When setting up a Cayman Islands investment fund and, where applicable, its Cayman Islands investment manager, consideration needs to be given to structuring the board of directors of each of these companies, not only in the context of corporate governance issues but also to ensure that they are not brought "onshore" for tax purposes.  The Cayman Islands Monetary Authority (CIMA) currently imposes relatively limited restrictions on the structure of the boards of open-ended investment funds, with its main requirement being that two individuals be appointed to the board of a licensed mutual funds or, in certain circumstances, a sole corporate director may be permitted (this is in addition to the requirement that such persons are fit and proper).  Whilst managers are therefore generally given wide scope when structuring the boards of their Cayman funds, in doing so they need to consider not just principles of good corporate governance but also relevant tax rules which may affect the tax residency of these offshore companies.  In the wake of international developments calling for enhanced corporate governance, CIMA is currently undertaking an industry wide consultation process with the intention of providing a set of guidelines on the primary duties of directors of regulated mutual funds as well as setting sector specific corporate governance standards.  This is expected to supplement the current statement of guidance on corporate governance issued by CIMA, which applies to all licensed entities within the Cayman Islands.  Without going into the detail of these new proposals, it is anticipated that managers will have more to consider in respect of the selection and on-going operation of the fund's board.

This note gives a very broad overview of some of the matters that Asian based managers should be aware of when structuring the boards of their offshore fund entities.  Specific tax advice should however always be taken in respect of the jurisdictions relevant to the operation of the fund.  This note does not purport to be and should not be considered to be tax advice.

Centre of Management and Control

Generally speaking, the concept of “central management and control” (CMC) is not found in legislation. In common law countries it is mostly derived from case law and is wholly a question of fact. In broad terms, the test looks at where the highest level of control (as opposed to the day-to-day management/supervision) of the company is conducted and one should expect that all relevant factors may be considered. 

In Hong Kong, one of the requisite conditions for a hedge fund to qualify for the profits tax exemption under the Revenue (Profits Tax Exemption for Offshore Funds) Ordinance 2006 (the Offshore Funds Ordinance) is that the fund has to be a “non-resident person” of Hong Kong. To qualify for the exemption, a non-resident person must not carry on any other business in Hong Kong other than the specified transactions, or transactions incidental to the carrying out of the specified transactions as defined in the Offshore Funds Ordinance. A fund will be regarded as a "non-resident person" if the CMC of the fund is not exercised in Hong Kong in that year of assessment.  According to the practice notes to the Offshore Funds Ordinance issued by the Inland Revenue Department of Hong Kong, CMC refers to the highest level of control of the business of the fund.  Given that the highest level of control of the fund generally rests with its board of directors, the Inland Revenue Department in Hong Kong will look at the composition of the board and where board meetings are held as part of their analysis to determine the place of CMC of the fund (however, as discussed below, this will not necessarily be conclusive). 

Assuming the fund is controlled by its directors, the location where the directors conduct the fund's business will determine the location of CMC. Usually this would be the place where the board meetings of the fund are carried out, however this will not be determinative if in fact high level management decisions are made in the relevant onshore jurisdiction.  For example, all board meetings could be held outside of Hong Kong, but if management decisions are made from within Hong Kong on a more casual basis then the CMC might still be found to be in Hong Kong.  Although, the place where the CMC is exercised is not necessarily the place where the main operations of the business are to be found, not surprisingly, the two places may often coincide.

It is generally recommended that the fund’s directors, in respect of Hong Kong based investment managers, comprise of a majority of non-Hong Kong residents/non-Hong Kong based directors and the fund's board meetings are conducted outside Hong Kong to substantiate that the CMC of the fund is exercised outside Hong Kong (i.e. the Fund is a “non-resident person” of Hong Kong for the purposes of the Offshore Funds Ordinance). However, the fact that the majority of the directors of the management board of a company are resident in Hong Kong does not of itself mean that the company is centrally managed and controlled in Hong Kong and won't necessarily mean that the fund won't be subject to the exemption under the Offshore Funds Ordinance.  The residency status of the directors should not determine the residency status of the fund, but minimising the number of the onshore resident directors and ensuring that a majority of directors are resident and based outside any one onshore jurisdiction may assist the CMC analysis.

Even where a fund appoints one or more offshore independent directors to its board, if these directors are merely “rubber stamping” the decisions of an individual or group of persons who essentially make the substantive decisions for the fund, then their involvement may be discounted for the purpose of determining the residency status of the fund.  Therefore all directors on the board should have genuine and substantial involvement in decisions relating to the highest level of control of the fund, such as execution of the fund/management documents, decisions regarding the business strategy of the fund, appointment of directors, advisers and service providers and updates on service providers' performance.  This will also mean holding sufficient meetings throughout the year in the context of the fund's activities and it is recommended that these are held at least four times per year.

