Global Tax Alert (News from Transfer Pricing) | 6 March 2014
Dutch Lower Court finds lack of arm’s length return in captive reinsurance case
On 17 January 2014, the Lower Court of Zeeland-West-Brabant (Court) ruled in a captive reinsurance case involving a Dutch insurance company and its Swiss subsidiary.1 The Swiss subsidiary did not have any employees and reinsured a large part of the risks with external reinsurers.
The Court agreed with the Dutch Tax Authorities that the conditions agreed between the Dutch insurance company and its Swiss subsidiary deviate from the conditions that would have been agreed to between independent enterprises. Based on research of a Court-appointed expert, the Court held that an arm's length return for the Swiss captive reinsurance company (Captive) was a return on equity of 7.5% in addition to the cost plus 10% (for 2005)and cost plus 11% (for 2006 – 2008) as set by the tax inspector.
This is the second recent Dutch court case regarding captive (re-)insurance companies.2 This follows from the increased attention of the Dutch Tax Authorities for internal (re-)insurance activities, which also becomes clear from the new Dutch transfer pricing decree.3
The case involved a Dutch mutual insurance company, (DutchCo), which does not have a profit motive. It paid surpluses from the insurance back to the participating members in the form of premium restitution.
Prior to 2002, DutchCo reinsured the majority of its risks with external reinsurers via an external reinsurance broker. DutchCo kept a small part of the risks for its own account.
In 2001, DutchCo established a subsidiary in Switzerland, Captive, to act as a captive reinsurance provider. DutchCo stated that the business rationale to establish Captive goes back to “9/11.” The resulting worldwide turmoil significantly impacted the reinsurance market. In an extremely nervous market, premiums increased and conditions were sharpened. From 2002 onward, all the reinsurance contracts of DutchCo were concluded with Captive (in exchange for payment of premiums), whereby Captive re-insured a vast majority of these risks with external reinsurers and kept a limited part of the risk for itself.
As mentioned above, Captive did not employ any personnel, but made use of the services of M GmbH in the person of the owner/director of M GmbH (on average two days a week), an external Swiss reinsurance broker on whose office address Captive was located. In this respect, Captive was charged an amount of about €150,000 annually.
The Dutch tax inspector argued that the reinsurance agreements with Captive were not concluded under the same conditions as with third parties. As a result, the tax inspector increased DutchCo's taxable profit for the 2005-2008 years equal to the premiums paid to Captive by DutchCo after deducting the cost plus remuneration for Captive (i.e. the service fees paid to M GmbH with a mark-up of 10% in 2005 and 11% in the 2006-2008 years). In addition to the tax assessments, the tax inspector levied penalties equal to 50% of the income adjustment (i.e., taxes as a result of adjustments due to profit shifting to Captive).
Decision of the Court
The Court stated that the conditions of the reinsurance agreements between DutchCo and Captive should be evaluated as if it would have been agreed between independent parties.
In this respect, reference was made to the arm's length principle as codified in Article 8b of the Dutch Corporate Income Tax Act 1969 (Article 8b). An expert was appointed by the Court based on the proposal of the parties. The expert was asked to examine whether DutchCo would also conclude the said reinsurance contracts with third parties under the same conditions as it had with Captive in the respective years. In other words: are the conditions of the reinsurance contracts at arm's length?
The considerations and conclusions of the expert, to which the Court agreed, included the following:
1. In addition to referring to “9/11,” DutchCo also noted two additional reasons for establishing Captive: i) through Captive, which is located abroad for fiscal reasons, DutchCo would like to re-insure part of the portfolio in-house, and ii) it did not want to keep the strongly profitable reinsurance activities itself, but place the activities with its own subsidiary.
2. In case Captive acts as a broker of external reinsurance policies, it is not understandable why DutchCo would pay a net premium for reinsurance to Captive that is higher than the premiums charged by external reinsurers. After all, Captive does not add value in the chain.
3. For the portion of risks born by Captive and hence not reinsured by Captive, it is also not understandable why DutchCo would pay a net premium that is higher than what Captive would pay to external re-insurers. In such as case, the expert agreed with the tax inspector that the probability of Captive not being able to satisfy its insurance obligations to DutchCo is higher than that of an external reinsurance company with a good rating.
4. In an arm's length relationship, it is unlikely that DutchCo would relinquish associated profit potential of the reinsured risks without anything in return. As noted above, Captive does not employ any personnel that take care of the negotiation with DutchCo. Furthermore, DutchCo is the only customer of Captive as a result of which the price setting is determined by DutchCo. This would have a price (i.e., premiums) decreasing impact.
5. In case Captive was to determine itself whether or not to re-insure the risks with external reinsurers, then DutchCo would actually assume more risks than if it had reinsured directly with renowned external reinsurers. In such a case, the reinsurance by DutchCo of its risks with Captive is not at arm's length.
