Cayman Islands: Business Advantages and Tax Minimization Attract U.S. Persons and Enforcement Challenges Exist
Published: 2008-07-24T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The Cayman Islands is a major offshore financial center and the registered home of thousands of corporations and financial entities. Financial activity there is in the trillions of dollars annually. One Cayman building--Ugland House--has been the subject of public attention as the listed address of thousands of companies. To help Congress better understand the nature of U.S. persons' business activities in the Cayman Islands, GAO was asked to study (1) the nature and extent of U.S. persons' involvement with Ugland House registered entities and the nature of such business; (2) the reasons why U.S. persons conduct business in the Cayman Islands; (3) information available to the U.S. government regarding U.S. persons' Cayman activities; and (4) the U.S. government's compliance and enforcement efforts. GAO interviewed U.S. and Cayman government officials and representatives of the law firm housed in Ugland House, and reviewed relevant documents. The full report on GAO's review is GAO-08-778 , being released at the same time as this testimony.
section_title: What GAO Found
paragraphs: The sole occupant of Ugland House is Maples and Calder, a law firm and company-services provider that serves as registered office for the 18,857 entities it created as of March 2008, on behalf of a largely international clientele. According to Maples partners, about 5 percent of these entities were wholly U.S.-owned and 40 to 50 percent had a U.S. billing address. Ugland House registered entities are often participants in investment and structured-finance activities, including those related to hedge funds and securitization. Gaining business advantages, such as facilitating U.S.-foreign transactions or minimizing taxes, are key reasons for U.S. persons' financial activity in the Cayman Islands. The Cayman Islands' reputation as a stable, business-friendly regulatory environment also attracts business. This activity is typically legal, such as when pension funds and other U.S. tax-exempt entities invest in Cayman hedge funds to maximize their investment return by minimizing U.S. taxes. Nevertheless, as with other offshore jurisdictions, some U.S. persons may use Cayman Island entities to illegally evade income taxes or hide illegal activity. Information about U.S. persons' Cayman activities comes from self-reporting, international agreements, and less formal sharing with the Cayman government. Because there is often no third-party reporting, self-reported information may be vulnerable to being inaccurate or incomplete. U.S. officials said the Cayman government has been responsive to taxpayer-specific information requests. The Internal Revenue Service has several initiatives that target offshore tax evasion, including cases involving Cayman entities, but oversight and enforcement challenges related to offshore financial activity exist. U.S. officials said that cooperation with the Cayman Islands government has been good. Also, Maples partners said that ultimate responsibility for compliance with U.S. tax laws lies with U.S. taxpayers.

section_title: Letter
paragraphs: I appreciate this opportunity to discuss offshore financial activity in the  Cayman Islands and the challenges posed for both tax policy and  administration. International financial activity is common in our  increasingly global economy, and is encouraged or facilitated by various  federal policies. Nevertheless, financial activity across foreign  jurisdictions poses challenges for both tax policy and administration.
Recognizing the serious problems posed by offshore tax evasion, you  asked us to study what is known about the business activities of U.S.  taxpayers involving Ugland House in the Cayman Islands. Specifically, you  asked us about the extent, motives, and tax implications of these activities,  as well as the extent to which the U. S. government has looked into these  taxpayer activities. The report we are issuing today focuses on these  activities. The objectives of our report were to determine (1) the nature  and extent of U.S. persons’ involvement with Ugland House registered  entities, and what business, if any, these entities carry on in Ugland House  and in the Cayman Islands; (2) what reasons attract U.S. persons to  conduct business in the Cayman Islands; (3) what information is available  to the U.S. government regarding U.S. persons’ Cayman Islands activities,  including which are associated with U.S. taxpayers; and (4) for tax  noncompliance and other related illegal activities, describe the U.S.  government’s compliance and enforcement efforts, and any related activity  on the part of the Cayman Islands government.
