Real World Asset Legal Structure
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The Real World Finance Core Unit (the “Core Unit”) recommends that MakerDAO (“MakerDAO”), with guidance from the Real World Asset Committee (“Committee”), review the following legal structure to implement financings in the United States and, subject to tax review on a case-by-case basis, other jurisdictions.
This memorandum does not address any Maker token holders’ individual tax circumstance.
Given the decentralized nature of Maker, the Core Unit prioritized (a) the ability of the Maker community to exercise “control” over real world activities and (b) minimizing tax leakage upon repayments of interest by the underlying borrowers (directly or indirectly) to Maker.
The Core Unit proposes to cause the formation of a Cayman Islands Foundation Company (“FoundationCo”) under the Foundation Company Law of the Cayman Islands.
FoundationCo will have substantial organizational and operational flexibility under the Foundation Company Law and can, as a legal matter, be structured in a manner to satisfy the MakerDAO’s requirements and/or concerns.
Further, FoundationCo will avoid many of the existing uncertainties and complexities associated with utilizing Cayman Islands trusts:
there is not a requirement for a charitable beneficiary,
there is no risk of unlimited trustee liability as the foundation company does not have trustees,
FoundationCo’s organizational documents permit the use of arbitration to resolve disputes in respect of its organizational documents,
FoundationCo will avoid some potential adverse treatment from countries unfamiliar with trusts, and
the absence of a trustee means there is not the need for a mechanism to replace and appoint a new third party trustee.
While the Foundation Company Law is a reasonably recent construct in the Cayman Islands (2017), the Cayman Islands Companies Act applies to foundation companies to the extent not specifically addressed in the Foundation Company Law. As a result, the foundation company will benefit from the existing jurisprudence in respect of Cayman Island companies.
Interestingly, the Cayman Islands did adopt some of the beneficial aspects of trusts in the Foundation Company Law. Namely, the “firewall” feature of Cayman Islands trust legislation gives the foundation company protection against adverse judgments by foreign courts in respect of the structure of the foundation company and the transfer of assets to the foundation company. In addition, like trusts, the foundation company may apply to the Grand Court of the Cayman Islands for opinions, advice or directions.
FoundationCo will have a legal personality similar to a Cayman Islands exempt company.
FoundationCo may have any legal purpose - commercial, charitable, private or any combination.
The Foundation Company Law does not have a minimum capital requirement.
At the time of its formation, FoundationCo will have a single-member shareholder. However, the Core Unit recommends, as permitted by Cayman Islands law, that FoundationCo not have any shareholder members. FoundationCo will, at that point, become a fully, bankruptcy-remote, orphaned entity. When FoundationCo ceases to have a member-shareholder, the Foundation Company Law requires FoundationCo to have at least one supervisor.
The supervisor will have those powers (limited) set forth in the organizational documents for FoundationCo. The organizational documents may provide that the supervisor carry out the decisions of the Maker Community. The Maker Community may elect and replace the supervisor. If the MakerDAO approves the concept of FoundationCo, the Core Unit will propose the scope of powers to be granted to the Supervisor.
A board of directors will manage FoundationCo. The board of directors may constitute one or more persons (a director could also be a corporate entity). Any person of full capacity may be a director and the Foundation Company Law does not require a Cayman Islands director. The directors will owe a fiduciary duty to FoundationCo. The Maker Community may elect and replace each of the directors on the FoundationCo board. This will satisfy, at a minimum, the MakerDAO’s preference to have an independent director.
FoundationCo’s organizational documents will provide for the rights, powers and limitations of the directors. The organizational documents could, for instance, require the directors to verify a Maker community vote on a specific matter before taking (or not taking) any course of action.
If the MakerDAO approves the concept of FoundationCo, the Core Unit will propose the scope of powers to be granted to the board of directors.
FoundationCo may or may not have beneficiaries. The Core Unit recommends that FoundationCo have Maker DAO as the Foundation’s exclusive beneficiary.
FoundationCo must have a secretary who is licensed or permitted under the Companies Management Act to provide company management services. The secretarial position will be outsourced.
FoundationCo must have a registered address. The registered address may be the same as that of the Secretary.
The Cayman Islands does not impose corporate or income tax on foundation companies. FoundationCo may register to be a tax exempt entity and then apply a tax undertaking certificate that will guarantee its tax status in the Cayman Islands for thirty years.
FoundationCo is not required to file or audit its company account.
Funding of FoundationCo.
Maker may make periodic loans to FoundationCo on such terms to be agreed. These loans may, for instance, reflect the underlying loan made, indirectly, by FoundationCo to the real world asset.
FoundationCo will have to pay an annual fee in the Cayman Islands. The current annual fee is $854.
FoundationCo may form one or more subsidiaries within or without the Cayman Islands.
For transactions to be undertaken in the United States, the Core Unit recommends that FoundationCo organize, as the sole member, a member managed, Delaware limited liability company (“Delaware LLC”).
Delaware LLC will be the legal entity making loans to the actual real world borrower.
As a member-managed limited liability company, the operating agreement of Delaware LLC can be a “flow-through” of the decision-making processes at FoundationCo. In this way, the directors of FoundationCo will direct the decisions made at the Delaware LLC level.
For transactions in other jurisdictions, for example, the European Union, it may be more advantageous for FoundationCo to organize a subsidiary in another jurisdiction.