Below is a non-exhaustive checklist of items for funds to consider when looking to establish a CMC outside of Hong Kong (however specific tax advice should be sort in respect of the circumstances of any one individual fund):

  • Majority of directors to be non-Hong Kong residents (a fund may have Hong Kong resident directors provided these directors exercise the CMC of the fund outside of Hong Kong).
  • Directors to be autonomous and should not merely "rubber stamp" decisions taken by one or more principals.
  • All directors to have genuine and substantial involvement in the highest level of control of the fund.
  • Meetings of directors should be held regularly and outside of Hong Kong.
  • Any written resolutions of the directors should be signed outside of Hong Kong.
  • The fund should execute contracts outside of Hong Kong.
  • Directors should keep a log and record of overseas business trips e.g. air tickets and board minutes.
  • High level decisions such as decisions in respect of the overall investment objective, strategies and policies of the fund should not be made through fax, email or phone but should be made during meetings held outside of Hong Kong.
  • Regular reports of the fund's performance should be submitted to the directors and records kept to show that the board of directors have actively monitored performance outside of Hong Kong.

As the fund will have the burden of proof in establishing its CMC is outside of Hong Kong a fund should keep supporting documents to substantiate the carrying out of the above actions such as through keeping on record, board minutes, passport copies, travel itineraries and copies of air tickets / hotel bills, etc.

Corporate Governance

The importance placed on good corporate governance has been gaining momentum over the last few years with the Weavering case hitting headlines across multiple jurisdictions from 2011. Overall responsibility for corporate governance lies with the board of directors and so not only should consideration be given to the selection of the persons to sit on these boards but also their on-going roles in the fund's business.

The Weavering Case concerned a Cayman Islands investment fund, the Weavering Macro Fixed Income Fund, whose directors were found to be personally liable for redemption excesses of $111m due to inflated net asset values of the fund. The case highlighted the high level of responsibility placed on each director of a fund and the importance of ensuring that each and every director carries out his or her fiduciary and common law duties properly.  In particular, the case highlighted that directors have a continuing duty to acquire and maintain sufficient knowledge and understanding of the fund's business to enable them to properly discharge their duties as directors and that they are expected to act in a professional, businesslike manner.  Therefore directors must continually apply their minds and exercise independent judgment as to the business and affairs of the fund and are expected to take an ongoing active role in the management of the fund throughout its life.

In CIMA's Statement of Guidance on Licensing - Mutual Funds, CIMA has provided that licensed investment funds shall be required to show that they are controlled and managed by persons who are fit and proper. In determining whether a person is fit and proper all relevant circumstances will be considered and the Statement of Guidance provides that each such person shall possess:

  1. Honesty, integrity and reputation;
  2. Competence and capability; and
  3. Financial soundness.

Operators of a licensed fund are also currently guided by the Statement of Guidance - Corporate Governance (SOG-CG) issued by CIMA.  The SOG-CG provides high level guidance for licensed entities as regards the structure and operation of their boards of directors, as well as risk management and audit function. 

The guidance set out in the SOG-CG includes, without limitation, the below items:

  • Board of directors to have a balance of appropriately skilled, experienced and qualified individuals.
  • Business should be conducted by the board of directors in a sound and prudent manner.
  • The board should meet regularly and devote sufficient time to their board responsibilities.
  • The board should be structured to ensure a balance of power and authority, so that no individual director has unfettered powers of decision.
  • The board should have in place systems to monitor independent risk functions and be required to report deviations to an appropriate level of management.
  • Where applicable, boards should establish procedures to require directors to disclose interests in order to prevent senior officers taking personal advantage of opportunities that arise as a result of his or her position.
  • Directors should consider all decisions and analyse all potential liabilities as required when carrying out their function as a director.
  • Directors are in a fiduciary position to the company and should act in good faith and with interests of the company.
  • In conducting his duties, a director is required to exercise the degree of care, skill and diligence of a reasonable diligent person with both the knowledge and experience expected of a director in his position and also any specific knowledge or skills he may have.
  • The board should have in place external and internal audit functions, with the establishment of an audit committee where appropriate.

On the 14th January 2013 CIMA commenced a private sector consultation on Corporate Governance for the financial services industry.  This contains a proposal to issue a Statement of Guidance that will apply to all mutual funds regulated by CIMA (the SOG-MF), setting out guidance on the role of a mutual fund director with a particular focus on confirming the primary duties, including those set out in the Weavering judgement, applicable to directors of a mutual fund.  This consultation ended on 16 August 2013 and a finalised version of the proposed Statement of Guidance is expected from CIMA in due course.  It is expected that the SOG-MF will supplement rather than override the current SOG-CG.

The CIMA led consultation, together with its industry wide survey of views on corporate governance as it relates to Cayman domiciled investment funds, demonstrates the importance which CIMA attaches to the future of corporate governance in a Cayman context and while the final outcome of the consultation has yet to be published, the exercise has encouraged a debate on topics amongst those directly affected by the issue, namely the investors, managers and service providers who are actively engaged in the investment funds industry.