We are often asked, by both new and established managers, “where should I form my next venture capital fund”? We will hold the short list for purposes of this article at the discussion of Delaware versus Cayman, those being far and away the most prominent places for venture capital funds chasing down reputable institutional capital to establish domicile. But before limiting the discussion to those two locations, we note in passing that a more localized consideration of where to organize your venture fund might be warranted on some less common fact patterns.
This might include a regional base of capital (for example, a manager limiting fund raising to high net worth family offices in Southeast Asia might select Singapore); a place of investment focus (for example, a fund that is investing all or most of its capital in India may be bound to set up shop in Mauritius or Singapore for tax treaty reasons); a type of investment structure (funds that deal in royalty income streams may locate in Luxembourg); or so forth.
In the end, though, a desire to attract global, institutional capital will most often lead to a choice of Delaware versus Cayman. Prominent institutional investors, almost no matter where located globally, are quite likely to be familiar with (and probably already invested in funds in) both locations. So, there is usually little to no serious headwind created by a determination to set up in one place or the other, absent some chance of commercial perception issues as discussed below.
With all this in mind, what to do? A careful analysis should consider all of the commercial, cost, regulatory and tax issues. Let us take those in turn.
Commercial Issues
While it is hard to generalize for every possible situation, there is a very high chance in our experience that your reputable, institutional investors globally could, if they wanted, subscribe to your fund whether it is Delaware or Cayman based. There are not likely to be “deal breakers” in terms of the potential for laws, rules or regulation to actually prohibit it, either from the standpoint of the domicile of the investor or from the standpoint of Delaware or Cayman welcoming your selected investors to subscribe. The word “reputable” above is, though, key to this: investors from blacklist countries or investors from non-blacklist countries that show up on terrorist watch lists or anti-money laundering lists won’t be welcome no matter which location you choose.
However, just because it might be technically feasible from a laws, rules and regulations standpoint, it is not always the case that investors will universally be happy about your choice, and some thought should be given to this. These degrees of willingness to invest in place X or Y, not being driven by actual laws, rules or regulations, are most often driven by perception, so to speak.
What we mean by that is, some non U.S. investors may think Delaware risks putting them too close to a regulatory system that seems onerous and intrusive to them, and they generally don’t like to make investments in Delaware, accordingly.
Likewise, another investor might attribute a bit of “tax haven” mentality around a choice of Cayman, and prefer not to invest there despite it being legally possible. We have encountered large corporate investors, German ones in particular, that have internal policies against investing in Cayman funds based solely on the potential for the appearance, in their view, of impropriety. This has not been particularly helped by the recent “blacklist” situation though that will be resolved quickly and has only marginally impacted this view. The irony of the perception about Cayman is that ultimately, the AML/KYC vetting and so forth in Cayman is quite stronger at present than what is legally required in Delaware.
But back to the headline: commercially, it is usually the case that a deal could get done in either Delaware or Cayman, as the tax analysis and at some point simply manager preference ultimately dictate. Really sticky investors the capital of which is needed could ultimately be accommodated through parallel funds or feeders, though it rarely comes to that in our experience. So we would say, be mindful of perception issues but let regulatory, cost and, particularly, the tax analysis drive the situation.
Administrative and Cost Issues
Forming a fund in the Cayman Islands is usually more expensive. A good benchmark is to add about 10% of total project costs for a fund formation undertaking if it will be Cayman domiciled compared to Delaware. There is also a more detailed time and procedure aspect to Cayman funds. This includes the need for levels of AML/KYC that are above the effort required in Delaware (though still much more user friendly than say Singapore, Mauritius, Hong Kong or most anywhere in the EEA), the requirement to maintain ownership registers, some requirements for greater levels of corporate formalities, and so forth.
Where there are good reasons otherwise to form a venture fund in the Cayman Islands these issues should not be determinative, but it is an aspect worth noting particularly for smaller or first-time funds on limited organizational budgets and/or with modest back office capabilities.
Regulatory Issues
In some cases, regulatory issues may warrant some consideration. This typically arises where a fund is making certain investments in regulated sectors. An exemplar case could be a media fund investing in FCC regulated businesses, or similar, often in the U.S. but sometimes outside of the U.S.
Of current particular focus are funds that may invest in U.S. critical technology companies, and thus fall under the watchful eye of CFIUS and the relatively new FIRRMA regulations. In years past, a group of U.S. venture capitalists taking down global capital and investing globally might have chosen Cayman based on tax reasons (see below). But today, a potential to do one or more U.S. critical technology deals may warrant stronger consideration of Delaware as a domicile (though the recently issued PPB guidance mitigates this concern in some cases).
