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Cayman CRS Guidance Part 2: Entity Equity-Interest Holders

Peter Cotorceanu Blog, Cayman Guidance Notes, CRS, Entity Equity, Interest Holders, OECD

In the last blog, we looked at several aspects of the Cayman CRS guidance that go above and beyond what CRS itself requires. In today’s blog, we look at a different aspect of the Cayman guidance. At first blush, this aspect appears to follow a requirement of the OECD’s CRS Implementation Handbook that flatly contradicts CRS. Read closely, however, it is (almost) perfectly consistent with CRS.

We’ll start with the CRS Implementation Handbook and then see what Cayman has done. But first some background.

As many of you know, a “financial account” in a trust that is an FI includes an “equity interest” in the trust. An “equity interest” is held by the settlor, certain beneficiaries, and “any other natural person exercising ultimate effective control over the trust.” So far, so good.

What if the equity interest is held by an entity? Under CRS itself (not the Handbook), the answer depends on the classification of the entity holding the interest.

There are only three possibilities: The entity holding the interest might be:

  • an FI
  • an Active NFE, or
  • a Passive NFE.

Let’s take each of these in turn.

  • FI: If the entity holding the interest in the FI is also itself an FI, the FI in which the interest is held does nothing. FIs don’t report other FIs and don’t look through them for Controlling Persons. This makes sense. After all, FIs have CRS reporting obligations. Therefore, the FI holding the interest will have its own reporting obligations. Consequently, there’s no need for the FI in which the interest is held to have its own separate reporting obligations or to look through the interest-holding FI for Controlling Persons.
  • Active NFE: Active NFE is the most privileged of all CRS classifications. Active NFEs have no CRS reporting obligations and are not looked through for Controlling Persons. Therefore, if an Active NFE has an equity interest in an FI, the Active NFE won’t report, and the FI will not look through the Active NFE for Controlling Persons. Subject to limited exceptions, the FI will report the Active NFE itself, but it won’t report the people behind the Active NFE.
  • Passive NFE: Just like Active NFEs, Passive NFEs have no CRS reporting obligations. But if a Passive NFE has an equity interest in a trust that is an FI, the trust must look through the Passive NFE for Controlling Persons. The FI trust will then report both the Passive NFE and the Controlling Persons, assuming they reside in countries with which the trustee’s country has a CRS information exchange agreement.

All of the above is basic CRS. Therefore, if a settlor or beneficiary who is an equity-interest holder in an FI trust is an entity, apply the above rules depending on the entity’s own CRS classification.

The waters get a little murkier with respect to equity-interest holders other than settlors and beneficiaires, i.e., persons who exercise “ultimate effective control” over trusts. In effect, the trust must identify any natural person (i.e., individual) who effectively calls the shots for the trust. Such an individual might or might not have a formal role in the trust. Key is that the person actually runs the show, whether formally or informally. And it’s irrelevant whether the person is exercising control through an entity or directly as an individual. The only thing that matters is that the person is exercising “ultimate effective control” over the trust, which is a pretty high threshold.

If you’re interested in my thoughts on whether protectors as such should be treated as exercising “ultimate effective control” over their trusts, read my previous blog on that topic, available here. A trickier question is whether trustees should be treated as exercising that sort of control. The OECD’s Implementation Handbook says “yes”. But is that right?

There is no question that, in the abstract, trustees generally exercise “ultimate effective control” over their trusts. There may be exceptions for BVI VISTA trusts, Cayman STAR trusts, and other trusts that narrowly circumscribe trustees’ duties. But in general, there’s no doubt that trustees generally meet this criterion. Except that, in this particular context, there’s a strong argument that they don’t.

How so?

