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. The Cayman Islands has been, and remains, the leading domicile for virtual asset investment funds globally.2 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). The framework implements Financial Action Task Force (FATF) recommendations on international standards on combating money laundering and the financing of terrorism and proliferation applicable to VASPs (including virtual asset issuances, exchanges, transfer and custodian services, and financial services related to a virtual asset issuance); 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, Cayman Islands regulatory requirements 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 Act (the ELP Act) governs the formation of exempted limited partnerships.
The ELP Act 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 Act.
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, namely a person who is licensed or permitted by the Companies Management Act (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, and ensure that the company complies with Cayman Islands anti-money laundering, countering the financing of terrorism and anti-proliferation financing obligations when accepting transfers of virtual assets without consideration.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) Act) 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:
- the Virtual Assets (Service Providers) Act (VASPA);
- the Securities Investment Business Act (SIBA);
- the Mutual Funds Act (MFA);
- the Private Funds Act (PFA);
- the Money Services Act (MSA);
- the Bank and Trust Companies Act;
- the Proceeds of Crime Act (PCA), the Proliferation Financing (Prohibition) Act, the Anti-Money Laundering Regulations (the AML Regulations) and existing guidance notes, and the Terrorism Act;
- the Stock Exchange Companies Act;
- the US Foreign Account Tax Compliance Act (FATCA) and the Organisation for Economic Co-operation and Development's Common Reporting Standard (CRS);
- the beneficial ownership regime; and
- the International Tax Co-operation (Economic Substance) Act (the ES Act).
Virtual assets service providers regulation
The VASPA took effect on 31 October 2020. At the time of writing, the registration obligations under the VASPA are in effect; however, the licensing, sandbox and notification regime for existing licensees is not yet in effect but is expected to be so before the end of 2021. In the meantime, all VASPs must apply to register with the Cayman Islands Monetary Authority (CIMA) and have that application accepted before they can commence virtual asset operations, regardless of whether they may subsequently require licensing or are an existing licensee (existing licensees must notify CIMA of their proposed virtual asset services).i Definition of a VASP
The VASPA defines a VASP as: a Cayman entity that provides a virtual asset services as a business, or within the course of a business, in or from within the Cayman Islands and that is registered or licensed in accordance with the VASPA or is an existing licensee that has been granted a waiver.
A virtual asset service is the issuance of virtual assets (i.e., the sale of newly created virtual assets to a public virtual asset exchange (whether to or from fiat or other virtual assets) and any of the following businesses provided for or on behalf of another party:
- exchange between virtual assets and fiat currencies or other virtual assets;
- transfers of virtual assets (which includes facilitation of such transfers);
- custody services (i.e., safekeeping and administration of virtual assets); or
- participation in, and provision of, financial services related to a virtual asset issuance or the sale of a virtual asset.
The VASPA licenses and regulates those engaged in providing virtual asset services for or on behalf of a third party. Virtual assets themselves, and those using virtual assets or VASPs for their own private purposes or as principals, are not affected.ii Definition of a virtual asset
The VASPA implements the FATF definition of a virtual asset, which is 'a digital representation of value that can be digitally traded or transferred and can be used for payment or investment purposes but does not include a digital representation of fiat currencies'. The central elements of the definition are transferability and exchangeability, intending to capture activities rather than asset types. This definition does not include digital representations of fiat currencies, which are intended to cover central bank digital currencies that may be issued by national central banks in future.
The VASPA excludes 'virtual service tokens' from the definition of a virtual asset. Virtual service tokens are non-transferable or non-exchangeable digital representations of value, including digital tokens whose sole function is to provide access to an application or service or to provide a service or function directly to its owner.iii Registration and licensing requirements
All VASPs – including businesses acting as VASPs on an occasional or limited basis – must either be registered with or licensed (or granted a waiver if an existing licensee) by CIMA before commencing any virtual asset operations (including issuances). If the VASP is a virtual assets custodian or exchange business, it must be licensed by CIMA (whether under the sandbox, the VASPA or under its existing licence having been granted a VASPA waiver by CIMA, as applicable) before commencing operations. All other VASPs must apply to and be registered with CIMA (or be granted a waiver from CIMA, as applicable) before commencing operations. A breach of this requirement is a criminal offence that may result in a fine or imprisonment.