The punch line is: if you are going to invest in regulated industries, you should have a more detailed discussion with counsel about structuring and choice of domicile than might otherwise be the case. Still though, since most venture funds do not make myriad regulated investments, the thinking usually moves quite quickly to the tax analysis. And that is the basis on which most ultimate decisions about domicile are in fact made.
Tax Issues
When thinking about tax, the conversation then usually covers some or all of the following eight issues, all of which have to be carefully considered together with counsel to determine the extent to which they may be applicable in your own situation.
Issues of Highest Importance
Requirement for Fund to File a U.S. Tax Return
Every partnership formed under the law of a U.S. state, like Delaware, except those that have no income, deductions, or credits for federal income tax purposes, is required to file a U.S. tax return using IRS Form 1065 each year. As a part of that tax return filing a Schedule K-1 is issued to each and every person or entity that was a partner in the partnership at any point in the year. In contrast, a partnership formed under non-U.S. law, like the Cayman Islands, is not required to file a U.S. return if that entity does not have “effectively connected income” (think of that as U.S. situs business income) or “U.S. source” gross income.
While not getting too deep in the weeds, there is a difference of opinion among tax practitioners whether a Cayman partnership with U.S. limited partners generates U.S. source income when it sells shares in a portfolio company. The capital gain allocable to the U.S. limited partners is clearly U.S. source income (with some exceptions we will not discuss) as to the U.S. limited partners but opinions differ as to whether that sourcing at the partner level also applies at the partnership level. Some Cayman funds file and some do not in this context. For those that do file there is a rule that says Schedule K-1 need only be issued to U.S. taxpayer partners. Some fund managers are sensitive to issuing U.S. tax forms to non-U.S. taxpayer partners and this latter rule is helpful in that regard.
Withholding Documentation the Fund Must Provide to Third Parties
A Delaware limited partnership is a U.S. entity for withholding purposes and need only provide a properly filled out form W-9 to third parties (e.g. banks, brokers, paying agents, etc.). A Cayman entity, in contrast, is a pass-through entity for withholding purposes. Such an entity is supposed to provide a Form W-8IMY to third parties like those listed above. This W-8IMY is supposed to include the withholding forms (e.g. W-9, W-8BEN, W-8BEN-E, etc.) of the partners in that partnership along with a “withholding statement” disclosing each partner’s share of income.
The difference in disclosure required in this context should not be minimized. Think of the not uncommon situation where a venture fund makes a small investment in another fund, perhaps for access to deal flow or to assist in launching a new manager. Let’s assume this fund being invested in is a U.S. filer. If the investing fund is a Delaware entity, then the subscription process will involve solely providing the form W-9. If the investing fund is a Cayman entity, then the withholding documentation provided will disclose the identity of all limited partners in the fund, information potentially thought of as sensitive business information. We have seen some Cayman funds refuse to provide this “second layer of information”, but our advice would be to do so only after understanding the risk that the withholding form provided may be viewed as invalid.
Treaty Benefits
Historically many countries (Brazil, Spain and Portugal, for example, among others) have applied a “blacklist” approach to foreign investment in their country, applying higher tax rates to investors from countries viewed as tax havens. Not surprisingly, the Cayman Islands is often on the blacklist for these countries, subjecting investment gains to higher taxes than would apply if a Delaware entity had invested. As mentioned above, recently the European Union added the Cayman Islands to its list of non-cooperative jurisdictions (referred to as the EU’s tax haven blacklist). Though expected to be temporary, this listing has caused consternation especially with some institutional European investors when considering whether to invest in a Cayman Islands fund. At least at present, this poses an issue for certain investors.
Issues of Lesser Importance
Requirement for the Fund to be a Withholding Agent
As a general rule, a Delaware limited partnership will act as a withholding agent with respect to U.S. source withholdable income (such as interest and dividends) and a Cayman limited partnership will not. As with most of tax there are exceptions to this general rule, but the general rule does inform most situations arising in practice. Some fund managers (where the fund expects to have U.S. source withholdable income) are unhappy at the prospect of performing any withholding obligation and on this dimension will prefer a Cayman entity. As a practical matter, venture capital funds do not earn much in the way of income subject to withholding, so this consideration is not often determinative.
Impact on U.S. Taxation of non-U.S. Limited Partners
The good news here is that the choice of Delaware or Cayman will have no impact on the requirement of a non-U.S. limited partner to file a US tax return. While a Delaware fund would involve issuing the non-U.S. limited partner a Schedule K-1, the receipt of that piece of paper does not determine tax filing requirements. The determining factor for tax filing status for the non-U.S. limited partners is the sort of income earned by the fund. “Effectively connected income” earned by the fund, whether formed as a Delaware or Cayman entity, will trigger a U.S. tax filing requirement for non-U.S. limited partners. Most venture capital funds with non-U.S. limited partners will have covenants against earning this sort of income.
