On 1 March 2016 the UK government published a consultation document on a new regulatory, corporate and tax framework for insurance linked securities (ILS) business. This follows up on a promise made in the March 2015 Budget, with the stated goal of enabling London to compete in the growing market for alternative risk transfer. The UK government recognises that ILS, which allow insurers and reinsurers to transfer risk to the capital markets, is a valuable and growing part of the global reinsurance market in which the UK does not currently compete.

The consultation runs until 29 April 2016 and poses a number of questions in light of the UK government's initial thinking as to how best to create a:

  • regulatory;
  • corporate; and
  • tax

environment that will encourage ILS insurance special purpose vehicles (ISPVs) to base themselves in the UK.

Following consultation, draft regulations for any new regime will be published later this year.
The document proposes the creation of a UK protected cell company (PCC) regime to best facilitate the emergence of a UK ILS market. It also makes a number of regulatory proposals. However in this blog I want to focus on the tax aspects of the consultation.

The issue

ISPVs have traditionally been established in low-tax, offshore jurisdictions as this minimises tax at the level of the vehicle itself. Investment in ILS, like any investment, works on the basis that investors wish to be taxed on their share of the ISPV's income in their home jurisdiction at applicable rates, without suffering an additional layer of tax in the investment vehicle. Jurisdictions such as Guernsey and Bermuda attract ILS business for this very reason.

A possible fix – debt-backed ISPVs

The consultation document seeks views on whether existing legislation (the 2007 Taxation of Insurance Securitisation Companies Regulations) could be amended to meet the stated objective and make the UK tax landscape attractive for 'debt-backed' ILS vehicles, such as those issuing CAT bonds. If the existing Regs were amended to apply to debt-backed ILS vehicles as proposed, the ISPV would be able to deduct interest payments to investors from otherwise taxable profits.

Interest payments from a UK based ISPV to overseas investors would need to rely on the UK's 'quoted eurobond' exemption so as not to be subject to UK withholding tax.

What about equity-backed ISPVs?

The existing Regs would not be suitable for adaptation to ISPVs that issue equity to investors (common in collateralised reinsurance deals) as the dividends paid to investors would not be tax deductible for the ISPV.

An alternative approach is therefore required to ensure a UK ISPV does not pay UK corporation tax on its profits, such treatment being considered vital to result in a commercially viable ILS structure where taxable profits effectively 'pass through' the vehicle to be taxed in the hands of investors.

The solution?

The consultation document therefore proposes a solution whereby a corporate ISPV (or cell(s) within a PCC) would be exempt from UK corporation tax, provided specified criteria are met. The stated preference is that this approach would work for both debt-backed and equity-backed ISPVs, to avoid having to operate two distinct regimes (not to mention swerving possible issues arising out of the OECD's proposals regarding the tax deduction of interest, as part of the Base Erosion and Profit Shifting project).

A number of possible criteria are suggested in the document (including that the ISPV provides (re)insurance risk mitigation, that there is clear and unambiguous risk transfer from cedant to the ISPV, and that the investors do not include any members of the cedant's group). Comments are sought as to whether these are reasonable requirements.

One issue for which a solution is not proposed in the consultation document is how to address UK withholding tax on dividends paid by an ISPV were the ISPV to be exempted from UK corporation tax. Whilst the UK does not generally levy withholding tax on dividends, it typically does for tax-exempt companies. The government seeks views as to how the withholding tax issue should be addressed.