6. Considering the parent – subsidiary relationship, it is not probable that DutchCo could not have counted on that Captive would have concluded the necessary reinsurance. In that case, it is considered sensible to have Captive as a captive reinsurance company. The remaining question then is what would constitute an arm's length price for Captive's activities.
The Court considered it plausible that the level of the premiums paid by DutchCo to Captive and the policy of Captive regarding whether to reinsure the risks with third parties were determined by DutchCo itself.
The Court also held that the tax inspector made it sufficiently plausible that the conditions of the agreement between DutchCo and Captive deviate from the conditions that would have been agreed between independent parties. Reference is made to the considerations of the expert.
Next, the profits of DutchCo should be determined as if the deviating conditions would not have been agreed to (based on Article 8b of the Corporate Income Tax Act). Taking into account the limited activities and lack of policy determination by Captive, the Court argued that an annual return on equity (including the accumulated non-arm's length premiums from the past) of 7.5% for Captive is reasonable in addition to a cost plus mark-up of 10% or 11% as set by the tax inspector. Hence, the Court lowered the adjustment to DutchCo's taxable income as assessed by the tax inspector.
The Court also adjusted the proposed “offense penalties” of the tax inspector to an annual penalty of €125,000 for the relevant years (about 25% of the additional corporate income tax). The Court believed that DutchCo intended to withdraw a considerable part of its profits from taxation in The Netherlands by setting up the structure with Captive and the excessive level of premiums paid to Captive.
Relevance of this case
It is important to note that the ruling is a decision by a lower court and should not be taken as general guidance on how to deal with captive (re-)insurance companies in the Netherlands. However, the ruling is interesting and relevant to consider for the following reasons:
- • In light of the new Dutch transfer pricing decree, which has a dedicated section on internal (re)insurance activities, the Dutch tax authorities increasingly are scrutinizing captive (re)insurance arrangements that tend to involve profit shifting outside the Netherlands. It seems that the Dutch tax authorities have already applied certain elements of this decree in practice.
- • Use of an expert in conducting an analysis based on the arm's length principle.
- • The high penalties sustained by the Court.
Application of TP method
The Court case did not provide information regarding how the cost plus mark-up and the 7.5% return on equity were determined.
The tax inspector disagreed with the Court about the application of the return on equity method. In his view, the percentage should be applied to the starting capital of Captive in 2001 and not to its capital increase due to the non-arm's length premiums paid by DutchCo to Captive. The Court disagreed and argued that the allocation of capital does not fall under the application of the arm's length principle.
The tax inspector was also of the view that 5% would have been a more appropriate return on equity (equal to the 10 year yield on government bonds), since Captive did not assume risks and its return should not be similar to that of DutchCo.
However, the Court argued that because DutchCo engages in premium restitution while Captive does not engage in premium restitution, it can be explained that the return of Captive is higher than that of DutchCo. This justifies that the return on equity to be attributed to Captive is set higher than the return on government bonds. The Court viewed 7.5% as an appropriate return on equity for Captive.
Transfer pricing documentation
The case did not comment on whether DutchCo had TP documentation in place that satisfied the Dutch TP documentation requirements. The lack of TP documentation will shift the burden of proof regarding the arm's length nature of the transfer price used to the taxpayer. Having proper TP documentation is important, especially in the case of business restructuring.
As noted above, the ruling is a decision by a lower court and should not be taken as general guidance on how to deal with captive (re-)insurance companies in the Netherlands. However, the ruling is interesting in light of the new Dutch TP decree and the increased attention of the Dutch Tax Authorities on internal (re)insurance activities.
The Court held that Captive had limited functionality and did not determine the policy itself. Given this fact, a return on equity of 7.5% was considered appropriate remuneration for Captive in addition to a cost plus 10% or 11% remuneration depending on the year of assessment; the excess profits of Captive were thus taxable in the Netherlands.
Both in this court case and the Lower Court of The Hague case, the business rationale of the structure and the functional profiles (including risks assumed and assets used) of the parties involved were important considerations.
1. The Lower Court of Zeeland-West Brabant, 17 January 2014, AWB11/3717, 11/3718, 11/3719, 11/3720 and 11/3721.
2. The Lower Court of The Hague, 11 July 2011, AWB 08/9105. See EY's International Tax Alert of 24 February 2012.
3. See EY's Global Tax Alert, Dutch State Secretary of Finance publishes Decree on transfer pricing and application of arms length principle, dated 26 November 2013, regarding this decree, which provides clarifications with respect to the application of the arm's length principle in the Netherlands (i.e., decree nr. IFZ 2013/184M dated 14 November 2013).
For additional information with respect to this Alert, please contact the following:
Ernst & Young Belastingadviseurs LLP, Amsterdam
- • Danny Oosterhoff
+31 88 407 1007
- • Clive Jie-A-Joen
+31 88 407 0807
- • Maurits Stuyt
+31 88 407 2321
Ernst & Young Belastingadviseurs LLP, Rotterdam
- • Ronald van den Brekel
+31 88 407 9016
EYG no. CM4229