Issues Involving Passive Foreign Investment Companies (PFICs)
PFICs are a complicated area and this post will not go into any detail regarding these rules – except to say that many non-U.S. formed early stage venture capital funded companies are PFICs for U.S. tax purposes. In order to avoid adverse tax consequences attendant to owning a PFIC, an election (called the “qualified electing fund” or “QEF election”) must be made. A Delaware fund, as a U.S. entity, makes the QEF election. A Cayman fund, as a non-U.S. entity, cannot make the QEF election and, instead, the U.S. partners in the Cayman fund make the election. So, the difference here is who has the burden of filing the U.S. tax form (Form 8621) to make the QEF election. As a practical matter, whether by the terms of the limited partnership agreement, a side letter, or business practice, the fund manager will need to make the determination of PFIC status for its non-U.S. portfolio companies (in some financings we will see Investors Rights Agreements containing a requirement that the portfolio company make the determination). As a result, the Delaware versus Cayman choice then impacts solely whether the fund or the investor makes the QEF election filing.
Issues Involving Controlled Foreign Corporations (CFCs)
The PFIC rules mentioned above and the CFC rules addressed in this paragraph fall into a category of the U.S. tax laws termed “anti-deferral” rules. Specifically, these anti-deferral rules are designed to prevent U.S. taxpayers from “parking” income or assets offshore and delaying the U.S. taxation on that income. The PFIC rules accomplish anti-deferral by either taxing sales of PFICs as ordinary income (along with a punitive interest charge) or by virtue of the QEF election, which is an agreement to treat the PFIC as a “modified pass-through” entity for U.S. tax purposes. The CFC rules achieve this anti-deferral by requiring some larger shareholders in non-U.S. companies controlled by U.S. shareholders to include in their income, on an annual basis, their pro rata share of certain types of income earned by the CFC, even if the CFC has not paid a dividend of those earnings. This “deemed dividend” each year is taxed as ordinary income.
CFC planning is a key difference between Delaware and Cayman funds. A Delaware fund is a U.S. person for CFC determination purposes, thus if a Delaware fund owns 10% or more of the vote or value of the foreign portfolio company, it will be counted as a “U.S. shareholder” for purposes of determining whether U.S. shareholders as a group own more than 50% of the foreign corporation, triggering CFC status.
A Cayman entity is not a U.S. person and the determination of U.S. shareholder status would occur at the partner level. As a result, unless the Cayman fund holds a large position in the portfolio company and a U.S. limited partner holds a large portion of the fund, it is unlikely that a Cayman based investor will contribute towards a foreign portfolio company being a CFC.
Historically, many firms with Delaware main funds have formed Cayman alternative vehicles to invest in non-U.S. portfolio companies for just this purpose (if not entirely shifted domicile to Cayman to avoid the need to do so).
The efficacy and necessity of this planning has changed given recent changes in U.S. tax law. At a high level, the 2017 Tax Cuts and Jobs Act changed some hyper-technical “attribution of ownership” rules that now cause many more non-U.S. entities to be CFCs. Fortunately, the U.S. Treasury has issued some proposed and final rules in this area, which, at their heart, seek to remove this “Cayman versus Delaware” distinction when determining who actually is affected by CFC status. These new rules (from last summer) retain the Cayman versus Delaware distinction in determining which entities are CFCs but they seek to remove the distinction between Cayman and Delaware when determining who is taxed on certain types of income earned by the CFC. CFCs may deserve a longer discussion, but, for purposes of this post, the take-away point is that the Cayman versus Delaware distinction previously applicable is less impactful.
FATCA and AEOI Issues
The venture capital community has been living with FATCA for the past 10 years now, so we will not delve into details here. One obvious point to make, though, is that a Delaware entity is not foreign and therefore is not a foreign financial institution (FFI) required to register with the IRS and perform FATCA due diligence and reporting on its investors. A Delaware fund’s sole interaction with FATCA is as a withholding agent when required. A Cayman fund is an FFI and is required to obtain a Global Intermediary Identification Number (GIIN), register with the Cayman Islands Tax Information Authority and perform annual reporting to that body. There are also similar Cayman requirements as to non-U.S. jurisdictions (AEOI). Thus, the FATCA/AEOI compliance costs for a Cayman fund generally will be higher than those incurred by a Delaware fund.
Conclusion
As can be gleaned from the above, the choice of jurisdiction for a venture capital fund depends on a number of factors. The above discussion is limited to certain matters that most frequently come into play when sitting down to make this determination. The importance and weighting of each factor will differ manager-to-manager. After considering the above, and mapping out the attributes of your proposed fund, a careful structuring discussion with counsel is warranted as a first step in your fund raising effort.
The authors
Paul Roberts
