BEPS is in many ways the same challenge for captives as Solvency II was for many insurers, says Mike Stalley, chief executive of FiscalReps and principal at complianceDNA.
The battle between tax legislators and taxpayers is not a new one; as tax codes are expanded to cover loopholes identified, professional advisors busy themselves identifying new ways of saving their clients tax. It is a lucrative business for many.
As long as the law is not broken, tax planning, even aggressive tax planning is acceptable – this has been the mantra for many years. However, in recent years a shift in attitude has been detected. The tax affairs of many global corporates has been under intense scrutiny, but with a focus on the fairness of their tax planning strategies being under the spotlight rather than the legality.
With the increased media scrutiny, the general public are beginning to question why large corporations are able to use tax avoidance schemes, schemes which are not available to the general public. But the issue of unfairness is not rooted in the fact that the general public are unable to use such schemes themselves, rather that the ordinary taxpayer, often willingly, pays the tax that they owe based on the income they earn, “their fair share”, and they want the large corporates to do the same. State services that the population relies upon are funded through taxes. It is a commonly held belief that if you want to benefit from those services, which corporate often do, it is only fair that you contribute your fair share to support them.
The OECD’s report on Base Erosion and Profit Shifting (BEPS) is a potential game changer for the tax avoidance industry. The main thrust of BEPS is to “ensure that profits are taxed where economic activities take place and value is created.” Interestingly though the concepts within BEPS are not new, instead BEPS is really an attempt to revitalise existing anti-avoidance legislation but more importantly an attempt to standardise them globally.
Tax arbitrage exists in many forms, in the main because corporations are global but taxes are national. If the arbitrage element can be removed then, theoretically at least, the taxes a corporate pays will be consistent regardless of the jurisdiction in which the profits are generated. There will then be less incentive to create “artificial” arrangements to avoid tax.
The main problem with this idea, and identified by the OECD, is that “countries are sovereign”. Each country will need to implement the BEPS principles in a co-ordinated fashion for it to be effective, but in many countries the tax policy that they set is a key factor in driving their economic growth. This is especiallythe case for many smaller countries that do not have natural resources or industries to generate wealth, but instead have opted for financial services as a way of creating economic success for their country.
The BEPS project is led by the OECD but supported by the G20 countries; the world’s largest economies who are concerned about the loss of tax revenues as a consequence of aggressive tax planning strategies – with many of the strategies utilising lower tax jurisdictions to achieve the tax reduction plans.
Many of the world’s captives are domiciled in these lower tax jurisdictions and consequently fall within the remit of BEPS. In the eyes of the tax inspectors it is probably not what captives do that is likely to cause conflict with post BEPS tax legislation, it is principally where and how they do it that is the problem.
Legitimate risk transfer using a vehicle such as a captive insurance company is a perfectly reasonable corporate strategy to manage insurable and uninsurable risks. Smoothing premium flows, accessing reinsurance markets and rewarding better internal risk management are all common features of a captive strategy and when run well will add value to a corporate. And as long as there is a clear commercial rationale, appropriate corporate governance, real economic substance and a clear premium pricing methodology, all properly documented, then there should not be a conflict with BEPS.
In terms of the captive industry, the challenges that come from the BEPS project can be summarised in four questions:
1. If the rationale for risk transfer is legitimate why does the risk transfer have to be to a vehicle domiciled in a lower tax jurisdiction, i.e. why the choice of domicile?
2. Why does it appear that the captive profits accrue in lower tax jurisdictions but much of the economic activity is carried out either by third parties or by individuals in other jurisdictions, i.e. lack of economic substance within the captive?
3. Can the same risk management results be achieved through a more traditional approach to insurance buying, i.e. is the captive still relevant?
4. Although the rationale for the captive today can be clearly argued to be one of risk management, was there ever a consideration that tax planning benefits could be achieved?
If the captive, its risk manager and its owner can provide positive, evidenced based answers to these questions then the justification for the continued use of the captive is clear and would stand a better chance of surviving any investigations from tax authorities. But it must be remembered that, compliance with BEPS is not the end objective here; compliance with sovereign countries’ tax legislation is the end objective, especially since countries may well interpret the basic BEPS principles differently and enact slightly varying tax legislation.
By way of an example, the UK Finance Act 2015 introduced a new tax onto the statute books, Diverted Profits Tax (DPT). The main objective of DPT is to tax those transactions where payments are made from a UK party to another party where a tax mismatch (essentially tax arbitrage) is achieved. Where this is relevant to the captive industry is when a UK resident policyholder pays an insurance premium to a captive domiciled overseas.
The legislation contains seven tests, which if all are met result in a DPT charge of 25% on the value of the transaction. Looking at the seven tests, an initial high-level review would suggest that the transaction would fail five of the tests almost immediately.
Test number six relates to the comparable rates of corporation tax between the UK and the domicile of the captive. In basic terms if the additional tax payable by the captive is less than 80% of the tax saved by the UK policyholder then the test is failed. This is referred to in the legislation as a “tax mismatch arrangement”. This test is unlikely to be met on many occasions, although it is worth pointing out that if the UK headline rate of Corporation Tax does reduce to 17% as stated, passing this test may become more achievable.
The final test looks at the strategic rationale for the captive transaction. Essentially if it can be reasonably determined that the non-tax benefits of the transaction are greater than the tax savings achieved, then the test is met and no DPT is payable. What this means for risk managers and captive owners is that if the captive can answer the four questions mentioned earlier in the article positively, and with supporting evidence, then their chances of not having to pay DPT are increased. The problem though, is that the test appears rather subjective and convincing tax inspectors of the value of a captive, when they have little knowledge of captives, could be challenging. One of the key aspects of this is test is whether alternative strategies than the use of a captive do exist. If a captive writes a PD/BI policy which is broadly similar to an open market policy and with comparable premium calculations then the justification for the use of a captive is harder, as a good alternative strategy can be evidenced to exist.
Interestingly the DPT legislation has the phrase “at any time” inserted within some clauses, which suggests that HMRC are looking at the entire life of the captive rather than just the current position. So, even if the strategic rationale now is one of risk management, can it be demonstrated that this was always the case.
To conclude, when Solvency II was introduced in 2016, it challenged many insurers to review their structure and strategy to ensure their commercial viability within the new regime. Some insurers failed to remain viable but most of them have been able to continue operating successfully under the new regime. BEPS in many ways is the same challenge but for captives. Those captives which have genuine economic substance and add tangible, quantifiable value to their owners should survive, even with additional tax costs factored in. Owners of captives which fall short have a decision to make.
But maybe BEPS is actually an opportunity for risk managers. If the risk manager can do the analysis and quantify the true value that their captive brings to the owner, its long-term viability can be assured and plans can be made to increase the role of the captive within the group.
If you consider that captives, in spite of significant lobbying by the industry, were not afforded any significant treatment from EU legislators beyond the proportionality principle when Solvency II was enacted, the likelihood of successfully persuading the OECD that captives are a special case which require special treatment is probably slim. A better focus may be to demonstrate the commercial value that captives, and the captive industry, bring to their owners and in doing so, clearly making the case that they are an essential risk management tool and aligned to the overall corporate business strategy. If done successfully, there should be no tax “surprises” in store for the CFO.
Mike Stalley FCA is the chief executive of FiscalReps and principal at complianceDNA. Since 2003 FiscalReps has provided the captive insurance industry with international premium tax services, focussed on tax compliance and not tax avoidance.
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OECD, BEPS, Mike Stalley, FiscalReps, complianceDNA, Europe, North America