To address our objectives, we reviewed and analyzed U.S. government and  private-sector documents; interviewed U.S. and Cayman Islands officials  as well as partners of Maples and Calder, the law firm that occupies  Ugland House; and examined data from sources in the U.S. and Cayman  Islands related to Ugland House and the Cayman Islands. For more  information on our methodology, please see the report we are issuing  today in conjunction with this testimony. We conducted our work from  July 2007 to July 2008 in accordance with generally accepted government  auditing standards. Those standards require that we plan and perform the  audit to obtain sufficient, appropriate evidence to provide a reasonable  basis for our findings and conclusions based on our audit objectives. We  believe that the evidence obtained provides a reasonable basis for our  findings and conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: The Cayman Islands is a United Kingdom Overseas Territory located in the  Caribbean Sea south of Cuba and northwest of Jamaica, with a total land  area approximately 1.5 times the size of Washington, D.C., and a  population of 47,862. While geographically small, the Cayman Islands is a  major offshore financial center (OFC) with no direct taxes that attracts a  high volume of U.S.-related financial activity, often involving institutions  rather than individuals. Although not easily defined, OFCs are generally  described as jurisdictions that have a high level of nonresident financial  activity, and may have characteristics including low or no taxes, light and  flexible regulation, and a high level of client confidentiality. The Cayman  Islands reports that in 2008 it had 277 licensed banks, over 80,000  registered companies, more than 9,000 registered investment funds, and  760 captive insurance companies. According to the Department of the  Treasury, U.S. investors held approximately $376 billion in Cayman-issued  securities at the end of 2006, making it the fifth most common location for  U.S. investment in foreign securities. As of September 2007, U.S. banking  liabilities to the Cayman Islands were the highest of any foreign  jurisdiction, at nearly $1.5 trillion. As of June 2007, U.S. banking claims on  the Cayman Islands stood at $940 billion, second only to the United  Kingdom.
section_title: U.S. Persons Are Frequently Associated With Ugland House Registered Entities
paragraphs: The international law firm of Maples and Calder, with its associated  businesses - Maples Corporate Services Limited and Maples Finance  Limited - is the sole occupant of Ugland House. Its business is to facilitate  Cayman Islands-based international financial and commercial activity for a  clientele of primarily international financial institutions, institutional  investors, and corporations. Similar to corporate service providers in the  United States, Maples Corporate Services Limited provides registered- office services, using Ugland House as a registered address, to entities it  establishes. Registered-office services include activities such as  maintenance of certain entity records and filing of statutory forms,  resolutions, notices, returns, and fees. Cayman Islands law requires  company-service providers like Maples and Calder to adhere to specific  Anti-Money Laundering (AML) and Know-Your-Customer (KYC)  requirements. For example, they must verify and keep records on the  beneficial owners of entities to which they provide services, the purpose  of the entities, and the sources of the funds involved.
Very few Ugland House registered entities have a significant physical  presence in the Cayman Islands or carry out business in the Cayman  Islands. According to Maples and Calder partners, the persons establishing  these entities are typically referred to Maples by counsel from outside the  Cayman Islands, fund managers, and investment banks. As of March 2008  the Cayman Islands Registrar reported that 18,857 entities were registered  at the Ugland House address. Approximately 96 percent of these entities  were classified as exempted entities under Cayman Islands law, and were  thus generally prohibited from carrying out domestic business within the  Cayman Islands.
Maples and Calder senior partners told us that approximately 5 percent of  the entities registered at Ugland House were wholly owned by U.S.  persons, while 40 to 50 percent were related to the U.S. in that they had a  billing address in the United States. A U.S. billing address does not  necessarily imply ownership or control. According to the partners, U.S.  persons associated with Ugland House registered entities are often  participants in investment and structured-finance activities, including  those related to hedge funds and securitization. Entities associated with  these activities are not generally directly owned or controlled. For  instance, investment-fund entities are often established as partnerships  and are essentially owned by the fund’s investors. Structured-finance  entities are not typically carried on a company’s balance sheet, and  ownership can be through a party other than the person directing the  establishment of the entity, such as a charitable trust, or spread across  many noteholders or investors, such as in deals involving securitization.  The entities created by Maples and Calder that are directly owned or  controlled include corporate subsidiaries, such as those used by  multinational corporations to conduct international business.
section_title: Several Factors Influence U.S. Taxpayers’ Decisions to Conduct Financial Activity in the Cayman Islands
paragraphs: U.S. persons who conduct financial activity in the Cayman Islands  commonly do so to gain business advantages, including tax advantages  under U.S. law. Although such activity is typically legal, some persons  have engaged in activity in the Cayman Islands, like other jurisdictions, in  an attempt to avoid detection and prosecution of illegal activity by U.S.  authorities.