U.S. Federal Income Tax
The Delaware LLC will be a disregarded entity for U.S. federal income tax purposes unless FoundationCo elects to “check the box” and have Delaware LLC treated as a corporation.
As a disregarded entity, Delaware LLC will not be subject to U.S. federal income tax and, for the purpose of U.S. federal income tax, FoundationCo will be viewed as the entity receiving interest income from the underlying borrower.
FoundationCo itself should not be subject to United States federal income tax so long as it is not “engaged in a US trade or business”. “Trading in stocks or securities for the taxpayer’s own account” is expressly excluded from being “engaged in a US trade or business”. The term “securities” generally means any “note, bond, debenture, or other evidence of indebtedness, or any evidence of an interest in or right to subscribe to or purchase any of the foregoing.” On this basis, FoundationCo itself should not be subject to United States federal income tax.
However, to benefit from the securities trading safe-harbor, FoundationCo must assure that its loan trading activities amount to trading securities and not loan origination. Absent any facts indicating that Foundation Co was involved in arranging, the purchase of loans (secondary market acquisitions) should be considered the purchase of securities and should fall within the securities trading safe-harbor. However, if FoundationCo is treated as originating a loan (either directly or indirectly) then such loan origination may expose FoundationCo to US federal income taxes.
Further, to the extent FoundationCo is regularly in the business of making loans to US borrowers, negotiating loan documents in the US and engaging in other regular and systematic business in the US, FoundationCo may itself be subject to US corporate income tax (21%) and a branch profits tax (30%). To address this risk, there may be multiple FoundationCo and Delaware LLCs organized on a deal-by-deal basis or, at a minimum, after a few number of loans.
The acquisition of securities (e.g., US Treasuries) on the secondary market will be considered a passive activity and FoundationCo will not be considered as engaging in business in the US for tax purposes.
Withholding Tax on Interest Income.
Generally, the underlying borrower will have an obligation to withhold a 30% tax on the interest it pays to FoundationCo (indirectly through Delaware LLC). This 30% tax applies to cross-border, US-source “fixed, determinable, annual, or periodic” (FDAP) payments. These payments include interest, dividends, and royalties.
Because FoundationCo should not be “engaged in a US trade or business” and therefore outside the jurisdiction of the Internal Revenue Service (“IRS”), the FDAP tax law imposes the withholding tax obligation (and liability for nonpayment of the tax) on the payer rather than the recipient. The payer, as a withholding agent, is required to deduct and pay any required withholding tax and report the payments and withholding to both the recipient and the IRS.
Notwithstanding the 30% tax on FDAP, FoundationCo may qualify for the “portfolio interest exemption”. The “portfolio interest exemption” exempts certain interest income from U.S. withholding tax. Each loan made by Delaware LLC will need to incorporate the “portfolio interest exemption” requirements. These include:
The debt instrument is in “registered form” (basically meaning that the identity of the holder of the debt instrument (i.e., Delaware LLC) is registered by the issuer (i.e., the Borrower) or the issuer’s agent or the debt instrument is held in a book-entry system – i.e., the debt instrument is not a bearer instrument);
FoundationCo does not own 10% or more of the capital or profits interests of the payor of the interest (i.e., the borrower);
FoundationCo provides the borrower (as payor of the interest) certain documentation regarding the recipient’s non-U.S. status, including IRS Form W-8BEN or W-8BEN-E; and
FoundationCo is not a bank.
To mitigate any adverse tax consequences, Delaware LLC may require that the underlying borrower gross-up its payment of interest to include the withholding tax. This may be a point for commercial negotiation as it will increase the underlying borrower’s costs and the borrower may require a more efficient tax structuring.
In addition to the tax consequences for Delaware LLC, there are further legal issues in the Cayman Islands to consider.
Cayman Islands “International Tax Co-Operation (Economic Substance) Act”
The Cayman Islands recently enacted the “International Tax Co-Operation (Economic Substance) Act” (the “Act”) to ensure the Cayman Islands’ commitment to the OECD’s Base Erosion and Profit Shifting Inclusive Framework.
The Act mandates that all Cayman Islands entities (subject to limited exceptions) must satisfy certain economic substance requirements in the Cayman Islands and submit an annual return to the Cayman Islands attesting to that satisfaction. Cayman Islands trusts are currently exempt from the economic substance requirements application to foundation companies and other companies.
If FoundationCo makes equity contributions into Delaware LLC (as opposed to shareholder loans), FoundationCo will qualify as a “Pure Equity Holding Company” under the Act. As a Pure Equity Holding Company, FoundationCo will have to demonstrate that it has adequate human resources and premises in Cayman for holding and managing equity participations in other entities. The Cayman Islands has issued guidance that states that a Pure Equity Holding Company may engage its registered office service provider in the Cayman Islands to satisfy this reduced economic substance test depending on the level and complexity of activity required to operate its business.The requirements for a Pure Equity Holding Company are lower than those for a Cayman Island company engaged in a financing business outside of the Cayman Islands.
Ogier (Cayman Islands) and Latham & Watkins (US tax) have advised on certain matters addressed in this submission.
The Core Unit has not investigated other potential structures utilizing legal entities established in jurisdictions that may benefit from a treaty with the United States for the avoidance of double taxation. There may be legal entities in other jurisdictions that afford the same level of flexibility as the Cayman Islands foundation company. However, such jurisdiction by jurisdiction review is outside the scope of this submission.