As with any legal definition, one has to consider the drafting history to discern its intended meaning. The definition of equity-interest holders in trusts was based on the definition of “Controlling Persons” of Passive NFE trusts. Take a look at the following table, which lays the two definitions side by side:

Controlling Persons of Passive NFE TrustsEquity-Interest Holders in FI Trusts
·      the settlor(s),

·      the trustee(s),

·      the protector (if any),

·      the beneficiary(ies) or class(es) of beneficiaries, and

·      any other natural person(s) exercising ultimate effective control over the trust

·      a settlor or

·      the trustee(s),

·      the protector (if any)

·      beneficiary of all or a portion of the trust, or

·      any other natural person exercising ultimate effective control over the trust

 

As you can see, while both trustees and protectors are expressly listed as Controlling Persons of Passive NFE trusts, they were both deleted from the definition of equity-interest holders in FI trusts. Why? Well, put yourself in the shoes of the draftsperson. You’ve been asked to come up with a definition of persons who hold an “equity interest” in a trust. As a matter of trust law, does a trustee hold an “equity interest” in its trust? Absolutely not. Trustees hold legal title to trust assets, but they do not hold equitable title. Only beneficiaries do. So, as a draftsperson, you are going to get out your big red pen and run a line through “trustee”. Which is precisely what the draftsperson of this provision did.

How about protectors?  Protectors don’t hold any title at all in trusts—not legal title and not equitable title. So, as a draftsperson, you are once again going to take your big red pen and this time run a line through “protector”. Which is also what the draftsperson of this provision did.

You decide to leave “settlors” in. Settlors, as such, don’t hold equitable title unless they are also beneficiaries. Nevertheless, you figure that the trust assets originated with them so, what the heck, they’re important enough to stay in the definition. And you also decide to leave in the catch all “any other natural person exercising ultimate effective control over the trust”. After all, if a third-party is running the show, you want to know who that person is.

Which brings us back to the question whether trustees should be treated as exercising such control.

Take a step back. You’ve just finished putting a big red line through “trustee” because trustees don’t hold equitable title. It you thought that trustees were nevertheless captured as persons “exercising ultimate effective control”, what would you have accomplished by deleting the express reference to trustees? Nothing. Except confusion. In my view, therefore, the deliberate deletion of “trustees” from the definition of equity-interest holders demonstrates a clear intent that they are not captured by the “ultimate effective control” language. Otherwise, the deletion would have been meaningless. The draftsperson might as well have left the red pen in his or her pocket.

Now back to the Handbook. The Handbook says that the reference to any other natural person exercising ultimate effective control over the trust includes “at a minimum” the trustee as an equity-interest holder. In my view, for the reasons set forth above, this is wrong turn number one.

But the next wrong turn—and it’s is a doozy—is the main topic of today’s blog. Here’s what the Handbook says:

  • If a settlor, beneficiary or other person exercising ultimate effective control over the trust is itself an Entity, that Entity must be looked through, and the ultimate natural controlling person(s) behind that Entity must be treated as the Equity interest holder.

Hold on cowboy! That’s just, well, all mucked up. (I’m biting my tongue here.)

That sentence from the Handbook would be much more accurate if “Entity” were replaced with “Passive NFE”:

  • If a settlor, beneficiary or other person exercising ultimate effective control over the trust is itself a Passive NFE an Entity, that Passive NFE Entity must be looked through, and the ultimate natural controlling person(s) behind that Passive NFE Entity must be treated as the Equity interest holder.

The only problem with this rewritten sentence—and this is a technical quibble—is that the Controlling Persons wouldn’t actually be equity-interest holders. The Passive NFEs would be. The Controlling Persons would be just that: Controlling Persons. But the important point is that both the Passive NFEs and their Controlling Persons would be reportable under CRS (assuming the applicable CRS information exchange agreements were in place).

The way to make the sentence completely accurate is to rewrite it along these lines:

  • Natural persons exercising ultimate effective control over a trust must be identified regardless of whether they act as individuals or through entities

But, of course, that’s not what the Handbook says. Instead, the Handbook directly contradicts CRS by totally ignoring the CRS classification of entities that are equity-interest holders in trusts and treating them all, in effect, as if they were Passive NFEs.

The confusion caused by this verbal sleight of hand is compounded by the fact that the concept of “control” is relevant in two completely different contexts. First, there is the phrase “Controlling Persons”, which is a defined term and which is relevant only to Passive NFEs. Second, there is the phrase “other natural person exercising ultimate effective control over the trust” which, as the above Table shows, is relevant to both FIs and Passive NFEs. That phrase is not defined but certainly does not mean the same thing as “Controlling Persons”. We know that because the definition of “Controlling Persons” includes that very phrase (along with settlors, beneficiaries, trustees, and protectors). So the two concepts can’t mean the same thing. “Persons exercising ultimate effective control” is a narrower concept than, and is subsumed within the definition of, “Controlling Persons”.