The Cayman Islands may attract U.S-related financial activity because of  characteristics including its reputation for stability and compliance with  international standards, its business-friendly regulatory environment, and  its prominence as an international financial center. For instance, because  the Cayman Islands’ legal and regulatory system is generally regarded as  stable and compliant with international standards, U.S. persons looking  for a safe jurisdiction in which to place funds and assets may choose to  carry out financial transactions there. Additionally, establishing a Cayman  Islands entity can be relatively inexpensive—an exempted company can  be created for less than $600, not taking into account service-provider  fees. Further, U.S. persons may also be attracted to the Cayman Islands  because it is proximate to the United States, operates in the same time  zone as New York, and is English speaking.
Another frequent reason for doing business in the Cayman Islands is to  obtain tax advantages, such as through reduction or deferral of U.S. taxes.  For instance, U.S. tax-exempt entities, such as university endowments and  pension funds, may invest in hedge funds organized in the Cayman Islands  in order to avoid the unrelated business income tax (UBIT). The  investment income of U.S. tax-exempts may be subject to UBIT if earned  by an investment vehicle organized as a U.S. partnership, a formation  common among U.S.-based hedge funds. However, tax-exempts that invest  in hedge funds organized as foreign corporations in jurisdictions like the  Cayman Islands can be paid in dividends, which are not subject to UBIT.
Additionally, some U.S. persons may use Cayman Islands entities to defer  U.S. taxes. For example, a U.S.-based multinational business may create a  Cayman Islands subsidiary to hold foreign earnings, which are not  generally taxed in the United States unless or until repatriated. Because  the Cayman Islands, like some other OFCs, has no direct taxes, Cayman  subsidiaries do not incur additional taxes owed to the Cayman Islands  government. One indication of the extent to which U.S. companies use  Cayman entities to defer taxes is their reaction to a recent tax law. In 2004,  Congress approved a received dividend reduction for certain earnings of  foreign subsidiaries of U.S. companies repatriated for a limited time.  Approximately 5.5 percent of the nearly $362 billion repatriated between  2004 and 2006 came from Cayman Island controlled foreign corporations.
Lastly, as with other offshore jurisdictions, some U.S. persons may  establish entities in the Cayman Islands to illegally evade taxes or avoid  detection and prosecution of illegal activities. The full extent of illegal  offshore financial activity is unknown, but risk factors include limited  transparency related to foreign transactions, and difficulties faced by U.S.  regulators and the courts in successfully prosecuting foreign criminal  activity. Voluntary compliance with U.S. tax obligations is substantially  lower when income is not subject to withholding or third-party-reporting  requirements. Because U.S.-related financial activity carried out in foreign  jurisdictions is not subject to these requirements in many cases, persons  who intend to evade U.S. taxes are better able to avoid detection. Persons  intent on illegally evading U.S. taxes may be more likely to carry out  financial activity in jurisdictions with no direct taxes, such as the Cayman  Islands, because income associated with that activity will not be taxed  within those jurisdictions.
section_title: The U.S. Government Has Access To Several Information Sources Regarding U.S. Taxpayers’ Business Activities in the Cayman Islands, but Most Information is Self Reported
paragraphs: Individual U.S. taxpayers and corporations are generally required to self- report their taxable income to the Internal Revenue Service (IRS).  Similarly, publicly owned corporations traded on U.S. markets are  required to file annual or quarterly statements with the Securities and  Exchange Commission (SEC). When an individual or corporation conducts  business in the Cayman Islands, there is often no third-party reporting of  transactions, so disclosures to IRS and U.S. regulators are dependent on  the accuracy and completeness of the self-disclosure. Cayman Islands  financial institutions are often not required to file reports with IRS  concerning U.S. taxpayers. This makes it more likely that there would be  inaccurate reporting by U.S. taxpayers on their annual tax returns and SEC  required filings.
