced in Europe, they have led to suggestions that the Cayman Islands start levying some form of tax.

But with its zero tax policy the foundation of its continuing success as a preeminent offshore jurisdiction, those calling for the group of three islands in the Caribbean to sort out its government's fiscal woes through taxation shouldn't hold their breath.

Indeed, authorities have dismissed the idea, instead redoubling efforts to woo more clients, with particular attention being paid to China.

In October, Premier of the Cayman Islands McKeeva Bush led a delegation to the China Offshore Summit in Shanghai to promote the jurisdiction to investors and officials, and announced plans to open a representative office in China. The trip also included a meeting with the state-owned China Harbour Engineering Company Ltd, which is to finance and build a cruise berthing facility in the Cayman capital, George Town.

The Cayman Islands is also looking at ways to diversify its economic base, announcing the construction of a $327 million special economic zone to attract global science, technology, commodities and derivatives, media, and educational entities to the country.

At the same time, the jurisdiction's traditional power base of finance and banking is enjoying rude health, built upon its well-established reputation for financial excellence.

Statistics from the Bank for International Settlements put the assets of banks resident in the Cayman Islands at over $1.7 trillion at the end of 2008, more than Italy, Portugal and Spain combined. The Cayman Islands also continue to ride high in various indices. These include the top spot in the Banker magazine's 2011 International Financial Centre survey in the Specialized Financial Centre category, and being rated in the top band for adherence to global regulatory and supervisory standards on international cooperation and information exchange in a report commissioned by the G20.

The jurisdiction is also doing much to improve transparency, having put in place 26 Tax Information Exchange Agreements (TIEAs), five of which were signed in the past year, including one with China in September.

The Cayman Islands has long enjoyed strong business ties with China, both in inbound and increasingly outbound operations, and is arguably the most well-regarded and recognized offshore jurisdiction among Chinese clientèle, much to the chagrin of its competitors.

According to Hong Kong government statistics, the Cayman Islands are the seventh-largest source of foreign direct investment and the sixth-highest destination of outward foreign investment from Hong Kong.

Cayman-registered companies have been permitted to register on the Hong Kong Stock Exchange since the mid-1990s, and as such Cayman-based legal experts are well versed in helping clients meet the exchange's requirements, with several hundred Cayman-based companies listed on the Main Board and Growth Enterprise Market.

Registering entities in the Cayman Islands takes just one day, with provision recently made allowing companies to register names in Chinese characters. There are no requirements for directors to be resident in the country, or for assets to be maintained there.

In addition, there are no exchange controls, meaning funds can be freely transferred to a from the country with no limit.

The country is also a common-law jurisdiction based on English law, with a highly-developed infrastructure and stable government, and Caymans-based legal advice is available during the Asian working day.

Greg Knowles, head of corporate in Asia for Hong Kong-based international law firm Maples and Calder, says Cayman companies are useful to Chinese outbound capital in many circumstances. These include  the holding of an overseas asset which is wholly-owned by a China entity; as vehicles for co-investment by multiple Chinese entities; as vehicles for the formation of a joint venture between Chinese and overseas parties in relation to assets overseas; and financing vehicles for the purchase of natural resources bound for the Chinese market.

“We see a continuation of the trends of previous years for Cayman vehicles to facilitate the flow of significant amounts of foreign capital into China in a manner consistent with local regulations, and the use of Cayman vehicles for overseas listings of Chinese businesses, possibly on exchanges such as the Bursa Malaysia and the Korean Stock Exchange, which have not traditionally seen significant Chinese listings,” said Mr Knowles.

He added that the use of Cayman vehicles for private equity and hedge funds where Chinese rules allow, and interest in Cayman trust structures from wealthy Chinese individuals, are also expected to increase.

There have been recent developments in Chinese law and regulations that those intending to go the Cayman route should bear in mind.

One set of Chinese regulations, collectively referred to as “Circular 10,” requires Chinese nationals and residents to obtain both national and local government approval before transferring assets into offshore vehicles.

Mr Knowles says a more recent, and from a tax perspective more significant, regulation is Circular 698, which require any person, wherever located, to make a filing with the Chinese tax authorities when selling Chinese assets, including via a non-Chinese holding company. Capital gains tax of 10 percent on any profit made on the disposal, unless profits have been taxed at a rate of at least 12.5 percent in another jurisdiction, or a valid reason for structuring the sale via a foreign vehicle can be given.

“Some pundits have even raised the suggestion that Circular 698 in particular may lead to a significant reduction in the use of Cayman vehicles in Chinese investment in the future,” said Mr Knowles. “But such views apparently misunderstand or overlook the fact that in many, if not most cases, the use of a Cayman vehicle is not wholly or mainly for tax planning purposes; and in any event the use of such a vehicle could not put the investor in any worse position than if the investment had been structured through an onshore jurisdiction or held directly.”

Mr Knowles also points out that it is not just Cayman structures that are subject to Circular 698. A local tax bureau in Jiangsu province required the Carlyle Group to pay tax on the disposal of an investment structured as the sale of shares in a Hong Kong holding company, with no offshore element present in the transaction. “Nobody could seriously suggest that Hong Kong companies have only a limited future as a vehicle for China investment,” he said.

The Cayman Islands have also been hugely popular among Chinese companies seeking to list in the US using the Variable Interest Entity (VIE) structure. The method is often used by Chinese companies in sectors where foreign ownership is barred or curtailed to get around the restrictions. The foreign investors take ownership in a company registered in an offshore jurisdiction, which in turn controls the Chinese entity through contractual agreements. These are structured in such a way that, under US regulations, it is considered equivalent to ownership, allowing a listing to go ahead.

However, on March 28, Buddha Steel called off its $38 million offering on the Nasdaq after its was told by local authorities in Hebei province that its VIE agreements were invalid.

Then in August, the China Securities Regulatory Commission reportedly asked the State Council to crack down on the VIE structure, although exactly how and to what extent have yet to emerge, prompting speculation on the impact it could have on companies that already use the structure, and those that intend to. In September, Chinese media reported an anonymous source as saying Chinese Internet companies are likely to be exempt from any clampdown on VIEs, although companies that have yet to launch their IPOs will be subject to it.

According to statistics collated by independent analyst Fredrik Öqvist, 42 percent of US-listed Chinese companies, excluding OTCBB listings, use the VIE structure. It is used by more than half of those on the NASDAQ, with fewer companies on the NYSE and ASE using the structure.

Pressure on VIEs is not just coming from Chinese authorities. In December, Pennsylvania Senator Robert Casey Jr. asked the Securities and Exchange Commission (SEC) to investigate the use of the structure by Chinese solar panel makers.

At around the same time, the SEC suspended trading and revoked the securities of Chinese software company Longtop, which is registered in the Caymans.

However, Mr Knowles said even if utilization of the VIE structure becomes less common, it is likely that any alternative structures for the introduction of foreign equity into the Chinese market would be facilitated by the use of Cayman vehicles, as the jurisdiction's stable legal system and flexible, modern framework of corporate legislation remain a major draw for international investors.

While there will be many eyes trained on how the VIE saga develops, the overall trend that sees the Cayman Islands as a key nexus for China-related capital flows is likely to grow stronger, as one of the most trusted, convenient and well-known offshore jurisdictions among Chinese operators.