An extract from The Virtual Currency Regulation Review, 3rd Edition

Introduction to the legal and regulatory framework

Owing to its neutral tax treatment, political stability and respected legal regime, the Cayman Islands is the global jurisdiction of choice for the formation of investment funds, which are increasingly investing in virtual assets and taking advantage of the investment opportunities in this space. A number of virtual asset exchanges have been launched by Cayman Islands entities.

The Cayman Islands Special Economic Zone provides a simplified route to establishing a physical presence and employing staff in the Cayman Islands.

In mid-2020, the Cayman Islands government introduced a new framework for regulating virtual asset businesses, known as virtual asset service providers (VASPs). A large proportion of the world's virtual asset hedge funds are based in the Cayman Islands. The framework implements Financial Action Task Force (FATF) recommendations for registering and licensing VASPs (including exchanges, transfer and custodian services), defines virtual assets and which virtual assets constitute securities, enables funds to use virtual assets as representations of equity interests, recognises virtual asset trading exchanges and introduces a regulatory sandbox licence. No case law has yet considered issues arising in the virtual assets space.

i Structuring of virtual currency businesses

There is no direct taxation imposed on Cayman Islands entities, and structuring will largely be driven by onshore tax considerations and business needs.

Exempted companies

The most common type of entity used by VASPS to form investment funds investing in virtual assets, virtual asset issuances (commonly known as initial coin offerings (ICOs) and security token offerings) and virtual asset exchanges in the Cayman Islands is the exempted company. Exempted companies conduct business on the basis of a declaration by the incorporating subscriber that the operations of the company are to be carried on mainly outside the Cayman Islands.

An exempted company must have a minimum of one shareholder and one director. The appointment of officers is optional. There is no requirement for Cayman-resident directors or officers.

Exempted limited partnerships

Exempted limited partnerships are more commonly used to form closed-ended funds investing in virtual assets, which may be investing in illiquid virtual asset issuances rather than more commonly traded virtual assets. The Exempted Limited Partnership Law (the ELP Law) governs the formation of exempted limited partnerships.

The ELP Law also contains provisions relevant to the affairs of an exempted limited partnership, being the primary legislation governing partnerships generally. An exempted limited partnership is a partnership consisting of at least one general partner (who has responsibility for the business affairs of the partnership) and any number of limited partners that is registered as such under the ELP Law.

An exempted limited partnership is not a separate legal entity. It is instead a set of contractual obligations affecting the partners, between themselves, where a general partner is vested with certain powers and obligations in relation to a business and the assets of the business.

Exempted limited partnerships are often treated differently to companies for onshore tax purposes, typically being treated as fiscally transparent. The general partner holds the partnership's assets in statutory trust for the partners, and is tasked with managing the business and affairs of the exempted limited partnership. If the assets of the partnership are inadequate to satisfy the claims of creditors, the general partner is liable for the debts and obligations left unpaid.

Foundation companies

A foundation company shares many of the features of an exempted company. A foundation company is a body corporate with limited liability and separate legal personality from its members and directors and other officers. It can sue and be sued and hold property in its own name. The key feature of a foundation company that often makes it an attractive vehicle for issuing virtual assets is that it is not required to have members following incorporation. This is a particularly useful structure for those projects that will ultimately be decentralised and governed by the community.

A foundation company must, however, unlike an exempted company, appoint a qualified person as a secretary, being a person who is licensed or permitted by the Companies Management Law (revised) to provide company management services in the Cayman Islands, and that secretary must maintain a full and proper record of its activities and enquiries made for giving notice.

Trusts

If ownership and autonomy are concerns, which may be relevant particularly for issuing virtual assets, they can be addressed to a certain degree by having a Cayman Islands charitable trust or STAR trust (introduced by the Special Trusts (Alternative Regime) Law) hold all the shares in issue of the exempted company. A Cayman Islands STAR trust is a non-charitable purpose trust that can hold assets for a specific purpose. The trustee must be a licensed trustee in the Cayman Islands.

ii Summary of Cayman laws to be considered in the virtual currency space

The following Cayman Islands statutory and regulatory regimes must be considered when structuring a virtual currency business in the Cayman Islands:

  1. the Virtual Assets (Service Providers) Law (VASPL);
  2. the Securities Investment Business Law (SIBL);
  3. the Mutual Funds Law (MFL);
  4. the Private Funds Law (PFL);
  5. the Money Services Law (MSL);
  6. the Bank and Trust Companies Law;
  7. the Proceeds of Crime Law (PCL), the Proliferation Financing (Prohibition) Law, the Anti-Money Laundering Regulations (the AML Regulations) and existing guidance notes, and the Terrorism Law;
  8. the Stock Exchange Companies Law;
  9. the US Foreign Account Tax Compliance Act (FATCA) and the OECD Common Reporting Standard (CRS);
  10. the beneficial ownership regime; and
  11. the International Tax Co-operation (Economic Substance) Law (the Economic Substance Law).

