Profit shifting crackdown: captives in the crosshairs

A new international framework is targeting tax avoidance—and it has implications for captive insurers. Jenny Coletta of Ernst & Young explains

In recent years, tax authorities around the world have been increasingly scrutinising captive insurance arrangements, focusing on questions relating to commercial purpose, pricing and substance. In what is likely to further exacerbate this trend, final reports on actions addressed in the Base Erosion and Profit Shifting (BEPS) project were released in October by the Organisation for Economic Cooperation and Development (OECD). This was the conclusion of a two-year project mandated by G20 finance ministers in response to concerns over the tax affairs of multinational groups. Overall these actions will result in fundamental changes to international tax regimes. While some of these changes have yet to be fully concluded or implemented in OECD member states, others have an immediate effect and may significantly impact captive insurers.

The final reports make it clear that the OECD regards captives as a potential source of profit shifting, with numerous references to captives made in a negative context throughout the documents. This raises concerns for groups with captive insurance arrangements as there is likely to be a further increase in scrutiny from global tax authorities as they implement and enforce the OECD BEPS actions.

With this in mind, what can groups with captive insurers do to prepare for the changing tax landscape? The following immediate key actions are strongly recommended:

• Review, and where necessary remediate, operating models to ensure new substance requirements are met and that risk of creating a deemed taxable presence outside the captive location is mitigated.
• Assess the capital or other commercial benefits arising from the arrangements for the insured, captive and the group as a whole.
• Review transfer pricing approaches and update or revise where appropriate.

Aligning transfer pricing outcomes with value creation

Much of the OECD work on BEPS has focused on preventing artificial transfers of profits or excessive allocation of capital to entities within a group, particularly those in low tax jurisdictions. It is perceived that inappropriate returns can be achieved in such entities where groups have been able to separate risks, functions and assets through contrived contractual arrangements. In particular, the OECD has looked to better align returns with value creating activities and prevent transactions that would not occur between third parties. In other words, profit should arise where there is genuine commercial activity taking place.

The OECD’s work on this action has resulted in an extensive rewrite of parts of the OECD Transfer Pricing Guidelines. These guidelines, originally published in 1979 and subject to much re-writing over the last 30 years, provide a framework under which global tax authorities may seek to tax intra-group transactions. Under the BEPS project, the OECD has now substantially re-written chapters of the guidelines. In particular, the revised guidelines now set out criteria for non-recognition of a transaction, meaning that tax authorities can now essentially ignore a transaction for tax purposes in certain circumstances. The key question in this analysis is whether the actual transaction possesses the commercial rationale of arrangements that would be agreed between unrelated parties under comparable economic circumstances.

The final guidance on non-recognition includes a captive insurance example in which a manufacturing company located in an area prone to flooding takes out insurance from an associated company in respect of inventory and plant and machinery risk, in exchange for a premium of 80 percent of the value of the inventory, property and contents. Given the substantial likelihood of claims, there is no active third-party market for the insurance of properties in the area.

The guidelines state that the captive insurance arrangement is “commercially irrational” and there is no market for insurance given the likelihood of significant claims. As such, he transaction should not be recognised under the revised guidelines. In other words, the insurance premium would not be tax deductible for the manufacturing company.

Another feature of the new guidelines is the increased emphasis on demonstrating control over risk in the entity taking on risk. Although the guidelines acknowledge that some functions may be outsourced by a risk-taking entity, it is clear that there must be competent and experienced decision makers who have access to information relevant to the decision to take on or lay off a risk. In particular, the report notes that the mere formalising of the outcome of decision making, for example, with a board meeting or signing of documents, would not qualify as “the exercise of a decision-making function sufficient to demonstrate control over risk”.

Where an entity cannot demonstrate control over a risk, the return from that risk will be allocated to the group entity that does in fact control the risk and the return to the first entity will be limited to a risk-free return.

In most OECD and many non-OECD countries, the guidelines provide tax authorities with guidance in construing intra-group transactions. It should be noted that the OECD guidelines are incorporated in tax legislation in many countries and as such these changes could be implemented with immediate effect.

Deemed taxable presence

The final report includes changes to conditions under which multinationals may be deemed to have a taxable presence in another jurisdiction, or a so-called ‘permanent establishment’ (PE). Conditions under which a PE arises and where it does, the taxing rights of the respective fiscal authorities, have historically been determined under domestic law and governed by the relevant double-tax treaty between states.

The international double-tax treaty framework for OECD member states (and many other states) typically follows the OECD Model Tax Convention. As a result of the BEPS project, the definition of a PE in the OECD Model Tax Convention has been widened. Now this includes not just situations where individuals have an authority to conclude contracts as was previously the case, but also situations where a person “habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification”.

This is particularly relevant for captives where individuals in group risk may operate in a capacity of managing or directing the captive. Activities may include procuring or outsourcing services from third-party captive managers or brokers. Even though the captive board may ultimately make decisions, to the extent individuals are dealing with these third-party providers when outside the captive location, even in a group risk role, this could give rise to PE risk.

The final report also includes changes to a previous exclusion from the PE rules for agents of independent status. The OECD has now changed the definition of an independent agent, so that an agent who acts exclusively or almost exclusively for a related entity will no longer be regarded as independent. This could create a PE for captive insurers that use a local agent to enter into a contract with a local affiliate. The changes to the PE rules will be given effect through a multilateral instrument that OECD member states will negotiate in 2016.

Implications

It is evident from the final reports that the OECD regards captives as a potential source of profit shifting, which may result in local tax authorities taking an increasingly aggressive stance towards captives.

As countries begin introducing anti-avoidance legislation as a result of the BEPS project (see, for example, the UK Diverted Profits Tax, and the Australian Multinational Anti-Avoidance Law), captives may be on the receiving end of increased scrutiny from tax authorities.

Captives should be aware of how the themes outlined in the BEPS reports may affect their business, and take action accordingly.