Private Credit – The Role Played by Offshore Financial Centres

Following a period of exponential growth in the private credit market in the years since the financial crisis, industry experts tell us that the current global macroeconomic environment will only lead to continuing growth in the market, at least for the foreseeable future.

However, in the context of a market that already exceeds US$1 trillion globally, the Australian private credit market is still in its infancy compared to the US and European markets. But in a clear sign that the Australian private credit market is indeed beginning to mature, there has been an influx of global institutional capital into the market of late. As recently as May this year, the ASX-listed Qualitas Limited announced a A$1 billion mandate with an unnamed global institutional investor for investment in Australian commercial real estate private credit opportunities.

In the context of global capital flows, money rarely moves from Point A to Point B, and market participants may be surprised to learn that regardless of whether inward capital investment originated from a US fund manager, a European investment bank or a Middle Eastern sovereign wealth fund, in many cases it will have mediated through the Cayman Islands, the tiny Caribbean island and British Overseas Territory that popular culture knows only as a tax haven. This has already proven true for several Australian private credit fund managers who have trumpeted mandates with global institutional investors.

But the emotive tax haven moniker is unfair. The Cayman Islands can more accurately be described as a tax neutral jurisdiction. There is no income, corporate or capital gains tax imposed on corporations, partnerships, trusts, or individuals regardless of their tax residence. Importantly, no withholding tax is levied on income earned in the Cayman Islands that is repatriated to a foreign jurisdiction. Accordingly, profits earned in the Cayman Islands may be distributed in the form of dividends, interest, etc., without being subject to an additional layer of tax.

This tax neutrality does not preclude individuals or entities that are resident in the Cayman Islands from being subject to taxation imposed by foreign jurisdictions by virtue of citizenship or other income-sourcing rules that apply in that jurisdiction. Equally, individuals or entities that are resident in foreign jurisdictions will be subject to taxation in respect of profits, distributions, dividends, interest, etc., received from entities domiciled in the Cayman Islands. But because no tax is imposed in the Cayman Islands, double taxation should not occur as taxing rights are allocated solely to the relevant foreign jurisdiction. As an example, an Australian tax resident who receives a distribution or dividend from a private credit fund domiciled in the Cayman Islands would be liable to pay tax on that distribution or dividend in Australia. The US domiciled fund manager who receives profits from the management of the fund would be liable to pay tax on those profits in the United States. But neither is liable for tax in the Cayman Islands.

This tax neutrality creates simplicity in tax outcomes for financial services businesses operating in the Cayman Islands and for foreign investors from across the globe who invest in such businesses (or in financial products offered by such businesses), combined with adherence to international standards for transparency, exchange of information and cross-border cooperation makes the Cayman Islands an attractive (and reputable) jurisdiction for international financial services businesses to operate in and can explain why the Cayman Islands has become a major international financial center and the world’s leading domicile for alternative investment funds, including hedge funds, private equity funds and private credit funds.

At present, there are more than 25,000 alternative investment funds registered in the Cayman Islands. By conservative estimates, 70 percent of non-US domiciled alternative investment funds are domiciled in the Cayman Islands, and all the world’s leading alternative investment fund managers have a significant presence there. In many cases, these managers have hundreds of different alternative investment funds, intermediary holding companies or other special purpose vehicles registered in the jurisdiction.

The alternative investment funds industry is further supported by a significant banking infrastructure with more than 100 international investment banks, including each of Australia’s largest four banks, having a subsidiary or branch registered in the jurisdiction.

The role of the Cayman Islands in global intermediation therefore cannot be underscored. A recent study completed by Capital Economics estimates that foreign investment mediated through the Cayman Islands is around US$4.5 trillion per annum.

As the global macroeconomic environment continues to promote growth in the global private credit market, alternative investment fund managers and other financial institutions increase allocations to private credit and competition tightens in the US and European private credit markets, it can be expected that Australia’s leading private credit fund managers will attract more and more global institutional capital, be it from alternative investment fund managers, investment banks, sovereign wealth funds, family offices or other financial institutions located across the globe.

At the same time, it can be expected that company tax advisors will continue to advocate for intermediation by way of the Cayman Islands in a sustained effort to manage their effective tax rates. This pressure is even heightened for exchange listed companies where the effective tax rate is often reported as a profitability metric.

Therefore, Australian private credit fund managers (and the lawyers and advisors tasked with undertaking due diligence and documenting the minutiae of capital investments) should expect more and more global institutional capital inflows to be executed with startingly complex multi-vehicle, multi-jurisdictional structures that, in many cases have a nexus with a tiny Caribbean island 15,000 kilometers away.