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By: Wilmington Trust
In today's global economy, corporate managers must make the most of available opportunities, wherever they are in the world.
For asset-financing transactions, which frequently have a myriad of tax, legal, and financial issues associated with them, creating a special purpose vehicle (SPV) is frequently the ideal approach. Establishing this SPV in the Cayman Islands may enhance the associated benefits.
As the name suggests, an SPV is an entity created to engage in a specific transaction, most commonly for asset acquisition, leasing, and securitization. Various structures may be used, including corporations, trusts, partnerships, and limited liability companies. Often, the documents creating the SPV contain language that clearly limits permissible activities. For example, the individuals managing the SPV might be prohibited from engaging in any unauthorized transactions, such as taking on additional debt or disposing of assets.
An SPV may be formed in many jurisdictions, but the Caribbean's Cayman Islands have gained favor. The legal talent available in the Cayman Islands, a British Overseas Territory, ranks among the best in the world, including many attorneys who were educated and have practiced in the United Kingdom. For sophisticated asset financing transactions, conducting business in the Caymans is akin to doing business in New York or London.
The political and economic stability of the Cayman Islands is certainly appealing to corporations wishing to sponsor SPVs. The Cayman legal structure allows companies to raise capital off of their balance sheets, often at lower costs, and SPV activities may be insulated from claims of potential creditors.
While other jurisdictions also offer the opportunity to create SPVs, these rival venues may be more closed to outsiders, with fewer world-class law firms. Plus, banking and trust structures may not be as easy to arrange as they are in the Caymans.
There are many other advantages to operating in the Caymans. Fees are generally modest, and the legal and regulatory framework is extremely flexible. Red tape is also minimal: No governmental authorizations or licenses are necessary in order to establish an SPV in the Cayman Islands. Incorporation generally takes less than 24 hours once the process is underway, and costs are modest. To set up an SPV, government fees range between US $574 and US $2,400, depending on the amount of capital involved, and total costs generally range between US $2,000 and US $3,000.
In essence, companies from all over the world find that the Caymans are a friendly and advantageous place to do business.
A Less Taxing Environment
Under current Cayman law, most SPVs are established as "exempted companies." An exempted company is not permitted to conduct business within the Cayman Islands, and, in return, it is entitled to a complete tax holiday for 20 years, with a possibility of a 10-year extension. In any event, there are no direct taxes in the Cayman Islands, so an exempted company will not have to pay any form of income tax, capital gains tax, or corporation tax. Similarly, no taxes will be withheld from any cash flows.
Establishing an SPV in a tax-neutral jurisdiction such as the Cayman Islands is especially helpful if the ultimate sponsor operates in a high-tax country such as the U.S. or U.K. A properly structured SPV may reduce or even eliminate taxes owed to the sponsor's home country.
In addition to tax relief, an SPV can protect assets from potential legal exposure. In some circumstances, the sponsoring company may maintain upside potential if a venture is successful, but may significantly limit its risk or liability if the project fails. If an SPV is properly structured, the sponsor may not have to reflect the debt of the SPV on its own balance sheet, thus improving its credit rating.
For corporate sponsors interested in the advantages described above, the Cayman Islands offer a favorable regulatory climate. Among the few requirements governing an SPV set up as an exempted company are that it must:
To make these requirements even easier to meet, a Cayman Islands SPV need have only one shareholder and only one director, which may be a corporation. Frequently, the SPV's manager, under the terms of an administration or management agreement, will choose a suitable director. Even though the parties to the transaction may feel more comfortable with the additional local presence of a Cayman-based director, the sole director does not have to be a resident of the Islands. The law allows for alternate directors or proxies to sit at board meetings. Regardless of the director's home base, rating agencies will expect that he or she be a person of substance.
The Register of Members may be kept at the SPV's registered office or at any other location. The annual filing cost falls in the same range as the incorporation fees mentioned earlier, based on the same criteria.
In a typical arrangement, the SPV is owned by a Cayman trust, and a charity or the ultimate sponsor is the beneficiary of the trust. A charitable trust or a property structured purpose trust structure is required in order to reinforce the SPV's "orphan" status so that its assets do not appear on the books of the corporations involved.
Fundamentals Of Asset Financing
When an SPV transaction involves asset financing, it usually falls into one of two categories:
For both types of transactions, cash flow generated by the underlying asset can enable the SPV to make the required principal and interest payments. Indeed, most SPV transactions are over-collateralized, so that the assets involved are projected to produce more income than necessary to pay interest on the securities that have been issued.
