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Economic substance of Captive Insurance Companies 

Why now?

The recent OECD Guidance, together with the OECD Forum on Harmful Tax Practices (“FHTP”) and the EU Code of Conduct standards reinforce the idea that the economic substance is under the spotlight of the OECD and local tax authorities. This, added to the perception that Captive Insurance Companies (“CICs”) may facilitate profit shifting based on intercompany agreements, has led to CICs being scrutinized worldwide for tax purposes

Questions such as whether CICs are performing a real economic activity, whether there is substantial income-generating activity taking place in the jurisdiction and/or whether CICs are effectively conducting an insurance business and controlling the related risks – are increasingly being raised by regulators and tax authorities. In this regard, MNEs should be in the position to evidence that profits attributed to a CIC are supported not only by intercompany agreements and the transfer pricing documentation but also by economic substance.

The economic substance concept has been approached by the OECD FHTP and the European Union Code of Conduct Group on Business Taxation (“EU Code of Conduct”) when reviewing preferential tax regimes. It is part of the OECD’s efforts to target the so-called cashbox entities that have no or minimal substance. More recently, the ATAD3 EU Directive proposal also addresses aggressive tax planning linked to the use of companies with no substance.

On March, 2021 no or only nominal tax jurisdictions (such as Anguilla, the Bahamas, Bahrain, Barbados, Bermuda, British Virgin Islands, Cayman Islands, Guernsey, Isle of Man, Jersey, Turks and Caicos Islands and the United Arab Emirates) initiated the first exchange of information under the FHTP global standard on substantial activities to ensure (i) that income can no longer be parked in low tax jurisdictions without the core business functions being carried out from that jurisdiction, and (ii) that the countries where the parent entities and beneficial owners are tax resident, get access to regular exchanges of information. The exchanges provide key data on the substance and activities of entities in no or only nominal tax jurisdictions to the jurisdictions in which the immediate and ultimate parent and the beneficial owners of the entities reside, and enable them to carry out risk assessments and to apply their controlled-foreign company, transfer pricing and other anti-base erosion and profit shifting provisions.

Economic substance is also embedded in the transfer pricing foundational principles through the identification of the substance of the commercial or financial relations between the parties involved in a transaction, and the assessment on their functional and operational profiles prior to properly setting or testing any transfer pricing policies. This principle is supported by Chapter I of the Transfer Pricing Guidelines (“TPG”).

Specifically towards CICs, this is considered in Chapter X of the TPG as a way to accurately delineate the actual transactions and allocation of risk to CICs. As there has been/is a perception that CICs may facilitate profit shifting based on intercompany agreements, CICs have been scrutinized worldwide for tax purposes. Now that there is industry specific guidance on how to approach this from a transfer pricing perspective, MNEs should be in the position to evidence that profits attributed to a CIC are supported not only by intercompany agreements but also by economic substance.

Substance test

In response to the requirements set in the OECD FHTP and the EU Code of Conduct, several jurisdictions have created different regulatory regimes with the common principle that any tax resident undertaking an activity in a relevant sector, including the insurance sector, must demonstrate compliance with certain substance tests.

Although there are subtle differences between the legislation in each jurisdiction, three main questions are commonly used to determine that an entity has economic substance in a given jurisdiction; it should:

  • Be directed and managed in the jurisdiction of tax residence;
  • Undertake core business income generating activities in the jurisdiction of tax residence; and
  • Have adequate people, premises and expenditure in the jurisdiction of tax residence.

MNEs should be aware of the above-mentioned general requirements and be able to provide robust support. Failure to satisfy these substantial activities requirements may result in other countries taking certain ‘defensive unilateral measures’ in response under a hypothetical tax audit, which could include denying deductions, imposing withholding taxes on payments to companies in such jurisdictions, or applying controlled foreign corporation rules to subsidiaries resident in such jurisdictions.

Chapter X of the TPG - Captive Insurance Companies

Following this trend, Section E of Chapter X of the TPG provides transfer pricing guidance for the insurance industry on the accurate delineation of CICs and the pricing of controlled transactions.

But, what does accurate delineation mean? At first sight, the concept seems simple: the accurate delineation of a transaction is about assessing how the actual behavior of the parties to a transaction stacks ups against what is provided in written agreements. But in practice, accurate delineation requires in-depth analysis of the facts and circumstances surrounding the CIC business (functions performed, risks borne and assets used by all parties involved) and whether such is consistent with truly operating an insurance business.

