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Hugh's Views Issue 14 -- July 2007
Hugh’s Reflections on Captive Value Added From the UK

Based on an earlier piece that appeared in Captive and ART Review of August 2007 Opinions and judgments expressed in this and all "Hugh's Views" editorials are those of the author, and do not necessarily reflect the opinions of captive.com or its partners. Readers should not act upon this or other information in articles posted at captive.com without appropriate professional advice after a thorough examination of the facts of their own specific situation. Captive.com is always happy to publish responsible dissenting opinions! E-mail your thoughts to Chris Mancini

I sat in on a rather disappointing captive session at the AIRMIC conference in London last month that was supposed to deal with captives in a soft market, but didn’t. The organizers had polled those who signed up for the session and reported an overwhelming majority wanted to hear about tax factors. So that was the main topic.

After the European Court’s decision in the Cadbury Schweppes case ( in which the UK’s Inland Revenue was reprimanded for applying discriminatory controlled foreign corporation rules against a lower-tax regime inside the EU) we all thought it was going to be easier to justify EU-domiciled captives as non controlled foreign companies (CFCs). In the EU there are low tax jurisdictions, such as Ireland’s (12.5%), Malta’s (about 4% under their complicated rules), and Gibraltar (being thrashed out). “Non-controlled foreign corporations”? That sounds like a contradiction in terms for captives, doesn’t it? If they weren’t controlled, they wouldn’t be “captive” insurance companies, would they? But for tax purposes you can have your captive deemed non-controlled. Non-CFC status is what UK captive owners all want if they are to avoid having to remit 90% of profits just to conserve the remaining 10% tax-deferred in the captive.

But no, according to David Hertzell, the outgoing AIRMIC captive special interest group leader. The UK CFC legislation is being modified to allow the Cadbury Schweppes decision to apply to entities like captives only if

1. Physical presence: They have a physical presence in the domicile. This could be bad news unless the contract management used by most captives “counts” as physical presence. But what the IR is probably looking for is full-time employees, dedicated office space, the kind of things that French owners of captives set up in Luxembourg for the very same reason.

But assuming this condition can be argued to be met, then the entity has to

2. Genuine Activity: The captive has to have a genuine activity, and not be just a paper company for transfer pricing purposes. This could be good news for captives that write direct business, but probably also for those that are mainly reinsurance captives, and can show that underwriting, claims, and investment decisions at least appear to be taking place in the captive’s office.

That reminds US-based captive owners of the old and still valid notions of “mind and management” that were meant to be carried out in the offshore captive domicile and not be seen to be going on back in the risk manager’s office, or the broker’s onshore office. However, it’s the last one that may make all the difference. And let’s not get into the subject of writing unrelated business, which might or might not be an “activity.”

3. Economic Rationale: The captive has to be able to show an economic rationale. This term, not very precisely defined, is meant, according to Hertzell, to demonstrate what profit the captive might be making if it were a distinct and separate enterprise engaged in similar activities. Good grief! This might involve managers and consultants in a lot of functional analysis of what the captive is being used for, and could therefore be bad news.

It is worth noting that I say “being used for”. avoiding the erroneous manner of speaking “what the captive does” because, as I have said many times, a captive insurance company doesn’t do anything – its owners, managers and underwriters do things. Policies are issued by the managers, claims are handled by the TPAs, etc. Captives don’t do anything. And that is one of their major advantages that has not been sufficiently demonstrated in most of the captive cases that I have studied in detail.

The economic rationale that the IR is calling for as one of the tests that a captive should not be considered a CFC is very close to what should be a demonstration of the value added of a captive. Is it enough to show that by using a captive the owners are not buying as much external insurance? Apparently not. You don’t need a captive to do that, after all. Is it enough to show that the captive is showing a positive bottom line, and therefore is somehow adding economic value? Again, apparently not, and it’s easy to see why. If the tax authorities are a bit hard on captives for their CFC status they could be much harder on them for the bigger issue of transfer pricing. Want to show a big profit in your captive that just happens to be in a low-tax domicile? Simple, just raise the rates to all the participating subsidiaries – and get yourself into a transfer pricing argument.

Hugh’s view:

Paying home-country taxes on captive profits is, of course, nothing new to US captive owners. The UK owners are fighting a rear-guard action; they will eventually do so, too. But it seems to me that the opportunity to be seized from the disappointment that emerges from the “lost Cadbury Schweppes opportunity” is the opportunity to start demonstrating the real captive value added – to the individual businesses, to the group as a whole, and to the hard-pressed risk manager for accomplishing what is expected from him. The ways of doing this internally are different from one captive owner structure to another, but it seems to me that they share a common ground – one that would go a long way to arguing the “economic rationale” argument with the UK’s IR. And that is a demonstration that the captive results (to be defined, of course) are better results than could have obtained by applying or using the next best alternative. This simple statement of the outcome of a captive value-added demonstration does require a lot of hard work to validate the captive “results”, for instance from the business customers themselves. It may seem even harder to validate the next best alternative, but it’s being done by every large organization that challenges its captive from time to time.

It’s time for some new captive economic rationale work, to get away from the discredited return on capital arguments, the irrelevant bottom-line arguments, and the hard-to-prove arguments about reducing the cost of risk. One of the drivers for UK owners ought to be the argument that this work will contribute to proving that, for tax purposes at least, a captive is not a CFC. And that would be a start at proving value added.

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Hugh Rosenbaum, one of captive.com's friends and valued contributors, is a freelance consultant. Hugh can be reached by telephone at +4420 8883 6729 or by e-mail at hughro2@yahoo.com. Learn how you can spend a day with Hugh!

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