When the transaction winds up, the SPV will sell its assets to redeem the outstanding securities, re-paying investors and lenders. In the meantime, hedging agreements such as swaps may be used to reduce the risks of interest-rate or currency fluctuations.
Further exploring the two categories mentioned above, SPV transactions may be designed to meet specific objectives. Examples include:
Banks and other financial institutions often hold loans that are considered to be high-quality, based on the collateral and/or the borrower's credit-worthiness. Ironically, ownership of such loans may be unappealing because regulatory requirements cause the firms holding these assets to back them with a high proportion of capital. Naturally, banks want to avoid this obligation, yet still profit from the high-quality loans they have made.
To attain these goals, banks can establish an SIV in the Cayman Islands, which will purchase the high-quality assets. This removes those assets from the bank's books and reduces the bank's need to hold additional capital.
Subsequently, the SIV can sell securities to investors, backed by the high-quality assets it is holding. For various reasons, including excess collateralization, shorter maturities, and repayment guarantees, the interest payable on the securities issued by the SIV may be lower than the interest paid by the ultimate borrowers. Thus, the originator of the loans can make money from interest-rate arbitrage: this is the spread between its interest income and its cost of funds.
Collateralized loan obligations (CLOs). In these deals, the lender does not sell the assets to an SPV. Instead, the lender creates derivatives in the form of credit-linked notes or credit default swaps. The notes or swap agreements are sold to the SPV, which issues securities that are backed by the income from these derivatives. In this manner, a CLO may serve to securitize the income and the risk of the underlying loans but not the actual assets. This structure allows the sponsor to retain some degree of control over the original assets.
Collateralized debt obligations (CDOs). Again, these arrangements provide the sponsor with access to the assets and their income, in certain circumstances. Often, CDOs are used to repackage asset-backed securities, mortgage-backed securities, and other structured products.
A Case In Point
As an example of how an SPV can work, let's say a fund formed to offer mortgage-backed securities is incorporated as a Cayman SPV. This fund issues three classes of rated, secured debt and one class of preferred shares to third-parties. The proceeds from these issues are invested in a portfolio of U.S. mortgage-backed securities.
This structure gives the fund the ability to reinvest monthly income from the underlying mortgage payments and delay distributions until its quarterly payments are due, thereby profiting from use of money. Having fixed-rate assets backing floating-rate notes may provide profit potential, via an interest-rate spread. Moreover, the structure of the SPV allows for substitution of collateral, should developments in the mortgage market make that desirable.
Aside from the business advantages described above, this transaction is extremely tax efficient. As mentioned earlier, the SPV itself faces no corporate, income, capital gains, or withholding taxes, as long as it is an exempted company that does not conduct business in the Cayman Islands.
The sponsor's U.S. taxes may be reduced, too. Under the U.S. Internal Revenue Code, an offshore issuer that invests in, and holds, passive U.S. assets, such as debt securities, generally is not subject to U.S. taxation. As long as that offshore issuer is not engaged in a U.S. trade or business and trades for its own account, a statutory exemption provides tax relief. Similarly, an offshore corporate issuer avoids the "taxable mortgage pool" rules on certain entities that securitize mortgages.
Many corporate entities can benefit from using a Cayman Islands SPV, but not every financial firm provides the support that sponsors need there. Mistakes may have costly consequences.
Therefore, companies interested in establishing a Cayman SPV should seek an advisor with extensive experience in domicile management, worldwide. A knowledgeable advisor will make certain that all documentary requirements are met, all fees are paid on time, and so on. This advisor should know the jurisdiction well enough to have established vital connections among regulators, agency representatives, and other key officials.
Interested sponsors should seek an advisor that offers a comprehensive package of accounting and administrative services necessary to maintain the SPV's independence from the ultimate sponsor. It is this status as a stand-alone entity that enables an SPV to provide tax and other advantages. Sponsors also will appreciate working with an advisor that helps a Cayman SPV establish and maintain required banking services.
The need for expertise may be especially acute when it comes to off-balance sheet financing in general, and SPVs in particular. With continuing focus on corporate accounting reform, more scrutiny may be given certain transactions and more disclosure might be required. In this environment, any sponsor seeking the benefits of a Cayman SPV should work with an advisory firm that brings genuine expertise to the table.
Updated: January 1, 2013
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
© 2013 Wilmington Trust Corporation.