By providing insurance policies to entities of multinational groups to which they belong, captive insurance companies allow multinational groups to consolidate and to manage complex business risks
However, underpayment of taxes – or perceptions thereof – can impede the ability of captives to effectively deliver these services. This topic is top of the agenda, since it can cause captives to experience a significant loss due to double taxation risks, transfer pricing disputes and reputational damage.
Nicolas Gillet, Partner, Transfer Pricing Leader and Francesca Michielin, Senior Manager, Transfer Pricing at EY, give a brief overview of transfer pricing aspects for captive insurance companies under the recent developments in the Organization for Economic Co-operation and Development (OECD)/G20 Inclusive Framework on Base Erosion and Profit (BEPS) activities, focusing on the main points that are likely to drive the attention of the tax authorities.
Ensuring that the appropriate amount of taxes is paid
Transfer pricing is not an area that has in the past captured much attention from multinational groups (MNE Groups) with captives in the Luxembourg market. However, it is becoming necessary to demonstrate that intercompany premiums paid to a captive are consistent with market rates. It is essential to consider the premiums paid to be tax deductible. If the premium is not arm’s length, the deduction taken for the premium payment could be adjusted or rejected altogether.
In addition, the growing attention on transfer pricing is driven by the recent developments under the OECD BEPS and the Global Anti-Base Erosion Model Rules (Pillar Two). The Pillar Two Model Rules (released on 20 December 2021) are part of the Two-Pillar Solution to address the tax challenges of the digitalization of the economy that was agreed by 137 member jurisdictions of the OECD/G20 Inclusive Framework on BEPS and endorsed by the G20 Finance Ministers and Leaders in October 2021. The project aims to ensure MNEs pay a minimum level of tax on the income arising in each jurisdiction where they operate. The EU implementation is still under finalization, and it may become effective as of 31 December 2023. In the global minimum (GloBe) tax regime, the income is calculated under the assumption that all the transactions among the entities in scope are settled under the arm’s length principle and properly recorded in the financial accounts. If not in line with the arm’s length principle, the prices of the transactions with related parties should be adjusted to compute the GloBe and avoid double taxation.
Therefore, to ensure that the transactions among entities of a MNE group are settled under the arm’s length principle and the appropriate amount of taxes is paid globally by a multinational enterprise and its captive, the transfer pricing principles for financial transaction included within the OECD Transfer Pricing Guidelines (TPGs) should be used as a guidance.
To which conditions can captive activity be considered as a genuine insurance business?
The TPGs set out what the indicators of genuine insurance should be, noting that all these factors would be expected to be found for an independent insurer, and thus for the captive arrangements to be respected, they should also be present for the captive insurer.
These factors regard the diversification of the pooling of risks, the improved economic capital position of the entities of the MNE group, the entity details (the captive should be a regulated entity), the characteristics of the risks insured (they must be insured in the external insurance market), the skills of the captive and the real possibility of suffering losses.
This last point is crucial as tax authorities may conclude that the contracts are not genuine insurance contracts and/or that the insurance may be considered performed by another entity in the group, or that there is no insurance. In this case, the premium paid to the captive can be considered non-deductible causing double taxation risks and, consequently, potential tax controversy.
To conclude that the contracts are genuine insurance contracts and to ensure compliance with regulations and tax rules, a transfer pricing analysis is necessary to assess whether the premium charged by the captive is in line with the arm’s length principle and it is derived using industry-accepted methods.
Different methodologies to determine premiums and tax rates
In general, two approaches for determining an arm’s-length premium in a captive insurance transaction are commonly used: comparable uncontrolled prices (e.g., comparable arrangements between or with unrelated parties) and actuarial analysis. These approaches appear to be broadly accepted in different parts of the world.
When looking for a comparable transaction carried out with a third party, comparability factors such as functions performed, lines of coverage, limits, geographic market, and economic circumstances should be considered. Differences in these factors that may affect the transfer price should be reflected and reasonable adjustments should be made accordingly.
Regarding the functions performed by a captive and the values that go with those, it should be highlighted that they can be limited compared to commercial insurers. It is therefore more important than ever to prepare a functional analysis that identifies the economically significant activities and responsibilities undertaken, the assets employed, and the risks assumed by each related party in relation to a captive.
About the comparable uncontrolled prices method, it should be noted that the TPGs state that when risks that are difficult or impossible to get insured in the open market are insured by a captive, the commercial rationality of such insurance may be questioned and the arm’s-length pricing of such policies may be more highly scrutinized.
Alternatively, professionally rendered actuarial and transfer pricing analyses should greatly strengthen a taxpayer’s transfer pricing documentation to demonstrate the arm’s length nature of the transactions carried out by the captive for that and regulatory purposes.
The actuarial analysis can also be useful in supporting the risk distribution and to determine whether the captive has a “real possibility” of suffering losses (indicators of genuine insurance offered by the TPGs).
On the other hand, the actuarial analysis should be properly explained in the transfer pricing documentation in a way that the tax authorities can easily understand by demonstrating that the arm’s length nature of the actuarial analysis results and that the assumptions of captives’ profit margin are consistent with market observations.
In case the actuarial analysis is chosen as the preferred method, it may be helpful to prepare a corroborative transfer pricing analysis that both supports that the pricing is consistent with the pricing that would be found in the open market, and that it helps tax authorities to better understand the pricing in case the premium amount charged by the Luxembourg captive is challenged. This corroborative analysis could be done using third-party benchmarks.
For completeness, it should be noted that the premium needs to be allocated among the entities that benefit from the coverage provided by the captive, allowing the correct tax to be paid by each entity insured by the captive.
The analysis of the Luxembourg captive functional profile and transactions with related parties from a transfer pricing point of view should not be conducted on a one-off basis but instead should be revisited annually in order to reflect any change that can affect the analysis (e.g., if there are changes to the MNE’s business activities, if a restructuring occurs or if there is a change to the MNE’s overall transfer pricing policy that would affect the analysis).
Due to the complexity of the relevant issues, a formal transfer pricing analysis should be conducted, and a proper transfer pricing documentation should be prepared to help mitigate the risks described above.