To this end, the OECD has referred to substance requirements when analyzing the accurate delineation of CICs through two main indicators to be considered to assess an insurance business as independent and genuine: control over risk and financial capacity.

i. Control over the insurance risks

Following the OECD approach, the first thing that should be evaluated is whether the CIC is effectively assuming the risks and exercising the corresponding control functions over such risks.

To answer those questions, Part IV of the OECD Report on the Attribution of Profits to Permanent Establishments is to be considered in the assessment on the extent to which the CIC owns the key entrepreneurial risk-taking (“KERT”) function of assumption of insurance risk.

As a general matter, activities related to underwriting such as setting underwriting policies, classifying and selecting insured risk, setting premiums (pricing), analyzing risk retention and accepting the insured risk, aim to decide whether to underwrite a risk or not, under which terms and conditions, whether to pool the risk portfolio to achieve an efficient use of capital, or whether reinsurance protection should be purchased or not.

On prevailing facts and circumstances, those activities could be considered as control functions.

Two relevant questions to assess on whether the CIC owns the abovementioned exercise of control functions and robust decision making on the assumption of insurance risk, are (i) whether it is equipped with personal means skilled with appropriate educational background, experience and seniority and, (ii) whether those and not others, are actively involved in the decision-making relating to the assumption of risk.

Should the particular facts and circumstances of the activities performed by the resources of the CIC not be in line with the above, the income generated by these activities might not be (entirely) allocated to the CIC but (partially) to other member of the MNE that is effectively assuming this risk.

ii. Financial capacity

Last but not least, it should be analyzed whether the CIC has the financial muscle to assume the insurance risks, which means being able to satisfy claims in the event of the risk materializing. The fact that the CIC is exposed to the downside outcome of the insured risk and to the possibility of incurring a significant loss could be an indicator that the insurance risk has been assumed by the CIC.

Determining whether the CIC has the financial capacity to assume the risk requires consideration of the capital readily available (in its balance sheet) and its options realistically available. CICs are expected to maintain a portfolio of risks, including a capital reserve based on regulatory needs and rating agency requirements.

The mentioned control functions and financial capacity indicators of the CICs operating as a genuine insurance business are linked to additional substance indicators provided by the OECD:

  • there is diversification and pooling of risk in the CIC;
  • the economic capital position of the entities within the MNE group has improved as a result of diversification and there is a real economic impact for the MNE group as a whole;
  • both the CIC and/or any reinsurer may be regulated entities that require evidence of risk assumption and appropriate capital levels or the insured risk would otherwise be insurable outside the MNE group;
  • the captive insurance has the requisite skills, including investment skills, and experience at its disposal; and
  • the captive insurance has a real possibility of suffering losses.

From the first item in above overview it becomes clear that genuine insurance requires risk diversification. Risk diversification is the pooling of a portfolio of risks, combining non-correlated risk and varied geographical exposures, allowing insurers to have a lower level of capital.

Risk diversification is at the core of the insurance business. Internal risk diversification might generate lower capital efficiencies than those achieved through external risk diversification. When a CIC exclusively covers internal risks, its level of diversification might be lower than when also external, nongroup risks are insured. In certain situations a CIC might lack the scale to achieve significant risk diversification or lack sufficient reserves to meet additional risks represented by the relatively less diversified portfolio of risks within a MNE group. In such cases, for transfer pricing purposes the accurate delineation of the CIC may indicate that it is not operating an insurance business but should be delineated differently. Next to that, it might be identified that certain capital efficiencies achieved through the pooling of internal risks in the CIC arise from the result of group synergies, the benefits of which ought to be shared with the Group entities that contributed to the creation of those synergies.

The takeaway

The recent Guidance provided by the OECD regarding CICs, together with the OECD FHTP and the EU Code of Conduct standards, reinforce the idea that CICs and their economic substance are (and increasingly) under the spotlight of the OECD and local tax authorities.

Questions such as whether CICs are performing a real economic activity, whether there is substantial income-generating activity taking place in the jurisdiction and/or whether CICs are effectively conducting an insurance business and controlling the related risks – are increasingly being raised by regulators and tax authorities.

In this regard, the best practice for CICs would be to conduct a proactive review to ensure (i) compliance with substance requirements before tax authorities come knocking on the door, but also (ii) that robust evidence on such compliance is available.

Contact us:

Cristina Bernardo Osoro
Senior Consultant
Deloitte Netherlands
Phone: +31(0)88 288 3294
crbernardoosoro@deloitte.nl

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