Considerations For Canadian Managers Operating Non-Canadian Funds

• Published date: 02 April 2024
• Law Firm: Maples Group
• Author: Ms Gwyneth Rees and Jeremy Bomford

Expanding Offshore

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 process will generally involve setting up an offshore fund structure. The Cayman Islands, in particular, have established themselves 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 70% and 80%.) The Cayman Islands model, based on tax neutrality and professional efficiency, has been reviewed extensively by managers, investors and their advisors over the years and is regarded as a triedand-tested solution, robust enough to withstand (among other things) the challenges of the 2007-2008 global financial crisis, the global COVID-19 pandemic of recent years, and the subsequent market turbulence in each case.

Fund Structuring

The offshore hedge fund structure most commonly used for non-US and US tax-exempt investors is generally the Cayman Islands 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 Islands corporate feeder fund (for US tax exempts and non-US investors) and a Delaware limited partnership as a US pass-through feeder fund (for US taxable investors), each investing into a Cayman Islands master fund (which makes the appropriate election to be regarded as transparent for US tax purposes). The master fund (which is also typically structured as a Cayman Islands exempted company, or sometimes as a Cayman Islands exempted limited partnership) will generally hold all the assets and carry out the trading activities in this structure. While there can be variations on the theme (e.g. 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 on income earned in Canada. 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, whether within or outside the safe harbour provision, could nonetheless cause the fund to be resident in Canada, and thus taxable there on worldwide income. The precise tax analysis can differ as between different Canadian advisors, and it is important that managers work closely with their legal counsel and tax advisors 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 any non-participating voting shares in the fund, among other things. Canadian tax advisors will generally advise that not only must ultimate legal control reside outside of Canada, but that de facto control must also be maintained outside Canada, and to that end certain advisors will recommend that as many services as possible be provided outside of Canada for Canadian-managed offshore hedge funds.

This is generally achieved by implementing the following types of measures:

1. appointing an administrator and other service providers for the fund that are located in the Cayman Islands or another jurisdiction outside of Canada;
2. 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 the Cayman Islands);
3. ensuring that the fund's governance takes place outside of Canada; and
4. 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 Islands fund it manages. In certain circumstances, it may be possible to establish a blocker fund, or a series of blocker funds, to address this concern.

Canadian Tax Treaties and Cayman Enterprise City

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 with Canada, which became effective on 1 June 2011, effectively allowing the same practice as between a Cayman Islands-resident foreign affiliate and its Canadian-resident corporate parent (as a result of the Cayman Islands being considered a designated treaty country for the purposes of the Income Tax Act of Canada). The advantage in using the Cayman Islands, however, is that there is no tax payable at the Cayman Islands stage of the process (unlike Barbados), nor are there any exchange control restrictions or regulations in the Cayman Islands. The Cayman Islands has also established a special economic zone, known as Cayman Enterprise City ("CEC"), where Canadian businesses may quickly and easily set up a substantive offshore base with a real corporate presence and mind and management in the Cayman Islands. The CEC comprises a number of specialist business parks, aimed at the internet, technology, academic, media, film, biotech, and commodities and derivatives industries, and combines the tax and jurisdictional benefits of the Cayman Islands with a number of government-mandated measures designed to attract new business (including exemptions from work permits, taxes and import duties, and an easy, fast-track setting up of operations in three to four weeks). Accordingly, the Cayman Islands offers significant opportunities for Canadian businesses looking to establish a tax-neutral offshore presence in a designated treaty country and whose specialism falls within one of the above areas.

Regulatory Framework and Compliance (Initial and Continuing Requirements)

'Mutual funds' have been regulated in the Cayman Islands since 1993. Under the Cayman Islands legislation, the term mutual fund in fact equates to 'investment fund', rather than a regulated retail fund (which is the US context for the term). Only 'mutual funds' that carry on business in or from the Cayman Islands are subject to regulation by the Cayman Islands authorities. Responsibility for such regulation rests with the Cayman Islands Monetary Authority ("CIMA").

What is a mutual fund under Cayman Islands law?

Under the Mutual Funds Act (As Revised), a mutual fund is defined to mean any company, unit trust or partnership (wherever established) that issues equity interests redeemable at the option of the investor, the purpose or effect of which is the pooling of investor funds with the aim of spreading investment risks and enabling investors to receive profits or gains from...