Over the next few years the Irish system of taxing companies will be radically reshaped. It will have a profound impact on financial services activities, particularly insurance and reinsurance. Pat Wall explains.
The effective abolition of the special tax regime for companies located within the International Financial Services Centre (IFSC) represents a major challenge and opportunity for the insurance sector. To conform to European Union competition policy, the special treatment available for IFSC companies must either be abolished completely or extended to insurance companies generally. If equivalent benefits can be preserved, enhanced and successfully defended, Ireland has a chance of becoming the most attractive domicile for insurance and reinsurance activities in Europe.
The availability of a low nominal rate of corporate taxation is not enough. In an industry where timing of payments and adequacy of reserves is everything, it is vital that the incidence of taxation is closely aligned with the recognition of commercial profit. In particular, the Irish approach to tax deductible reserving compares very unfavourably with what is available in other jurisdictions, and the regime for taxing insurance companies in Ireland makes it relatively unattractive as an insurance and reinsurance domicile. The changes forced on us by Brussels should be seized upon as an opportunity to carry out “root and branch reforms” that would put Ireland at the forefront as a centre for international insurance and reinsurance business.
Corporate tax rate changes
The IFSC regime is to come to an end in the year 2005 in accordance with the agreement reached between the Irish government and the European Commission in July 1998. For certain new projects, the IFSC regime will cease on 31 December 2002. New projects, which cannot be approved after 31 December 1999, are subject to strict quotas. These restrictions do not apply to the formation of captive reinsurance and insurance companies where the sponsoring captive's manager was already approved. Such managers can continue to form captives, which will benefit from the old 10% regime until 2005.
The removal of the ring fence around the IFSC will have profound consequences. The government has received approval from the European Commission and is committed to introducing a standard rate of corporation tax of 12.5% to apply to all trading income, including the income of insurance and reinsurance companies. Standing beside that will be a 25% corporation tax rate that will apply to passive income such as royalties, dividends, rents and interest. There is substantial precedent on the subject of what constitutes trading, as opposed to passive, income and by and large the question of what qualifies for the 12.5% tax rate should not create difficulties.
As a general rule, all of the investment income for insurance and reinsurance companies is treated as part of the trading result and, therefore, would qualify for the 12.5% tax rate. Clearly, if there was any suggestion that the company was over-capitalised this position could be put in doubt. In effect, any IFSC insurance or reinsurance company will move on to a 12.5% rate of taxation when its entitlement to the 10% rate expires in 2003 or 2005. For companies with long tail risks, this provides a vital degree of certainty.
Given the ongoing debate on EU tax harmonisation, it is reasonable to ask whether there is a risk that Ireland will be forced to increase its corporation tax rate. I believe the risk is low. There is no EU policy on tax harmonisation. There is certainly a debate on whether a single market can be completed in the absence of tax harmonisation, but those who argue for harmonisation seem to ignore the experience of the US which, while having a common system of federal taxes, tolerates wide differences in the rates of state taxes. I do not think anybody would argue that the US is not a single market for goods and services!On the other side of the debate, there are powerful and convincing reasons why differential fiscal policies are important in avoiding the problems of centralisation and regional economic imbalance. Indeed, Ireland's fiscal policy over the last 40 years is a shining example of how low corporate tax rates, when combined with other initiatives, can be used to stimulate economic activity.
The tax base
The debate on nominal tax rates tends to obscure the real issue: the level of effective taxation. This is as much a function of the taxable profit or tax base as it is the rate.
The definition of the tax base of insurance and reinsurance activities is likely to provoke considerable debate as the IFSC ring fence is dismantled. As a general rule, the regime for Irish insurance and reinsurance companies compares unfavourably with that available elsewhere. For example, most European countries permit some level of tax deductible equalisation or catastrophe reserving.
It is ironic that Germany, which is leading the current debate for tax harmonisation within the EU, has arguably the most generous system in this respect which has resulted in the development of a vibrant reinsurance business in Germany and a healthy level of domestic captive formation. Germany, with the highest level of nominal corporate tax rates has one of the lowest levels of effective corporation tax in the EU.