In addition to the information that both IRS and SEC receive from filers of  annual or quarterly reports, the U.S. government also has formal  information-sharing mechanisms by which it can receive information from  foreign governments and financial institutions. In November of 2001, the  United States signed a Tax Information Exchange Agreement (TIEA) with  the government of the United Kingdom with regard to the Cayman Islands.  The TIEA provides a process for IRS to request specific information  related to taxpayers. IRS sends TIEA requests to the Cayman Islands based  on requests from inside the agency. In addition to the TIEA, the U.S.  government and the Cayman Islands also entered into a Mutual Legal  Assistance Treaty (MLAT) in 1986. The MLAT enables activities such as  extraditions, searches and seizures, transfer of accused persons, and  general criminal information exchange, including in relation to specified  tax matters.
Since the TIEA began to go into effect, IRS has made a small number of  requests for information to the Cayman Islands. An IRS official told us that  those requests have been for either bank records of taxpayers or for  ownership records of corporations.  The IRS official also told us that the  Cayman Islands government has provided the requested information in a  timely manner for all TIEA requests. Since the MLAT went into effect and  through the end of 2007, the Department of Justice told us that the U.S.  government has made over 200 requests for information regarding criminal  cases to the Cayman Islands.
Some financial intelligence information on U.S. persons’ Cayman activities  is available to U.S. regulators. The U.S. government’s financial intelligence  unit, FinCEN, works to gather information about suspected financial  crimes both offshore and domestic. As part of its research and analysis,  FinCEN can make requests of its counterpart in the Cayman Islands, the  Cayman Islands Financial Reporting Authority (CAYFIN). CAYFIN can and  does make requests to FinCEN as well. FinCEN and CAYFIN routinely  share suspicious activity information.
In fiscal year 2007 CAYFIN made 25 suspicious activity information  requests to FinCEN to follow up on potential new as well as existing  Cayman Islands-generated suspicious activity reports (SARs), while  FinCEN made 6 requests to CAYFIN. According to CAYFIN, financial  institutions primarily filed suspicious activity reports on U.S. persons for  suspicion of fraud related offenses. Other offenses leading to the filing of  suspicious activity reports included drug trafficking, money laundering,  and securities fraud, which mostly consisted of insider trading.
In addition to the formal information sharing codified into law between  the U.S. government and Cayman Islands government and financial  institutions represented by TIEA and MLAT requests and SARs, Cayman  Islands officials reported sharing with and receiving information from  federal agencies, state regulators, and financial institutions.
section_title: U.S. and Cayman Officials Have Taken Steps to Address Illegal Activity, but Enforcement Challenges Exist
paragraphs: To address the challenges posed by offshore illegal activity, IRS has  targeted abusive transactions in areas related to transfer pricing, hedge  funds, offshore credit cards, and promoters of offshore shelters. IRS  officials said that some abusive transactions identified through these  initiatives involved Cayman Islands entities, although the exact extent of  this involvement was unclear because it does not maintain jurisdiction- specific statistics regarding abusive transactions.
While the full extent of Cayman involvement in offshore illegal activity is  unclear, U.S. officials were able to point to specific criminal investigations  and prosecutions involving the Cayman Islands. Over the past five years  IRS field agents have requested information regarding suspected criminal  activity by U.S. persons in 45 instances pertaining to taxpayers or subjects  in the Cayman Islands. We analyzed 21 criminal and civil cases to identify  common characteristics of legal violations related to the Cayman Islands.  Among these cases, the large majority involved individuals, small  businesses, and promoters, rather than large multinational corporations.  While they were most frequently related to tax evasion, other cases  involved securities fraud, money laundering, and various other types of  fraud. In most instances, Cayman Islands bank accounts had been used,  and several cases involved Cayman Islands companies or credit-card  accounts.
