One of the many past reasons to form captives, particularly in offshore jurisdictions with low tax rates, was to take advantage of certain lax income tax laws. However, most of the earlier income tax benefits have either been greatly reduced, eliminated or are in the process of being eroded in the current economic climate.


As British Chancellor George Osborne said in his speech before the


House of Commons regarding the 2010 Budget: “This is the origin of our 80:20 rule of thumb—roughly 80 percent through lower spending and 20 percent through higher taxes.” The latter part of the statement is quite revealing and no doubt resonates with finance ministers in other countries facing similar pressures.


It is now generally accepted that, in the present climate, captive vehicles formed solely to take advantage of tax benefits are somewhat rare. Successful captives are formed for true and identified risk management reasons. The tax benefits obtained, if any, should be viewed as a bonus.


Approach of tax authorities Generally, most if not all tax authorities, when confronted with the issue


of evaluating the tax status of a captive insurance company, will seek to determine the following:


• What is the tax residence of the captive? Is the captive’s insurance business being conducted in the country


in which the parent company is resident, regardless of the relevant insurance regulations? The courts in the UK have held in the past that the activities of a captive are more than the executive decision to accept the business and could extend to the offering of services, the setting of premium levels, the negotiation of terms and the acceptance of risks. Such a situation means that the courts will look at the business of the captive as a whole, rather than where contracts are formally made.


If, for instance, it is held that the activities of the offshore licensed captive


are being carried out in the parent company’s jurisdiction (because most likely the risk management department is based there), there is a potential risk that the captive would be treated as being tax-resident in that jurisdiction and its total profits taxable in that jurisdiction.


• Is the captive a controlled foreign company? Most countries now either have controlled foreign company (CFC)


or anti-abuse legislation to capture the profits of a captive based in a low-tax jurisdiction. Generally, if a captive is based in a low-tax jurisdiction, then most if not all of its profits are likely to be assessed against the parent company’s and taxed at the applicable income tax rate, subject to any exemptions or reliefs that may be available under these rules.


In recent years, many tax authorities have, or are in the process of, tightening their respective CFC and anti-abuse legislation (such as moves by the EU member states following the European Court of Justice’s ruling on the Cadbury Schweppes case) that could potentially have an adverse effect on the tax position of the group that owns a captive in a low-tax jurisdiction.


• Should income tax relief be given on premiums paid? Generally, premiums paid to an offshore captive will qualify for


income tax relief in the tax return of the group entity paying the premium, provided that the expense is reflected in its financial statements, the contract satisfies the relevant accounting standards (such as International Financial Reporting Standards 4) and the terms of the contract issued by the captive are consistent with arm’s-length principles.


There is a risk that if the captive is not well-capitalised and has insufficient resources to pay claims (maybe there is a formal parental guarantee), premiums may be reclassified by the tax authorities as capital instead and income tax relief denied.


In order to qualify for income tax relief, the premium expense must


be made ‘wholly and exclusively’ for the purposes of the insured’s trade. If, for instance, the parent company pays premiums on behalf of its subsidiaries and does not recharge the expense internally, then the parent company is unlikely to get income tax relief on the premium expense that relates to other group companies. In a connected party transaction involving a captive (directly or indirectly), the relevant transfer pricing rules may apply.


Transfer pricing generally This aspect of tax legislation is now the single most important issue


for captive owners and captives, given the proliferation of countries that have either modified their tax laws or introduced transfer pricing rules in accordance with Organisation for Economic Co-operation and Development (OECD) guidelines. The tax authorities use this legislation frequently to challenge insurance arrangements involving captives—and win, if the arrangements are not on arm’s-length principles.


In April 2009, in the landmark Dixon’s [Dixon’s is an electrical retailer] case (DSG Retail and others v. HMRC), which focused on captive


14 emea captive 2011


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