Fabrice Frère, Aon Risk Solutions
Recommendations from the OECD have reversed the burden of proof on the legitimacy of captives, referring to them as potential vehicles for tax avoidance. Captive International speaks with Fabrice Frère, managing director at Aon Risk Solutions, about the onerous task of preparing for a potential BEPS audit which now falls upon captive owners.
In an attempt by the Organisation for Economic Co-operation and Development (OECD) to clamp down on tax avoidance strategies, captive insurance companies have found themselves under increased scrutiny from tax administrations worldwide.
This is a result of the OECD’s base erosion and profit shifting (BEPS) Action Plan, which over 100 countries and jurisdictions are currently collaborating on to implement the measures required to tackle such strategies.
BEPS 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, according to the OECD.
“The issue we have with BEPS implementation by tax authorities is that it tends to reverse the burden of proof."
Such referrals to captives in OECD documents as potential tax avoidance vehicles – along with a subsequent surge in activity from tax administrations in a couple countries – has led to more questions being raised about companies’ captive arrangements, according to Fabrice Frère, managing director of Aon Risk Solutions.
The negative references to captives means that it is possible the local tax authorities within these countries and jurisdiction may also take an increasingly negative stance towards the captives, says Frère.
“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 for setting up a captive. And a real economic rationale behind a captive.”
The BEPS burden
There are a number of potential consequences for captives owners with captives based in countries or jurisdictions which are implementing, or are planning to implement the various OECD BEPS Action Plans in their regulations, according to Frère.
“The issue we have with BEPS implementation by tax authorities is that it tends to reverse the burden of proof,” Frère says. “So 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 the captive owners.”
Temporary double taxation, a non-recognition of premiums, increased costs of administration and compliance, increased documentation and reporting, and a greater number of tax audits are all possibilities now faced with the increased scrutiny from tax administrations.
One such burden Frère sees is the administrative costs to captive owners if faced with a potential BEPS audit.
“The thing is that you need multiple expertise for captive administration, from accounting and reporting, to insurance/reinsurance, regulatory compliance, or actuarial, and you can’t justify a full time job on each of those for the vast majority of captives who underwrite a limited number of re/insurance policies.”
Assigning all of these duties to one single person is uncommon, Frère suggests, which is why there are professional captive managers who have built teams capable of providing the necessary services to each captive.
But one of the key issues that Frère identifies is that there is currently still a lot of uncertainty regarding how local tax authorities interpret the BEPS Action Plan with regard to implementation.
As the BEPS recommendations are simply the best practice recommendations, it is possible both the interpretation and implementation will differ country by country.
“Some tax authorities are more aggressive than others. Some tax authorities don't ask any questions about captives, others ask plenty of questions about captives. It really depends on the country of origin.”
Frère adds: “There is plenty of room for interpretation currently. And that’s creating fiscal uncertainty.”
However, Frère suggests the OECD is both aware that fiscal risks may be triggered due to these different interpretations, and is going in the right direction by setting targets to provide more certainty.
“If there is tax evasion captive somewhere in the world - no one at the FERMA level or even at the Aon level is in favour of that,” he says. “We absolutely agree with the underlying principles of that. If you look at the captive as a kind of animal, you need to know and understand what's behind it before you make a wrong decision about it.”
Addressing these challenges
In order to help captive owners and captive better cope with this new regulatory landscape, Frère stresses the importance of raising awareness of BEPS with clients, and to engage with associations such as the Federation of European Risk Management Associations (FERMA) and the European Captive Insurance and Reinsurance Owners’ Association (ECIROA) to produce technical papers for the OECD.
Frère believes it is important to be explicit with what the implications of BEPS are towards clients, and what they should be careful about. This includes how best to prepare for a potential BEPS audit, and being able to provide the right answers to the tax administration.
Part of this process is understanding the frameworks that tax authorities implementing the OECD’s recommendations look for, Frère says that it now falls upon the 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 asking 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 only secondary to the whole operation.
“Captive owners know why they have a captive and 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 fully 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 only tend to look at people and premises, he adds.
Many captive owners buy the services they need from outsourced provider, focusing the captive’s board on decision marking.
“And that's triggering scrutiny from the tax administrations who say ‘well you have this entity and you don't have any employees’ so that immediately rings a red bell with them.”
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, Frère says, and that the captive’s capitalisation is in proportion to risks underwritten.
With regard to producing technical papers for the OECD, Aon Risk Solutions and Frère have been engaging with the likes of FERMA and ECIROA to produce some technical papers to address concerns with the existing recommendations.
“We told them we believed the industry should be doing something and reacting towards the European Commission and the OECD to defend the captive case, and to make it very clear that we, as an industry, are not a tax avoidance mechanism.”
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OECD BEPS, Captives, Fabrice Frère, Aon Risk Solutions