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For Offshore Captives, Economic Substance Is a Compliance Concern

Clear Crystal Globe with Stacks of Coins in the Background
July 29, 2020

For captive insurance companies located in offshore domiciles, abiding with economic substance requirements has become an important compliance consideration.

The focus on economic substance has its basis in the Organization for Economic Cooperation and Development (OECD) Base Erosion and Profit Shifting (BEPS) project. "It's a concept that was taken up with some vigor by the European Union," said Michael Frith, senior counsel and managing director at the Carey Olsen law firm in Bermuda.

Mr. Frith made his comment as part of a Strategic Risk Solutions (SRS) webinar focusing on "Economic Substance and Captives."

Another panelist, Derek Bridgeman, managing director at Strategic Risk Solutions (Europe) Ltd., noted that BEPS emerged in 2012 when the OECD embarked on an initiative aimed at addressing companies' perceived efforts to shift profits to gain tax advantages.

The OECD followed up in 2015 with 15 action items covering such areas as the digital economy, treaty abuse, substance, transfer pricing, and transparency, he said.

"The key focus was that they were designed to tackle aggressive tax planning strategies that exploit gaps and mismatches in tax rules in order really to reduce the company's tax burden," Mr. Bridgeman said.

Because the action plan items are recommendations, the manner in which they're implemented is determined at the national tax authority level, Mr. Bridgeman said. As tax authorities apply BEPS and the OECD action plan to corporate activities, there are several areas for captives to consider, as follows.

  • Economic rationale—is the captive transaction commercially rational, or is value created in the process? "The aim here is to satisfy the principal tax test," Mr. Bridgeman said.
  • Risk pricing and capitalization appropriateness—is the risk transfer pricing comparable with market quotes or based on actuarial pricing models, or is the captive's capitalization reflective of the risks underwritten?
  • Governance—is there actual decision making in the right location at the right time, or is the captive effectively controlling the risks of the transaction?
  • Substance—is the captive performing a true economic activity, or is there substantial income-generating activity taking place? "Really, what the regulators and the national authorities are looking to understand is the mind and management of the captive," Mr. Bridgeman said. "The aim again is to demonstrate that the income-generating activities are undertaken by the captive."

Mr. Frith noted that essentially every offshore captive domicile has equivalent legislation and guidance around the issue of economic substance.

"The fundamental principle, and this is where it's pertinent to all of the sort of similar offshore jurisdictions, the regime is intended to ensure that jurisdictions should not facilitate offshore structures or arrangements aimed at attracting profits which do not reflect real economic activity in the jurisdiction," he said. "This is a concept that is very focused on those jurisdictions like Bermuda, like Cayman, for example, as the OECD views us as no or only nominal income tax jurisdictions."

In Bermuda, the commitment to reflect real economic activity in captives and other relevant companies is set out in the Economic Substance Act of 2018 and associated regulations and guidance. Other offshore jurisdictions have their own legislation that, in concept, is essentially identical, Mr. Frith said.

"In Bermuda, and elsewhere, there are essentially five requirements," Mr. Frith said. They include the following.

  • The entity must be managed and directed in the jurisdiction.
  • Core income-generating activities must be undertaken in the jurisdiction.
  • The company must have adequate full-time employees with suitable qualifications within the jurisdiction.
  • The company must have an adequate physical presence in the jurisdiction.
  • The company must have adequate operating expenditure in the jurisdiction.

Captive insurance companies are required to file detailed economic substance declarations concerning their operations in the jurisdiction, Mr. Frith said. Findings of noncompliance can result in civil penalties and the spontaneous exchange of the information that the company has filed in its economic substance declaration with authorities in each of the jurisdictions where the parent is located and the jurisdiction in which it has claimed to reside for tax purposes.

Knowingly making a false declaration is a serious offense, Mr. Frith said.

The economic substance requirement "has created, in effect, an entirely new regulatory paradigm for the offshore world," said Mr. Frith.

For a captive insurance company, the role of the board can be very important. Being able to demonstrate that your board meets in the jurisdiction and that it is engaging in robust decision making in the jurisdiction are essential. "Then, of course, there's the oversight role that the board has in relation to compliance overall," Mr. Frith said. The board should ensure that everything the captive is doing meets the relevant requirements.

Conducting committee meetings such as an underwriting committee meeting in the jurisdiction is significant as well. And, if the captive does have employees, the senior employees should be in the jurisdiction. Strategic decisions should be made in the jurisdiction, and making risk management and operational decisions in the jurisdiction further bolsters the captive's position.

Richard Daley, managing director at Strategic Risk Solutions (Bermuda) Ltd. and the webinar's moderator, suggested several best practices captive insurance companies can follow to help them comply with economic substance requirements.

  • Captive insurance companies should have local directors. Local professionals can help by being well versed in local regulations and, from a practical point of view, having several local directors on the captive's board allows the company to hold meetings to address administrative tasks without requiring directors located elsewhere to travel to the jurisdiction.
  • To demonstrate that real decision making is taking place in the domicile, it's important that committees like underwriting, investment, and audit and risk should be formalized.
  • Strategy session meetings should take place in the domicile and be documented.
  • And, having a disciplined pricing and reserving process in place will go a long way in protecting the captive if it's challenged by tax authorities or regulators.

Mr. Bridgeman suggested that, going forward, captive insurance companies in offshore domiciles should take a proactive approach. "Just consider a BEPS health check," he said, suggesting captives look at the key areas of focus of the jurisdiction's tax authorities, consider best practices, and look at what tweaks the captive might be able to make to reduce tax authority scrutiny.

In addition, he said, the OECD still has some misconceptions around captives, so industry engagement and organized lobbying efforts around the true risk management benefits of captives are essential.

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