Implications of Cayman’s Economic Substance Law on red-chip structures

By Wang Hanqi and Willow Wei, Dentons
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The International Tax Co-operation (Economic Substance) Law 2018, passed by the Cayman Islands on 17 December 2018, and to be enforced by the Cayman Islands Tax Information Authority, took effect from 1 January 2019. As the Cayman Islands has become a preferred place of choice for Chinese companies to seek US dollar-denominated funding and implement overseas IPO plans using red-chip structures, how the Economic Substance Law (ESL) may affect use of red-chip structures deserves our attention.

A so-called “red-chip structure” is a shareholding structure whereby a Chinese company holds or controls any onshore assets either directly or indirectly (variable interest entity, or VIE structure) through use of any offshore special purpose vehicles incorporated outside the PRC.

Wang Hanqi
Senior Partner

Many users of red-chip structures, being Chinese companies, seek US dollar-denominated funding through their Cayman Islands entities before implementing their overseas IPO plans with the Cayman Islands entities as issuers.

In an existing red-chip structure, typically the primary business assets of the group entities are based in China. Does the ESL raise any new compliance requirements to red-chip structures? The authors will analyze this first by looking at the scope of application of the ESL.


The ESL requires “relevant entities” that carry on “relevant activities” to have demonstrable “economic substance” in the Cayman Islands.

Relevant entities. “Relevant entities” include Cayman Islands companies (including foreign-funded companies incorporated in the Cayman Islands), limited liability companies and limited partnerships incorporated under the Companies Law (2018 Revision), the Limited Liability Companies Law (2018 Revision) and the Limited Liability Partnership Law 2017. Generally, Cayman Islands companies established to take advantage of red-chip structures are exempt companies incorporated in the Cayman Islands, to which the new ESL applies.

Willow Wei

Relevant activities. According to the ESL, a relevant entity that carries on a “relevant activity” is required to fulfil relevant reporting duties and satisfy the economic substance test in relation to that relevant activity. The “relevant activities” as defined in the ESL include nine categories of activities, such as headquarters business and equity holding business.

If a Cayman Islands vehicle in a red-chip structure is identified as a pure equity holding company under the ESL, the implementation of the ESL will have minimal impact on the vehicle’s fulfillment of compliance duties. However, in practice, Cayman Islands companies (the potential issuers) could also be affected by the ESL.

These Cayman Islands companies are incorporated by Chinese companies as financing platforms before implementation of their overseas IPO plans. When providing funding to these companies in US dollars, investors will sign or develop a series of transaction documents with the existing shareholders, including a shareholder agreement and a restated and amended articles of association for the Cayman Islands companies, as well as documents setting out a range of preferred rights to which the investors are entitled, including without limitation, right of first refusal, pre-emptive right, board composition, veto power (protective clause), priority of liquidation, conversion right, registration right, redemption right, anti-dilution right, and right of receiving dividends.

These preferred rights enable investors to control management activities of the group companies, either directly or indirectly. Moreover, at the Cayman Islands company level, employee stock option plans are put in place, or will be established by the group companies.

It is also worth noting that the financial statements submitted from group companies to foreign securities regulators during their overseas IPOs are prepared on a consolidated basis, with the Cayman Islands entities as potential issuers. In such a context, the red-chip structure may be considered having been designed to serve a “headquarters business”, which is defined as a business activity with a management team that takes or controls, or provides substantive advice for the taking or control of, significant risks arising from the business activities of a group of entities.

In practice, however, analysis on a case-by-case basis in line with specific circumstances of Cayman Island entities involved in red-chip structures needs to be conducted.

Requirement to satisfy “economic substance” test. According to the ESL, entities that carry on different “relevant activities” are required to satisfy varied compliance requirements in respect of economic substance. For example, a Cayman Islands company identified as “a pure equity holding company” is simply required to comply with all applicable filing requirements, and have adequate human resources and adequate premises in the Islands for holding and managing equity participations in other entities.

If any “relevant activity” carried on by a Cayman Islands company as part of a red-chip structure is considered “headquarters business”, this company must satisfy the following compliance requirements: (1) the core income generating activities, i.e., taking relevant management decisions, co-ordinating group activities, and incurring expenditures on behalf of group entities, shall take place in the Cayman Islands; and (2) meetings of the board of directors must be held in the islands with adequate frequency, and all minutes of the meetings of the board of directors must be kept in the islands.

Therefore, we suggest that Chinese companies planning to design a structure for overseas financing and IPO, as well as those with an established red-chip structure, or having gone public with such a structure, pay attention to any further regulations and guidelines of the Cayman Islands Tax Information Authority.

As the ESL comes into effect, multinationals who have not built a red-chip structure, but have incorporated entities in the Cayman Islands, also need to pay attention to the compliance requirements in respect of Cayman Islands companies under the ESL. Steps to be taken may include formulating or adjusting internal control and compliance policies in line with their strategies and cost objectives.

Wang Hanqi is a senior partner and Willow Wei is a counsel at Dentons


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