Indeed, a fair case can be made that Germany is one of the most attractive locations for insurance business in Europe, and it is surely no accident that it boasts some of the largest insurers and reinsurers in the world.
Captive reinsurance companies located within the IFSC are permitted a form of tax deferral under what is known as the five year funded basis of accounting. This system will presumably have to be unwound or extended outside the IFSC in order to comply with the agreement reached between the government and the EU Commission.
Changes in the accounting rules on the level of reserving and the application of substance over form doctrines will also have a sizeable impact on the definition of accounting and, therefore, taxable profits. The accounting treatment of certain financial reinsurance products can be quite controversial and increasingly a more consistent and rigorous approach is to be expected. The traditional approach to reserving was not always the most scientific and this will certainly be subjected to more rigorous scrutiny going forward.
Harmful tax competition
Both the EU and the OECD have thrown the spotlight on the issue of tax competition between tax jurisdictions particularly in the area of financial services. In an increasingly global, deregulated marketplace, tax distortions are having an ever more obvious and measurable impact on business behaviour, particularly in financial services. For example, low tax jurisdictions have been able to divert large volumes of reinsurance business out of the London market. Bermuda is the often quoted example.
An OECD report last year labelled such practices “fiscal dumping” and equated harmful tax competition to the dumping of goods. The EU Commission has published a code of conduct designed to curb what it sees as predatory tax policies and in a recent report listed some 80 harmful tax regimes within the EU; only Austria was not on the list!
It is to be expected that OECD and EU member countries will tighten up their tax rules designed to prevent the outflow of business to tax havens. If Ireland positions itself properly it could benefit from these developments.
Haven or gateway?
There is an important difference between Ireland's profile and that of a traditional tax haven. In essence, a tax haven is a place to hide from the fiscal and regulatory authorities. I believe that the days of the traditional tax haven are numbered. They will be increasingly forced to adopt “onshore” standards of regulation and transparency, thus largely eliminating their advantages except for undesirable business which relies on secrecy and deception for its efficacy. The existence of a benign tax regime does not of itself denote a tax haven. On such a definition Germany is a haven for insurance companies!
While offering a low tax rate, Ireland offers an environment which is transparent to the scrutiny of outside regulatory and fiscal authorities. With a regulatory and fiscal environment that is supportive of financial services, Ireland facilitates the efficient conduct of cross border trade which might not otherwise take place. It is, in effect, a gateway to markets, a conduit through which international business can flow, rather than a final resting-place for monies seeking to escape taxation or detection.
As a member of the EU and the OECD, Ireland is in a powerful position to act as a conduit for legitimate business which is currently located offshore and which will increasingly find it difficult to do business with EU and OECD member countries if it remains so.
Ireland has an extensive and rapidly growing network of tax treaties. Our ability to conclude such treaties underscores the distinction between Ireland as a low tax jurisdiction and a tax haven. In the insurance and reinsurance industry, the existence of such treaties is vital to the avoidance and minimisation of withholding taxes on premium and investment income flows.
If, as is expected, OECD countries implement the recommendations of the report on harmful tax competition, the incidence of such withholding taxes and the rigour with which they are applied will increase, making locations such as Ireland ever more attractive.
An international financial services gateway
Many of the traditional financial centres or tax havens are currently attempting to copy the Irish model in an effort to reposition themselves. They are adopting regulatory standards that militate against secrecy and the attendant unsavoury practices, such as money laundering. But they suffer from being outside the important trading blocks.
Ireland is in a much stronger position to offer certainty to the international community. Ireland can facilitate legitimate trade in international services to an extent that the traditional tax havens cannot. The authorities have quite rightly focused on that legitimate trade and must be careful that business forced out of the traditional tax havens is of the right quality.
The 10-year experience of the IFSC has proven the Irish ability to manage growth and maintain quality. The ending of the IFSC regime is not an end but a beginning. The activities that have been nurtured in the incubator of the IFSC are about to grow up! The future of Ireland as an important centre for international financial services, including insurance, looks bright.
Pat Wall is a partner with PricewaterhouseCoopers in Dublin. He specialises in international taxation of insurance and financial services.Tel: +353 (0) 1 704 8602; e-mail: firstname.lastname@example.org