Securities and investment laws

i SIBL

The SIBL regulates securities investment business in the Cayman Islands. Securities investment business refers to dealing in securities, arranging deals in securities, managing securities and advising on securities.

The definition of a security is set out in the SIBL and contains a list of instruments that are common in today's financial markets (securities, instruments creating or acknowledging indebtedness, instruments giving entitlements to securities, certificates representing certain securities, options, futures and contracts for differences).

Virtual assets that can be sold, traded or exchanged at any time that represent or can be converted into any of the instruments listed in the SIBL or represent a derivative of any such instruments are themselves securities. If a Cayman entity was deemed to be issuing securities, it would be exempt from any form of licensing under the SIBL if the nature of the security was an equity interest, debt interest, or a warrant or similar for equity or debt interests.

If a Cayman entity was issuing or trading digital assets that were securities, it would be subject to registration or licensing under the VASPL.

ii MFL and PFL

The MFL gives CIMA responsibility for regulating certain categories of mutual funds operating in and from the Cayman Islands. The PFL gives CIMA responsibility for regulating certain categories of private funds operating in and from the Cayman Islands.

To be categorised as a mutual fund under the MFL, the fund must:

  1. be issuing equity, and not debt or contractual interests: in other words, shares, limited partnership interests, LLC interests or trust units (this therefore excludes token issuers, but the fund's equity interests can be represented by tokens);
  2. be a collective investment vehicle effecting the pooling of investor funds;
  3. issue equity interests that are redeemable or repurchasable at the option of the investors; and
  4. be established in the Cayman Islands or be a foreign fund seeking to make an offer or invitation to the public in the Cayman Islands to subscribe for its equity interests.

Mutual funds that are master funds are also covered by the MFL. To be categorised as a private fund under the PFL, the fund must adhere to the same requirements as those listed above with the exception of point (c): the PFL must issue equity interests that are not redeemable or repurchasable at the option of the investors.

All mutual funds and private funds must be registered with CIMA. The only funds that are not regulated, and therefore are not required to be registered with or licensed by CIMA, are:

  1. single investor funds – these are not master funds and are not mutual funds as there is no pooling of investor funds; and
  2. listed or otherwise regulated funds that are not incorporated or established in the Cayman Islands and that make invitations to the public in the Cayman Islands to subscribe for a fund's equity interests through a person licensed under the SIBL, provided that the fund in question is either listed on a stock exchange recognised for the purpose by CIMA or regulated in a category and by a regulator recognised for the purpose by CIMA.

Banking and money transmission

i MSL

The MSL regulates money services businesses in the Cayman Islands. Such businesses include the business of providing (as a principal business) money transmission and currency exchange. The applicability of this law will depend upon the specifics of any virtual asset issuance, virtual asset exchange or decentralised finance business. While any specific virtual asset issuance may, by its nature, fall within the remit of the MSL, the MSL is unlikely to apply to most virtual asset issuances.

The MSL provides that an entity in the business of providing, inter alia (as a principal business), money transmission or currency exchange requires a licence. The meaning of a currency exchange is not defined by the law; however, the Penal Code defines currency notes as legal tender in the country in which they are issued. If a money service business intends to offer services around digital representations of fiat currencies, which are not virtual assets under the VASPL, it will be subject to regulation under the MSL and not the VASPL. However, if the money service business also intends to offer services around virtual assets, it needs to consider whether it requires registration or a waiver under the VASPL.

ii Bank and Trust Companies Law

Cayman entities require licences to conduct banking business or trust business. Banking business means the 'business of receiving (other than from a bank or trust company) and holding on current, savings, deposit or other similar account money which is repayable by cheque or order and may be invested by way of advances to customers or otherwise'. Trust business means the 'business of acting as trustee, executor or administrator'.

Following the introduction of the VASPL, businesses that previously required licensing as a trust company under the Bank and Trust Companies Law because of undertaking custodian activities will need to be licensed as a VASP under the VASPL.