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Tax Issues - Part 2

Tax rates

Non-residents who wish to implement a risk management program involving the use of captive insurance companies to insure property situated, or events occurring outside of Canada should now consider British Columbia as a comparable domicile for their captive insurance company.

Effective April 1, 1998, amendments were made to the International Financial Business (Tax Refund) Act that allow British Columbia captives who insure prescribed risks of non-residents of Canada relating to property situated or events occurring outside of Canada, relief from income taxes payable to the Province of British Columbia. This reduces the effective income tax rate to 29.12%.

Deductibility of premium

There are two tests that have been established for an insurance premium paid to a captive to be deductible for income tax purposes by the insured company. Firstly, there must be a "genuine transfer of risk" and secondly, the amount of the premium must be reasonable in the circumstances. The existence of a parental guarantee has been held to mean that a transfer of risk did not take place.

For those cases where there is no risk transfer, there is a danger that Revenue Canada can successfully argue that the transaction is a "sham" that no deduction is available to the "insured" because no valid policy of insurance exists between the parties.

Generally, for Canadian companies, premiums paid by the parent and its affiliates to a B.C. captive are a deductible expense to the insured for income tax purposes.

Deductibility of loss reserves

For a Canadian company that retains risk corporately, no deduction is permitted for loss reserves. However, a captive, as an insurance company, is permitted to claim loss reserves in accordance with the applicable regulation. The amount of the reserve deductible for tax purposes must be discounted in accordance with the rules contained in the Regulations to the Income Tax Act.

Repatriation of earnings

A B.C. captive owned by a Canadian parent is able to pay dividends to its parent free of tax, as this constitutes an inter-company dividend paid out of earnings that have already been taxed in the captive's hands.

Offshore domiciles have in the past promoted themselves on the basis that earnings can be repatriated to Canadian shareholders free of tax as "exempt surplus". However, if the earnings of the offshore captive are generated from the insuring of Canadian related company risks, the FAPI rules apply and Canadian tax would be due. The "advantage" of exempt surplus only applies to non-FAPI income. Non-FAPI income can only be generated in limited ways as discussed above under the heading FAPI.

In order for the benefits of exempt surplus treatment to accrue, the Barbados corporation must be a "resident of Barbados" and in order to be such a resident for the purposes of the Canada-Barbados Income Tax Treaty it must be subject to tax in Barbados. This created a problem for Barbadian insurance captives as they were not subject to tax. Therefore, Barbados changed their laws so that the captive was subject to tax at the rate of 0% for the first 15 years, after which the rate would be increased to 2% of the first $250,000 of taxable income, or $5,000 which is the current annual license fee and 0% in respect of taxable income in excess of $250,000. The annual license fee would then be waived. While the captive would be subject to tax, total cost would not go up. Our latest information is that Revenue Canada has issued a Technical Interpretation letter that indicated that, in their view these amendments would not make a Barbadian insurance captive resident in Barbados for purposes of the Treaty.

It should also be remembered that taxes are only an issue in a profit centre captive. Captives that are established as cost centres would have no reason to worry about the effect of income tax on domicile choice.

B.C. capital tax

Insurance companies are exempt from British Columbia's corporation capital tax.

Goods and Services Tax ("GST")

GST at a rate of 7% is collected on the purchase of most goods and services. Insurance and reinsurance premiums are categorized as "exempt" sales; therefore, no GST is payable by the consumer on the premium amount.

Where an insurance company pays property damage claims, it will have to pay the GST incurred by the insured only when the insured is not eligible for GST "input tax credits" on its purchases.

While adjusters' fees are GST exempt, most other claims "adjusting" costs will attract the GST.

The GST is meant to apply solely to Canadians; therefore, any foreign programs may be operated without incurring any additional costs. Any GST paid on expenses related to foreign programs would be fully recoverable.

Reporting Requirements for Offshore Transactions

Revenue Canada significantly changed Form T106(E) for all reports filed after December 31, 1995. This form requires details regarding all transactions with "non-resident persons" with which the corporation had "non-arms length" transactions. A separate form is required for each non-resident person. Significantly more detail is now required to be disclosed, including SIC codes, disclosure of transfer pricing methodology, additional disclosures regarding the non-residents' activities and financial statements for controlled non-residents of non-treaty countries. It appears that this additional detail is required in order to provide Revenue Canada with a more appropriate data base on which to select candidates for tax audits. In particular, the answers to the transfer pricing question may trigger audits. Revenue Canada may question whether the premium charged by the offshore captive is appropriate in the circumstances. This question should not be as important to Revenue Canada in respect of a B.C. captive.

The February 27, 1995 federal budget also brought in foreign reporting rules. On March 5, 1996, Revenue Canada and the Department of Finance jointly released draft legislation to implement these foreign reporting rules. Draft forms were also released. These requirements extend beyond captives, however, foreign captives will be caught in this very broad net. All interests in foreign affiliates are included in this reporting mechanism. The level of detail required is comprehensive including detailed ownership structures, full financial disclosure and detailed calculations of surplus accounts if any dividend or deemed dividend has been received in the year. This level of disclosure extends far beyond any previously known, and may be a precursor to future tax changes. Information is being gathered so that Revenue Canada and the Department of Finance know where to make changes to tighten up the rules.