VASPs already licensed under any other regulatory laws may not need to be registered separately or licensed under the VASPA; however, they will need to notify CIMA of the details of their activities. The need for separate licensing or registration may be waived by CIMA on a discretionary basis. A notice is not required where an existing licensee is carrying on activities that involve virtual service tokens only.
Investment funds wishing to accept subscriptions in virtual assets or make redemptions in kind must take structuring advice to determine whether they or their Cayman Islands service providers may fall within the framework. For example, if a Cayman Islands investment manager or administrator owns and operates a virtual assets wallet on behalf of an investment fund, it may be undertaking custodian or virtual asset transfer activities and may need to be licensed or registered under the VASPA. Most non-tokenised investment funds investing in virtual assets are unlikely to be VASPs. Funds issuing tokenised equity interests or contractual rights in the fund's profits are likely to be VASPs, as they will be undertaking a virtual asset issuance. Any VASP considerations in respect of an investment fund are in addition to that fund's obligations under the PFA, MFA and Cayman anti-money laundering obligations.
All VASPs will be subject to ongoing requirements, including regulatory audits by CIMA, preparing audited financial statements, appointing and maintaining compliance officers and obtaining CIMA's written approval before issuing or transferring equity interests representing 10 per cent or more of its total equity interests.
The VASPA requires virtual asset custodian services to demonstrate that they meet capital, disclosure and safekeeping standards as part of their licensing application. Virtual asset exchanges must meet not only capital and safekeeping standards but also disclosure, onboarding, trading supervision, operational and clearance and settlement standards. At the time of writing, details of these standards are not yet available.iv Regulatory sandbox
The VASPA introduced a time-limited regulatory sandbox licence available to both virtual asset service providers and fintech businesses. An initial licence is valid for up to one year and may be reviewed when CIMA deems appropriate.
The flexible sandbox licence permits CIMA to tailor restrictions, monitoring covenants, limits on the offering of the service, or specific obligations. It is intended for VASPs whose virtual asset activity is not properly supervised by an existing regulatory law or may pose substantial market, systemic or anti-money laundering (AML) and counter-terrorist financing risks. For fintech companies, the sandbox licence can help accelerate adoption of the innovative technology or delivery channel they have developed. At the time of writing, details of the sandbox licence, eligibility and conditions are not yet available.
Sandbox licensees must comply with the sandbox principles of honesty, integrity, fair treatment of customers, the protection of customer data and assets, and such other principles as CIMA may prescribe by way of regulations and publish on its website.
Securities and investment lawsi SIBA
The SIBA 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 SIBA 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 SIBA 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 SIBA 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 VASPA.ii MFA and PFA
The MFA gives CIMA responsibility for regulating certain categories of mutual funds operating in and from the Cayman Islands. The PFA 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 MFA, the fund must:
- 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);
- be a collective investment vehicle effecting the pooling of investor funds;
- issue equity interests that are redeemable or repurchasable at the option of the investors; and
- 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 MFA. To be categorised as a private fund under the PFA, the fund must adhere to the same requirements as those listed above with the exception of point (c): the PFA 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:
- in the case of mutual funds, those that are single investor funds – these are not master funds and are not mutual funds as there is no pooling of investor funds;
- in the case of private funds, those that constitute 'non-fund arrangements', which include joint venture vehicles, proprietary vehicles, debt issues and debt issuing vehicles, and preferred equity financing vehicles; and
- for both mutual funds and private funds, those that are 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 SIBA, 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.