Again, my view is that neither trustees nor protectors should be treated as natural persons “exercising ultimate effective control over the trust”. Of course, reasonable people can take a different view. Fair enough. But, as I’ve said before, what’s key is that the person in question must exercise “ultimate effective control”. It’s irrelevant whether they do so directly or through an entity. But they must—one way or the other, directly or indirectly—exercise ultimate effective control over the trust. It’s critical, therefore, not to conflate the concept of “Controlling Persons”, which is a defined term and not relevant in the present context, with the narrower concept of persons exercising ultimate effective control.

Now let’s turn to what the Cayman guidance say on this topic, which is real subject of today’s blog. Subject to an exception for publicly traded companies, the guidance says:

  • In order to determine whether there is any other natural person exercising ultimate effective control, it will be necessary to look through any entity exercising such control (such as a corporate protector or enforcer).

Hurrah! Hats off to the TIA! They got it right. Almost entirely. And certainly much better than the Handbook.

First, unlike the Handbook, the Cayman guidance does not incorrectly say that FI trusts must look through all entity equity-interest holders, including settlors and beneficiaries, and identify their Controlling Persons. Rather, the guidance correctly zeroes in on just the phrase “other natural person exercising ultimate effective control”. Second, unlike the Handbook, the Cayman guidance does not muddy the waters by referring to “controlling persons” as such, which is a separate concept relevant in a completely different context (i.e., with respect to Passive NFEs). Third, unlike the Handbook, the Cayman guidance does not say that trustees are to be treated as “exercising ultimate effective control” over their trust. All good so far. However, there is one problematic part of this sentence from the Cayman guidance. It is the reference to a “corporate protector or enforcer”. The guidance can be read to imply, though it does not expressly say, that all protectors and enforcers are to be treated as if they exercise ultimate effective control over their trusts and that, therefore, all corporate protectors or enforcers are to be looked through. This would certainly be consistent with the OECD’s CRS FAQ on protectors. However, for the reasons set forth in my blog on that topic (available here), the assumption that all protectors exercise ultimate effective control over their trusts is questionable to say the least.

What about “enforcers”? If you’re from Cayman, you know that Cayman STAR trusts use “enforcers” rather than “protectors”. Enforcers are charged with enforcing STAR trusts. Therefore, “enforcers” arguably come a lot closer than run-of-the-mill protectors to exercising ultimate effective control over their trusts.  In any event, the reference to “enforcers” in the Cayman guidance puts to rest any argument that a person with a protector-like role isn’t, in effect, a protector for Cayman CRS purposes: If it walks like a duck and quacks like a duck, it’s a duck!

One final point. The Cayman guidance says that an entity that exercises ultimate effective control must be looked through to determine whether there is any natural person exercising such control. It does not say—and neither should it—that the “Controlling Persons” of such an entity are to be treated as exercising ultimate control over the trust. For example, the Controlling Persons of a company generally include any person who has a greater than 25% ownership interest in the company. But a person with 50% or less ownership doesn’t actually exercise control over that entity, at least not through ownership. Therefore, a 50%-or-less shareholder of a company that exercises ultimate effective control over a trust should not be treated as exercising ultimate effective control over the trust even if the person owns more than 25% of the entity, i.e., the threshold for Controlling Persons of Passive NFEs.

To make this more concrete, take a protector company that, for whatever reason, you have determined actually exercises ultimate effective control over its trust. There are three equal shareholders, each with equal voting rights. If that company were a Passive NFE, each shareholder would be a Controlling Person of the company because each owns more than 25% of the shares. However, in my view, none would be a natural person exercising ultimate effective control over the trust because none can control the company that controls the trust.

In conclusion, as we saw in the last blog, the Cayman TIA requires some things of Cayman FIs above and beyond what CRS requires of FIs generally. More’s the pity. However, when it comes to entity equity-interest holders in trusts that are FIs, the Cayman guidance mercifully does not follow the CRS Implementation Handbook down the garden path. The only problematic part of the guidance is its apparent assumption that all protectors and enforcers necessarily exercise ultimate effective control over their trusts. But, hey, no-one’s perfect.