It is the responsibility of owners to prove that their captives are equipped to take on and manage their risk, and that they do not exist purely for tax reasons, according to speakers at the European Captive Forum in Luxembourg.
In a session on the transfer pricing principle under the base erosion and profit shifting (BEPS) initiative, Loic Webb-Martin of PwC UK addressed the challenges facing the captive industry coming from the tax authorities, suggesting that the key to success is to be prepared
He quoted the Organisation of Economic Co-operation and Development’s (OECD) definition of the transfer pricing principle, saying: “Commercial or financial relations [must not] differ from those which would be made between independent enterprises.”
This means that transactions within a group must be the same as with an outside insurer, however, as captives tend to not offer insurance outside of their own groups, trying to achieve this comparison is “not an easy exercise”.
According to Webb-Martin, captives should consider substance, capital, commerciality, allocations, premiums and risks covered. If these issues are all handled correctly, transactions will work as they would with a third party, and “you will be able to prove it to a tax authority”.
To prove its activity constitutes a “bonafide commercial transaction”, a captive has to be able to prove it has the ability to assume and manage the risks it takes on, and show that the price each of its insured is paying is ‘arm’s length’, reflecting what is happening in the overall insurance market.
It will also have to show that the profit made on the captive is ‘reasonable’ and relative to the capital required to support the business.
In another session on BEPS, Fabrice Frère of Aon Global Risk Consulting highlighted the country-by-country tax reporting requirements, saying it will trigger audits everywhere. Captives will face increased scrutiny in these audits, he said, and they must be prepared to answer difficult questions.
Captives must be able to demonstrate that good commercial reasons are behind their existence, and that they have strong governance, fair pricing, capitalisation and documentation. He stressed: “Anything that is not documented does not exist.”
Another speaker, Praveen Sharma of Marsh, suggested that captives have to evolve with the issues and adapt to changes in regulation, even though some of those in the OECD “don’t understand captives”.
While tax benefits may once have been the primary reason to launch a captive, and commercial aspects were a bonus, the commercial aspect is generally the primary reason for a captive and any tax benefits are “the icing on the cake”, Sharma said.
Captives must have competent and experienced professionals at a decision-making level to question the validity of transactions, document activity, and consider expected losses, profit margins and expenses, in order to be able to prove their position with regards to commercial viability.
