Cayman Hedge Funds - Benefits for Canadian Managers
This article first appeared in the August 2012 edition of Canadian Hedge Watch Monthly Report.
When a Canadian hedge fund manager has built up a successful track record using a domestic Canadian fund vehicle, as a logical next step, it may wish to use the same investment strategy to attract international investment. This will generally involve setting up an offshore fund structure. The Cayman Islands, in particular, has established itself as a pre-eminent centre for this type of work, with the majority of the world’s hedge funds being domiciled in the jurisdiction (estimates typically range between 75% and 80%). The Cayman model, based on tax neutrality and professional efficiency, has been reviewed extensively by managers, investors and their advisers over the years and is regarded as a tried and tested solution, robust enough to withstand the challenges of the credit crisis and resulting market turbulence.
The structure most commonly used for non-US and US tax-exempt investors is the Cayman corporate fund (i.e. the exempted company), either as a standalone vehicle or as part of a master-feeder structure. The traditional master-feeder structure for a hedge fund will typically involve a Cayman corporate feeder fund (for US tax exempts and non-US investors) and a Delaware limited partnership as a US pass-thru feeder fund (for US taxable investors), each investing into a Cayman corporate master fund (which makes the appropriate election to be regarded as transparent for US tax purposes). The master fund will generally hold all the assets and carry out the trading activities in this structure.
While there can be variations on the theme (for example to ensure management and performance fees/allocations can be taken out in the most tax efficient manner) this common structure generally allows international investors with different tax treatments to invest in the same fund in a tax-efficient manner for all concerned. In addition to these tax efficiencies, the consolidation of investment capital in the master fund increases the level of overall fund assets and so can reduce trading and operational costs through economies of scale.
The Canadian Dimension
When establishing an offshore hedge fund for a Canadian manager, two key issues to address from the outset will be the "mind and management" of the fund and whether the fund is carrying on business in Canada as a result of the Canadian management. Under Canadian tax legislation, there is a 'safe harbour' provision which specifies designated investment services that may be carried on by the Canadian manager of an offshore hedge fund without risk of causing the fund to be carrying on business in Canada and thereby subjecting the fund to Canadian tax. These designated investment services include investment management and advice with respect to qualified investments. However, any activities constituting mind and management control of the fund occurring in Canada, such as general governance authority, would fall outside the safe harbour provision and also could cause the fund to be resident in Canada, and thus taxable there.
The precise tax analysis can differ as between different Canadian advisers, and it is important that managers work closely with their legal counsel and tax advisers to obtain the appropriate advice on Canadian tax issues. For example, there may be sensitivities around the location of the other service providers to the fund (e.g. the administrator), the board of directors of the fund (and master fund), and the holder(s) of the non-participating voting shares in the fund, among other things. Canadian tax advisers will generally advise that not only must ultimate legal control reside outside of Canada, but that de facto control must also be maintained outside of the jurisdiction, and to that end certain advisers will recommend that as many services as possible be provided outside of Canada for Canadian-managed Cayman hedge funds.
This is generally achieved by implementing the following types of measures:
a) Appointing an administrator and other service providers for the fund that are located in Cayman or another jurisdiction outside of Canada.
b) Appointing a board of directors for the fund that comprises at least a majority (if not all) independent directors that are not resident in Canada (there are a number of providers of professional independent directors based in Cayman).
c) Ensuring that the fund's governance takes place outside of Canada.
d) Where the fund issues participating non-voting shares to investors, having the non-participating voting shares in the fund (typically referred to as "founder" or "management" shares) held independently of the fund manager and its affiliates – for example, arrangements would typically be made for the voting shares to be held in charitable trust and particular care should be taken to ensure that the charitable trust documentation satisfies the requirements that independence and control are maintained outside of Canada.
In addition, restrictions apply in relation to the promotion and sale of shares in the fund to Canadian investors, so the Canadian fund manager may not want to admit its Canadian investors directly into the Cayman fund it manages. There seem to be differing views of Canadian counsel as to whether a simple blocker fund, or series of blocker funds, can address this concern.
For Canadian fund managers who wish to give their Canadian fund exposure to a Cayman master fund’s returns, without making a direct investment in the Cayman fund as a feeder, a derivative (such as a forward sale agreement) may be used pursuant to which the Cayman master fund serves as a reference fund. To this end the counterparty under such a derivative may seek to hedge its exposure by investing in a special purpose vehicle (also typically a Cayman exempted company) which in turn invests in the Cayman master fund. This structure can be particularly useful to a Canadian fund manager, because of the potentially favourable domestic tax treatment of this arrangement in Canada, where the counterparty is unable or unwilling to hedge its exposure through an investment in a Canadian-domiciled reference fund.
Canadian Tax Treaties
Historically Canada has had strong links with Barbados due to its double tax treaty with the jurisdiction, which essentially allowed certain profits made by a Barbadian foreign affiliate of a Canadian resident corporation to be repatriated to Canada tax-free, after paying lower taxes in Barbados. The Cayman Islands signed a Tax Information Exchange Agreement ("TIEA") with Canada which became effective on 1 June 2011, effectively allowing the same practice as between a Cayman resident foreign affiliate and its Canadian resident corporate parent. The advantage in using Cayman, however, is that there is no tax payable at the Cayman stage of the process (unlike Barbados), nor are there any exchange control restrictions or regulations in the Cayman Islands. In addition, Cayman companies may apply to the government to receive a written undertaking that they will not be subject to various descriptions of direct taxation in the Cayman Islands for a minimum period of 20 years.
Furthermore, the Cayman Islands is fully committed to international standards of tax transparency and international co-operation, is a member of the Steering Group and Peer Review Group of the OECD's Global Forum on Transparency and Exchange of Information and received a favourable review during its phase one assessment on meeting the OECD's tax transparency standards on exchange of information. It also has TIEAs in place with 27 countries at the time of writing, including Canada, with several more in the process of being finalised. The Cayman Islands Tax Information Authority also administers bilateral agreements with the 27 EU Member States in relation to the automatic reporting of savings income information, in effect since 2005.
Accordingly, a noticeable increase has been observed in Canadian managers forming Cayman-domiciled hedge funds and management companies in order to take advantage of the Canada-Cayman TIEA and the streamlined licensing regime available in the Cayman Islands for these types of entities.