International tax developments

The Organisation for Economic Co-operation and Development (OECD) published transfer pricing guidance for captives, for the first time, in February 2020. That guidance will form a new section of the OECD Guidelines, the de facto transfer pricing rulebook for revenue authorities in OECD countries.

This article will focus on the OECD’s 2020 material on captive insurance, as well as some of the wider international tax considerations that should be taken into account alongside transfer pricing.

The OECD guidance provides an overview of captive insurance, and focuses on the commercial rationale for captive arrangements, “accurate delineation” of such arrangements, and transfer pricing methods that may be appropriate to employ.

A key concept of the 2017 OECD Guidelines is “non-recognition”, whereby, in short, a tax authority can disregard a transaction if it is not commercially rational and replace it with an alternative transaction.

By definition, if transactions are observable between third parties, they must be commercially rational. In addition, however, per paragraph 1.122 of the 2017 OECD Guidelines: “Importantly, the mere fact that the transaction may not be seen between independent parties does not mean that it should not be recognised”.

The new guidance on captives describes various reasons as to why a multinational enterprise (MNE) may use captive insurance, including that a group may use a captive to provide insurance for risks that are difficult or impossible to insure externally, but that doing so can “raise questions” as to the arm’s length nature of the pricing of the arrangements, as well as to whether the arrangements are commercially rational.

It is therefore crucial that captive owners clearly document their commercial reasons for the existence and ongoing operation of their captives.

The new OECD guidance sets out which of its recognised transfer pricing methods might be appropriate for captive insurance transactions. A key challenge here is, of course, that unlike many other types of transactions considered in transfer pricing studies, captive insurance may not be easily benchmarked using commercial databases as information is not publicly available.

Likewise, third party comparable uncontrolled transactions may not be easily identifiable or even available at all given captive insurance transactions are typically intra-group.

Per the OECD guidance, the accepted methods include:

• The comparable uncontrolled price method, which involves using uncontrolled transactions. An example of this would be a group operating company that purchased property insurance from both the captive and a third party insurer on the same terms, covering similar risks (eg, buildings of equivalent value in similar areas), and for the same or a similar price. This “comparable uncontrolled price” is then used to support the pricing of the intra-group transaction for transfer pricing purposes.
• The transactional net margin method, which benchmarks the profitability of the captive (in this case by reference to a combined ratio and return on capital) against the profitability of third party insurance/reinsurance companies. However, captive owners must carefully consider whether third party insurance/reinsurance companies are really comparable to the captive, given their differences in scale and level of diversification. A further consideration is that third party insurers/reinsurers often seek to hold additional capital over and above regulatory requirements to achieve a rating benefit, which can distort their return on capital in comparison to that of captives.

• Performing an actuarial analysis of premiums paid. This is an application of an “other” transfer pricing method under the 2017 OECD Guidelines. Given the possible shortcomings of the other two accepted approaches, this could be the most suitable method.

An additional area covered with respect to pricing is “group synergies”. This refers to situations where the captive pools risks on behalf of other entities in the multinational group, and then accesses the reinsurance markets as a single buyer.

In this type of scenario, where this results in reduced overall reinsurance premiums for the group, the guidance stresses that these premiums savings should be passed on to the pool participants and not retained by the captive, with the captive retaining only a service fee to remunerate it for its functions performed.

Alongside the transfer pricing treatment of captives, there are other direct tax considerations associated with a captive’s operating model design, such as its tax residence and whether a permanent establishment could be created as a result of remote decision-making.

For example, a captive incorporated outside the UK could be considered UK tax-resident if it is centrally managed and controlled from the UK. Where a captive is tax-resident outside the UK but supported by risk management functions in the UK, this could create a permanent establishment (a taxable presence) in the UK such that some of the captive’s profits may be subject to UK corporation tax.

Targeted measures, such as the UK’s diverted profits tax (DPT) which seeks to tax profits artificially diverted from the UK at a punitive rate, have prompted enquiries into some captive insurance arrangements where the captive is based in a low to no-tax jurisdiction. In line with the new OECD guidance on determining whether a captive arrangement is a genuine insurance transaction, it is important to be able to explain to the tax authorities why the captive is used, covering both the original setup and its continued use.

HMRC’s DPT guidance contains an example of a captive insurance arrangement where there are no commercial motives for the transaction other than the tax saving, concluding that a DPT charge should arise.

In addition, controlled foreign company (CFC) rules have now been implemented across the EU as a result of the EU’s Anti-Tax Avoidance Directive. The application of CFC rules, both in the EU and more widely, to the activities of the captive should be considered.