IRS and Department of Justice (DOJ) officials stated that particular  aspects of offshore activity present challenges related to oversight and  enforcement. Specifically, these challenges include lack of jurisdictional  authority to pursue information, difficulty in identifying beneficial owners  due to the complexity of offshore financial transactions and relationships  among entities, and lengthy processes involved with completing offshore  examinations.
Despite these challenges, U.S. officials consistently report that  cooperation by the Cayman Islands government in enforcement matters  has been good. Further, both the International Monetary Fund (IMF) and  the Caribbean Financial Action Taskforce (CFATF) have cited the Cayman  Islands for its efforts to comply with international standards, such as those  related to anti-money-laundering and terrorist-financing activities.  However, Cayman Islands government officials and senior partners from  Maples and Calder stated that their role in helping the U.S. ensure  compliance with U.S. tax laws is necessarily limited. Cayman Islands  government officials stated that they cannot administer other nations’ tax  laws and are not aware of any jurisdiction that undertakes such an  obligation as a general matter. Senior partners from Maples and Calder  stated that complying with U.S. tax obligations is the responsibility of the  U.S. persons controlling the offshore entities, and that they require all U.S.  clients to obtain onshore counsel regarding tax matters before they will  act on their behalf. Cayman officials told us that until a request is made by  the U.S. for tax-related assistance, the Cayman Islands government is  “neutral” and does not act for or against U.S. tax interests.
section_title: Concluding Observations
paragraphs: Ugland House provides an instructive case example of the tremendous  challenges facing the U.S. tax system in an increasingly global economy.  Although the Maples and Calder law firm provides services that even U.S.  government-affiliated entities have found useful for international  transactions and the Cayman Islands government has taken affirmative  steps to meet international standards, the ability of U.S. persons to  establish entities with relatively little expense in the Cayman Islands and  similar jurisdictions facilitates both legal tax minimization and illegal tax  evasion. Despite the Cayman Islands’ adherence to international standards  and the international commerce benefits gained through U.S. activities in  the Cayman Islands, Cayman entities nevertheless can be used to obscure  legal ownership of assets and associated income and to exploit grey areas  of U.S. tax law to minimize U.S. tax obligations. Further, while the Cayman  Islands government has cooperated in sharing information through  established channels, as long as the U.S. government is chiefly reliant on  information gained from specific inquiries and self-reporting, the Cayman  Islands and other similar jurisdictions will remain attractive locations for  persons intent on legally minimizing their U.S. taxes and illegally avoiding  their obligations.
Balancing the need to ensure compliance with our tax and other laws  while not harming U.S. business interests and also respecting the  sovereignty of the Cayman Islands and similar jurisdictions undoubtedly  will be a continuing challenge for our nation.
Chairman Baucus, Senator Grassley, and members of the committee, this  concludes my testimony. I would be happy to answer any questions you  may have at this time.
section_title: Contact and Acknowledgments
paragraphs: For further information regarding this testimony, please contact Michael  Brostek, Director, Strategic Issues, on (202) 512-9110 or  brostekm@gao.gov. Contact points for our offices of Congressional  Relations and Public Affairs may be found on the last page of this  statement. Individuals making key contributions to this testimony include  David Lewis, Assistant Director; Perry Datwyler; S. Mike Davis; Robyn  Howard; Brian James; Danielle Novak; Melanie Papasian; Ellen Phelps  Ranen; Ellen Rominger; Jeffrey Schmerling; Shellee Soliday; Andrew  Stephens; Jessica Thomsen; and Jonda VanPelt.
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This is a work of the U.S. government and is not subject to copyright protection in the  United States. It may be reproduced and distributed in its entirety without further  permission from GAO. However, because this work may contain copyrighted images or  other material, permission from the copyright holder may be necessary if you wish to  reproduce this material separately.