Praveen Sharma examines tax considerations for captives and explains why any potential saving should be regarded as an additional benefit to the parent and not an end in itself.
Over the next few years, captive insurance companies and their respective owners are going to be confronted by a host of challenges, from both a regulatory and a tax perspective. Issues relating to Solvency II Pillars I and II are presently occupying the minds of many risk managers and their respective advisers. However, risk managers should also keep a close eye on those tax changes that have been introduced, or are in the process of being implemented in the near future, which could impact the net benefits of owning a captive.
One of the many past reasons to form captives, particularly in offshore jurisdictions with low tax rates, was to take advantage of certain lax income tax laws. However, most of the earlier income tax benefits have either been greatly reduced, eliminated or are in the process of being eroded in the current economic climate.
As British Chancellor George Osborne said in his speech before the House of Commons regarding the 2010 Budget: “This is the origin of our 80:20 rule of thumb—roughly 80 percent through lower spending and 20 percent through higher taxes.” The latter part of the statement is quite revealing and no doubt resonates with finance ministers in other countries facing similar pressures.
It is now generally accepted that, in the present climate, captive vehicles formed solely to take advantage of tax benefits are somewhat rare. Successful captives are formed for true and identified risk management reasons. The tax benefits obtained, if any, should be viewed as a bonus.
Approach of tax authorities
Generally, most if not all tax authorities, when confronted with the issue of evaluating the tax status of a captive insurance company, will seek to determine the following:
• What is the tax residence of the captive?
Is the captive’s insurance business being conducted in the country in which the parent company is resident, regardless of the relevant insurance regulations? The courts in the UK have held in the past that the activities of a captive are more than the executive decision to accept the business and could extend to the offering of services, the setting of premium levels, the negotiation of terms and the acceptance of risks. Such a situation means that the courts will look at the business of the captive as a whole, rather than where contracts are formally made.
If, for instance, it is held that the activities of the offshore licensed captive are being carried out in the parent company’s jurisdiction (because most likely the risk management department is based there), there is a potential risk that the captive would be treated as being tax-resident in that jurisdiction and its total profits taxable in that jurisdiction.
• Is the captive a controlled foreign company?
Most countries now either have controlled foreign company (CFC) or anti-abuse legislation to capture the profits of a captive based in a low-tax jurisdiction. Generally, if a captive is based in a low-tax jurisdiction, then most if not all of its profits are likely to be assessed against the parent company’s and taxed at the applicable income tax rate, subject to any exemptions or reliefs that may be available under these rules.
In recent years, many tax authorities have, or are in the process of, tightening their respective CFC and anti-abuse legislation (such as moves by the EU member states following the European Court of Justice’s ruling on the Cadbury Schweppes case) that could potentially have an adverse effect on the tax position of the group that owns a captive in a low-tax jurisdiction.
• Should income tax relief be given on premiums paid?
Generally, premiums paid to an offshore captive will qualify for income tax relief in the tax return of the group entity paying the premium, provided that the expense is reflected in its financial statements, the contract satisfies the relevant accounting standards (such as International Financial Reporting Standards 4) and the terms of the contract issued by the captive are consistent with arm’s-length principles.
There is a risk that if the captive is not well-capitalised and has insufficient resources to pay claims (maybe there is a formal parental guarantee), premiums may be reclassified by the tax authorities as capital instead and income tax relief denied.
In order to qualify for income tax relief, the premium expense must be made ‘wholly and exclusively’ for the purposes of the insured’s trade. If, for instance, the parent company pays premiums on behalf of its subsidiaries and does not recharge the expense internally, then the parent company is unlikely to get income tax relief on the premium expense that relates to other group companies. In a connected party transaction involving a captive (directly or indirectly), the relevant transfer pricing rules may apply.
Transfer pricing generally
This aspect of tax legislation is now the single most important issue for captive owners and captives, given the proliferation of countries that have either modified their tax laws or introduced transfer pricing rules in accordance with Organisation for Economic Co-operation and Development (OECD) guidelines. The tax authorities use this legislation frequently to challenge insurance arrangements involving captives—and win, if the arrangements are not on arm’s-length principles.
In April 2009, in the landmark Dixon’s [Dixon’s is an electrical retailer] case (DSG Retail and others v. HMRC), which focused on captive reinsurance arrangements, the UK courts held that Dixon’s reinsurance arrangement was not on an arm’s-length basis and, as a result, additional tax was payable. Although DSG Retail had engaged an accounting firm to prepare a transfer pricing report to support its position, the ‘comparable’ data put forward to the courts were considered to be inadequate. The case was settled for an amount understood to be in excess of £50 million.
In light of the Dixon’s case and the pressing need for tax authorities to find sources of additional revenue, transfer pricing for captives is clearly something that multinational companies with such arrangements need to take seriously. An additional factor to consider is the increased interest of tax authorities to enter into agreements with each other to exchange information about the tax status of taxpayers under the Mutual Assistance Directive and International Tax Enforcement arrangements.
The following illustration presents a simplified example of a structure adopted generally by many multinational companies involving captives:
Multinational companies, when analysing their insurance arrangements involving captives, should evaluate whether the premiums are commensurate with the level of risk assumed by the captive. In most circumstances, this would require an actuarial analysis of the riskadjusted expected rate of return.
In this evaluation, consideration would need to be given to the captive’s capital base, its rating, if any, its infrastructure and the diverse nature of its business. Whether the premium charged by the captive is reasonable would very much depend on the nature of its business, the risk retained and the retrocession premiums it pays in turn to a third-party reinsurer for the transfer of its risk. In some circumstances, it might even be possible to work backwards from such retrocession premiums to establish what may constitute an arm’s-length arrangement.
Where a captive is involved in extended warranties or service contracts, as in the Dixon’s case, the evaluation will also need to take into account the method adopted to share its profits in line with the role the group entity plays in selling these warranties or contracts, meeting the ensuing contractual obligations to customers and bearing associated risks. This may involve considerations of what and how intangible assets— for example, brand and know-how—are employed in this part of the group’s commercial activities.
In all circumstances, multinational companies should ensure that relevant documentation is produced to justify the insurance arrangement involving a captive before the inception of the contract.
Tax authorities are under increasing pressure to generate tax revenues for their respective governments and they are more than likely to challenge transactions with captives using existing tax legislation to determine whether any additional tax is due. Consequently, multinational companies should conduct a thorough feasibility study not only to evaluate the need for a captive, its domicile and capital base, and the risk to be written and retained therein, but also the pricing philosophy that may need to be followed. Most importantly, multinational companies should ensure that all insurance arrangements with the captive are well documented and the pricing methodology fully justified using actuarial and third-party comparable data.
In the future, multinational companies must ensure that the rationale for either forming a new, or utilising an existing, captive in a particular jurisdiction is based on sound commercial principles. Any resulting tax benefits should be the ‘icing on the cake’ and not the cake itself.
Praveen Sharma is global leader of the insurance regulatory and tax consulting practice at Marsh. He can be contacted at: firstname.lastname@example.org
Marsh, tax, EMEA, captive, insurance