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With the OECD’s base erosion and profit shifting (BEPS) measures rolling out in the US, captive insurance companies find themselves under increased scrutiny from the IRS, which wants to clamp down on potential tax avoidance vehicles. US Captive explores the implications.
In a combined effort, the Organisation for Economic Co-operation and Development (OECD) and the G20 countries are looking to tighten up on tax avoidance strategies, especially base erosion and profit shifting (BEPS), which specifically refers to the tax avoidance strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations.
While the concept and outcome are relatively simple, with more than 100 countries and jurisdictions collaborating to enact measures put forward by the OECD, the implementations of BEPS measures can sometimes end up lost in translation, according to Fabrice Frère, managing director at Aon Risk Solutions.
Country-by-country reporting comes under Action 13 of the OECD BEPS Action Plan. Its aim is to promote greater transparency for tax administrations by providing them with relevant and reliable information to conduct high-level transfer pricing risk assessments.
The US Internal Revenue Service (IRS) uses the country-by-country data in conjunction with other taxpayer data for high-level assessment of transfer pricing, as well as other BEPS tax risks.
Although the initiative is aimed at multinational enterprises, many captive insurance companies are owned by such multinationals and have found themselves under increased scrutiny from tax administrations worldwide, largely due to referrals to captives in OECD documents as potential tax avoidance vehicles.
“We wanted to make a case that captives are not a tax avoidance tool,” says Frère. “You don’t set up a captive with the purpose of avoiding tax or minimising tax. There are some genuine risk management reasons and a real economic rationale for setting up a captive.”
At a domicile level, the sentiment is also that captives are not tax avoiders. Richard Smith, president of the Vermont Captive Insurance Association, argues that for most companies they have become a critical part of their risk management system.
“Captive insurance companies licensed in Vermont are not created for the tax planning purposes outlined as concerns under BEPS,” Smith says.
“Captives are genuine insurance or reinsurance operations which form a vital part of the risk management system of their owners, are fully regulated by the insurance supervisory authorities in each jurisdiction, are subject to governance and control requirements, and fully transparent.”
US reporting: ahead of the game?
As far as BEPS Action 13 is concerned, the US has already implemented its country-by-country reporting, according to tax advisory firm KPMG’s report updated in July 2017: BEPS Action 13: Country implementation summary.
It currently applies to multinational enterprises in the US with annual consolidated group revenue equal to or exceeding $850 million in the previous year.
According to the report, a US territory ultimate parent entity may designate a US business entity that it controls to file on its behalf.
The IRS states: “Per Treasury Regulations §1.6038-4 (TD 9773), the ultimate parent entity will have to file Form 8975 and Schedules (sic) A (the country-by-country report) with its annual income tax return.
“From September 1, 2017, Form 8975 and Schedules (sic) A may be filed for a reporting period with the income tax return for the taxable year of the ultimate parent entity of the US multinational with or within which the reporting period ends.”
Non-compliance with the country-by-country reporting—including reasonable cause relief for failure to file—could result in penalties ranging from $10,000 to $50,000.
A burden on captives
One issue that captives now face is that the recommendations from the OECD have essentially reversed the burden of proof with regard to their legitimacy, according to Frère.
The negative reference to captives means that it is entirely possible that the local tax authorities within these countries and jurisdictions may also take an increasingly negative stance towards captives, he says.
“The issue we have with BEPS implementation by tax authorities is that it tends to reverse the burden of proof,” Frère says. “It’s not for the tax administration to demonstrate that the captive is wrong, it’s for the captive owner to demonstrate that the captive is right. And that’s creating a huge burden on captive owners.”
The increased scrutiny from tax administrations could result in temporary double taxation, a non-recognition of premiums, increased documentation and reporting, along with a great number of tax audits, Frère notes.
However, one particularly burdensome possibility is the administrative costs and compliance of a potential BEPS audit.
“You need multiple expertise for administration of a captive, from accounting and reporting, to insurance/reinsurance, regulatory compliance, or actuarial. The vast majority of captives who underwrite a limited number of re/insurance policies can’t justify a full-time position for all this,” Frère says.
How to prepare
Preparing for a potential BEPS audit and being able to provide the right answers to the tax administration are crucial for captive owners.
Understanding the frameworks that tax authorities implementing the OECD’s recommendations look for should be a high priority and, Frère says, it now falls upon captive owners to make sure they have properly documented this in terms of three key areas.
The first is the economic rationale, which is not only why a company has a captive in the first place, but what value the captive arrangement adds, against metrics such as total cost of risk or capital efficiency.
Frère suggests that it’s usually quite easy to demonstrate that a captive delivers numerous risk management and business advantages, and that any tax implication is secondary to the whole operation.
“Captive owners know why they have a captive—they typically have a number of very good business reasons for having a captive otherwise they wouldn’t have it,” Frère adds. “But it’s not necessarily fully documented or the documentation is not up to date.”
The second area is governance and ‘substance’ which, Frère says, is essentially how the captive is operating, and who is doing what, where and when.
While the OECD looks at different ways to assess substance—including functions, risk and capital—national tax authorities tend to look only at people and premises, he adds.
Danielle Rolfes, a partner with the Washington national tax practice of KPMG and former international tax counsel with the US Department of the Treasury, comments: “Many of the BEPS recommendations focus on where multinational corporations have substance, which tends to equate to people, so we would expect many chief tax officers to try to realign certain of their structures to where they otherwise have substance.”
Furthermore, Frère suggests that many captive owners buy the services they need from outsourced providers, allowing the captive’s board to focus on decision-making.
“That triggers scrutiny from the tax administrations who say ‘well you have this entity and you don't have any employees’ so that immediately rings an alarm bell with them,” he adds.
The third area relates to transfer pricing and capitalisation, which is aimed at demonstrating that the pricing of a transaction and the captive’s capitalisation levels are appropriate.
Captive owners must therefore need to examine whether the risk transfer pricing is comparable with market quotes, and that the captive’s capitalisation is in proportion to risks underwritten, Frère concludes.
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OECD BEPS, KPMG, Aon, Captives, Tax, North America