Financial institutions are currently under intense scrutiny regarding perceived shifting of profits to low-tax jurisdictions, and nowhere is this more apparent than for captive insurance companies. Cross-border transactions which have long been a fundamental component of tax-efficient operational structures are in the spotlight, although tax authorities are often struggling to understand the highly complicated process of attributing actuarial and commercial values to internal reinsurance contracts, key elements to the transfer pricing process of determining internal prices between group companies. Despite the complexities, the sheer volume of cashflow under internal treaties and the potential for tax grab via relatively minor adjustments means that we are seeing a significant increase in aggressive tax audits.
Recent government and public outrage over what are branded ‘immorally’ low payments of corporation tax by multinationals is having a considerable effect on how groups structure and price their internal business relationships. The ‘Action Plan on Base Erosion and Profit Shifting’ report (‘BEPS’), published by the OECD in July 2013, now comes with unequivocal G20 endorsement, and a 15 point shopping list which promises to address concerns over the transparency of global tax arrangements, with recommendations for a coordinated multilateral approach to international taxation standards arriving by the end of 2015. The position is exacerbated with increasing adoption of tax ‘blacklists’ by various jurisdictions, most recently France, where transactions with ‘non-cooperative’ jurisdictions are subject to potentially onerous controls in transfer pricing and withholding tax, combined with severe penalties for non-compliance. Of particular note here is that these ‘tax-haven’ lists often include Bermuda, Jersey and the British Virgin Islands, traditional long-term homes for the insurance industry.
So what of captive insurers? There was concern in industry circles when the first iteration of the BEPS analysis, issued in early 2013, specifically held up captive insurance activity as a ‘key pressure area’ in relation to tax avoidance, lumping internal reinsurance contracts with aggressive tax-driven hybrid financial and debt instruments. However the concept of ‘artificiality’ is the crux here: location of business activity is key to profit allocation, and the primary issue addressed in the BEPs analysis is preventing the shift of profits to legal entities in locations where in reality there is little or no material business activity. Given both the tangible substance of insurance captives and the proactive commercial role that they play both for related parties and in the wider market as a whole, to consider that captive reinsurance transactions involving, say, Bermuda represent prima facie tax avoidance structures is simply not realistic.
What is clear from the ongoing BEPS work is that related party financial transactions will inevitably come under the microscope, and the quantum of business carried out by captives is making them an obvious target for transfer pricing audits. It is also apparent that the technical approach needed to price internal reinsurance treaties is far from simple, and this is all the more important given the generally widespread application of standardised internal treaties used across multiple jurisdictions. Simply lifting terms, conditions and pricing from external 3rd party reinsurance contracts and applying these verbatim for internal purposes will no longer suffice: in practice the variations in relative financial standings of the counterparties to a reinsurance transaction mean that traditional transfer pricing methods such as testing quota shares and commissions against an apparently identical 3rd party comparable uncontrolled price are often inappropriate. Now more than ever insurers need to review and if necessary change the terms and conditions of internal treaties to meet current transfer pricing standards before the almost inevitable knock of the tax inspector.