In captive insurance, tax is no longer the cake itself, but the cherry on top. Birte Fehse and Praveen Sharma of Marsh explain
What challenges do captives face around the Organisation for Economic Co-operation and Development’s (OECD) base erosion and profit sharing (BEPS) action plan?
Birte Fehse: The main challenges are around a captive’s operating model. This includes the ability to prove the captive has a good business case and that the activity, the people and the captives are commensurate with money that goes into the captive. Transfer pricing is the second challenge. For captives, proving that the transfer pricing they have in place is comparable to the commercial market and that it is a genuine commercial transaction is important.
Praveen Sharma: The issue is that the G20 has tasked the OECD to come up with proposals to reduce, if not eliminate, tax evasion transactions. Consequently, captives have been captured under the OECD project and have been deemed by the OECD to be a tax avoidance mechanism. That means captives and their owners will have to review their current operating models.
Multinational companies will have to rethink why they have a captive at all, what value the captive brings to their overall risk management strategy, and how the captive should operate going forward. Once the substance and value of the captive has been determined and established, the next consideration is the premium that the captive should receive for the risk it is assuming. Although these new requirements seem quite challenging, as they will require a shift in the operating model, they are not insurmountable.
What is the likely impact of BEPS on the captive insurance industry?
Sharma: It will mean that captives and captive owners will have to rethink how the captive is involved in the overall risk management strategy, how the contract of insurance is structured, who makes the decisions regarding the contract of insurance, the risks the captive insurer is taking, how it is assessing those risks, and whether it has any decision-making powers at the captive board level to reject or question the validity of the contract of insurance.
What can the industry do to respond to these challenges?
Sharma: At the moment, the industry is unable to do much until the BEPS proposals have been implemented in the legislation of the OECD members. For the moment, companies should start looking at country-by-country reporting. Having said that, many countries already have transfer pricing and controlled foreign companies legislation. Consequently, it would be appropriate for captive owners to commence a review of the current captive involvement and structure to determine possible changes to the operating model.
Fehse: Now is a good time to start preparing because whatever happens in terms of legislation, the general trend towards more transparency and tax matters means there will be more scrutiny on captives in the future.
The advice, even though it has not been defined 100 percent, on how BEPS will affect captives is to get ready to have the correct documentation in place. Marsh is looking to work with the Federation of European Risk Management Associations (FERMA) on how we can build a constructive dialogue about the role of captives. We plan to engage in a dialogue to educate and work with the OECD on the genuine commercial role that captives have to play as risk and insurance vehicles.
Sharma: It has already been announced that FERMA has opened a dialogue with the OECD, and that FERMA has issued a position paper on the topic. Ultimately it is about educating the OECD on captives and emphasising that captives are no longer being formed for tax avoidance purposes, rather, they play a significant role in managing the total cost of risk of the multinational group.
As captives are now well regulated by the respective supervisory authorities, they are being structured and applied on a genuine commercial basis, and tax is not the main driver.
The tax is the icing on the cake, but not the cake itself. The commercial aspect represents a large slice, so if the tax savings are not there then the commercial portion is still quite big. Many years ago, tax was the cake and the commercial reasoning was the icing, but now the balance has shifted.
Multinational companies are under tremendous pressure for capital as well as for managing group costs. The OECD needs to understand the modus operandi of why companies form or utilise a captive and why is it structured the way it is.
Multinational companies therefore assess the viability of utilising a captive after taking into account all relevant commercial issues including capital, costs, value and risks. Tax is no longer a critical issue for multinational companies.
Fehse: If you run your captive professionally then BEPS should not be such a big challenge. It is helping to further professionalise captives.
Sharma: Captives have been around for many years, and in that time there have been challenges to the industry that it has overcome.
We have adapted and modified captive insurance, so we should see this as just another challenge that we will have to overcome and adapt to accordingly. If we have to restructure the insurance arrangement, we will have to restructure the organisation, the corporate governance, the decision-making process and the board member structure.
Fehse: Captives should work with their organisations’ tax departments to make sure they are in line with each other, because BEPS is all around the role of the captive as a wider part of the organisation.
Together they need to have a clear business case, so companies need to be able to articulate why they have chosen to have a captive in place, working with the tax department to get clarity on how intercompany transactions are set, and to document that.
Also, having good reporting and management information in place is essential. In addition, companies need to make sure cash flows in and out of the captive are well documented, well explained, and transparent.
Sharma: Documentation is critical, so between now and whenever the BEPS proposals are fully implemented into the respective national tax laws, companies should start looking at their process, people and structure, and then think about their transfer pricing and the methodology being adopted.
This should all be documented so that, by the time BEPS does get implemented, companies are prepared to defend their positions.
In the UK, we already have the diverted profits tax, which is very much a part of the BEPS proposals. Companies have the justification for why a captive exists, whether it is for tax or commercial reasons, and for how the pricing is calculated.
Many countries already have transfer pricing regulation, but now companies have to look at the value chain. That analysis should start happening today.
