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Tax Issues

As with many tax issues, the rules applicable to captives are complex and subject to change. While this summary is provided for your information, it is recommended that appropriate tax advice be obtained.

Federal Excise Tax

Generally, a 10% excise tax is imposed by the Canadian government on premiums for insurance placed outside of Canada. An exemption is granted for insurance coverage not available in Canada, and for contracts of reinsurance. However, since a B.C. captive is located in Canada, no excise tax applies. Premiums placed directly with an offshore captive for insurance generally available in Canada attracts this tax, unless the program is fronted.

For U.S. exposures, the U.S. government imposes an excise tax of either 4% on direct policies (not fronted) or 1% on reinsurance premiums (fronted programs).

Premium Taxes

Premium taxes are payable in every province of Canada on both licensed and unlicensed insurance. The rate of tax varies with the class of insurance. Licensed insurance generally attracts a rate of approximately 3% of the gross premium written, while the unlicensed rate varies by province.

British Columbia's premium tax rate for unlicensed insurance is currently 7%, while some of the other provinces impose much higher rates (Alberta - 50%), which are intended to be punitive and to force the use of licensed insurance. Since the tax applicable to licensed insurers is less than that applicable to unlicensed insurers, there is further incentive to have a captive program fronted if it involves risks outside British Columbia. For companies insuring significant British Columbia risks there is a distinct advantage to the use of a B.C. captive, as that portion of the policy can be written direct, thereby avoiding fronting fees.

Canadian premium taxes do not apply to U.S. exposures. Premium taxes are only payable on policies covering persons resident and property situated within a particular province. Premium taxes on U.S. risks would be payable to the state where the insured corporation is resident or where the property is situated.

Unlike many U.S. domiciles, British Columbia does not impose any additional premium taxes related to B.C. captives. In comparison, premium taxes for U.S. captive domiciles are generally in the range of 1/2% to 3/4% of premium written regardless of where the risk is located.

Federal Withholding Taxes

Certain payments from residents of Canada to non-residents, including investment income, attract federal withholding taxes. Unless reduced by treaty, the general rate is 25%. For off shore captives that may be required by the fronting company to provide trust funds as security for their obligations to the fronting company, this may present a problem. It is generally accepted that withholding taxes do not apply to insurance and reinsurance premiums.

Since a B.C. captive is a resident of Canada, withholding taxes are not an issue when dealing with a Canadian fronting company.

Income Taxes

Canada's income tax system is based on residency. Residents are taxed on their worldwide income. Non-residents are taxed on income attributed to carrying on a business in Canada.

Residency

Canadian income tax is payable by corporations considered to be either resident in Canada or carrying on business in Canada. Companies incorporated in Canada after 1965 are deemed to be resident for tax purposes, and a B.C. captive is, therefore, a taxable Canadian corporation. One of the main advantages of an offshore captive is that these jurisdictions normally provide an exemption from income taxes. While offshore captives do not pay income tax to their local governments, they must diligently watch how their affairs are handled to ensure that the Canadian tax authorities do not catch the income of the captive in the Canadian tax net.

Residency is not defined in the Income Tax Act. It is determined on the facts of each case and based on previous court rulings. One of the tests to establish residency is the "mind and management" test. If management control is exercised over the business decisions of the company from Canada, then the company may be deemed to be a resident of Canada for tax purposes. This could potentially undermine one of the reasons for establishing a captive offshore.

FAPI

Foreign Accrual Property Income ("FAPI") rules, which are applicable to offshore captives only, attribute certain types of income to the Canadian shareholders directly, and the shareholders must include this income in their own taxable income calculations on a current basis. The intent of the rules is to prevent Canadian taxpayers from avoiding tax on inactive income, including premium and investment income earned by an offshore captive attributable to the insuring or reinsuring of Canadian risks. However, the FAPI rules were not very effective in taxing the income being generated by offshore captives. Accordingly, the Canadian Federal Budget of February 22, 1994 changed the rules significantly so that most income earned by offshore captives is now caught in the FAPI net.

These FAPI rules are extremely complex and subject to a variety of exceptions. It is generally accepted that a company should employ a tax expert specifically skilled in this area to review the application of these rules and, if necessary, to complete the related documentation and filings if FAPI does apply.

Under the new FAPI rules, which generally have effect for taxation years commencing after 1994, the insurance or reinsurance of Canadian risks will be caught in the FAPI net with limited exceptions. These exceptions will, in most cases, be very difficult to meet. The insurance or reinsurance of non-Canadian related company risks will also be caught in the FAPI net unless the captive employs six or more full-time people and its business is conducted principally with arms-length persons. Since Canadian risks in most cases will be caught in the FAPI net the captive domicile in British Columbia is probably more appropriate when all factors are considered.

The vast majority of captive business is related company business. In British Columbia, the rules specifically preclude captives from writing third party business. For any companies contemplating programs involving third party business, this would have to be done offshore.