Who is winning this annual European fixture? David Ingmire offers some advice on tactics.

In the early 1980s, Ian Hunter, the UK Inland Revenue author of the 1984controlled foreign company (CFC) legislation, reassured the captive insurance industry: “We are only trying to catch the ‘grotty' captive,” he said. We naively hoped that captives carrying on a genuine insurance business would be left alone while only money-box operations thinly disguised as captives would feel the full weight of the anti-avoidance CFC legislation.

Those words soon acquired a hollow ring not only in the UK but in many countries in Europe. It soon became apparent that tax authorities regard captive insurance as prima facie a tax avoidance exercise, to be examined on a case by case basis; to persuade them otherwise was a hard task, especially as the average inspector of taxes had had little experience of insurance operations. In the UK, the Inland Revenue has been able to persuade Parliament on several occasions since 1984 that ever stricter CFC legislation is required to combat perceived “loopholes”. This culminated in changes, effectively commencing in 1996, aimed particularly at offshore captive insurers.

At the same time, in the UK and elsewhere in Europe, sharper teeth arebeing given to transfer pricing regulations. In the UK, tighter rules are combined with the advent of self-assessment for companies, with the possibility of penalties being levied if transactions with overseas, affiliates, including premiums paid to captives, are not at arm's-length.Furthermore, premium taxes where applicable are an expense of payingpremiums to a captive, although not necessarily a greater one than if the premiums were paid into the market.This article examines how the captive insurance industry is adapting itself to meet these continuing attacks.

Controlled foreign company rules
The basic rule is that the profits of an offshore captive controlled by an onshore parent company are liable to tax in the parent unless one of a number of exemptions can be claimed.

In the UK, between 1984 and 1995, the most popular exemption had been the “acceptable distribution”. Up to 1995, a captive paying at least 50% of its book profits to the UK by way of dividend within 18 months of its year end was “acceptable”. Then, however, the calculation was increased from 50% to 90%, but the 90% was to be based on taxable profits, not accounts profits.

This means that for every captive, a tax computation on UK lines has to be prepared in order to demonstrate that the 90% test is being met.If the Revenue considers that the captive is over-reserved, it will seek a disallowance, which results in an increased tax profit and, therefore, an increased dividend. Lengthy correspondence is often required and“compromises” demanded even in cases, in the writer's view, where thecaptive could be said to be under-reserved! This is not only expensive and time-consuming, but 90% dividends can cause a serious drain on a captive's reserves, so that recapitalisation is often required if its business is to be developed and increased.

Elsewhere, CFC legislation operates particularly harshly for groups withLuxembourg insurance subsidiaries. Although Luxembourg tax is itselfavoided by allowing generous reserving, its profits when attributed to the parent in, say, France or Germany, must add back the over reserves.One of the anomalies of CFC legislation has always been that, in a multi-national group, a captive's profits are often derived from insurance business it conducts around the world, i.e. mostly from business which cannot possibly have tax avoidance in the parent's country as a motive. Some of the ways in which captives are seeking to avoid this shackle on their business have already been implemented and others are being explored.

The great advantage in finding a solution is that, if commerciallyacceptable, it can mean that tax in the parent is avoided altogether. Inthe UK before 1996, for example, 50% of a captive's profits were subject to UK tax when remitted as a dividend, now the industry is being forced to go along routes which result in the UK tax take actually being reduced rather than increased because alternatives to the “acceptable distribution” are being sought.

Possibilities to explore are:

Exempt activities
In the UK this test is satisfied if the captive derives 50% or more of its net premium income from unrelated (non-group company) risks and it has its own staff and premises in its offshore location. Similar rules apply in other regimes. A favourable result can be obtained by the careful programming of reinsurances but, by and large, captives have looked over their shoulders at the US experience and have decided that the commercial risk of writing third party business outweighs the potential tax benefit.

Mixer companies
If ownership of a captive is transferred to an overseas group holding company in, say, the Netherlands, dividends being paid up to satisfy the acceptable distribution are “mixed” with dividends received from high tax areas before being paid up to the parent, so that the captive's dividends are deemed to have paid tax at the world-wide average rate, and tax is reduced by this double tax relief. This procedure may well involve changing the local tax status of the captive so that it is no longer completely exempt. The Dutch tax authorities would also need to be satisfied that the captive is carrying on a genuine insurance operation.

Close down and start again
This involves putting all or part of an on-going insurance programme through a company which is not a CFC: this usually means a company which is not actually controlled by the insured. This has a number of advantages, not least the administrative ones that the operation will not need to be included in the CFC section of the new self-assessment return of the parent and any lingering doubts about transfer pricing disappear.

Rent-a-captives have been around for a long time. They are not normally CFCs because each insurance programme forms only a part of an overall business. The potential disadvantage is, of course, a commercial

one in that profitable programmes are technically at risk from the loss makers. Rent-a- captives have been comparatively successful in attracting US business where the insured is often happy to put up substantial capital to cover the risk gap on its insurance programme.

A variation of the rent-a-captive is the protected cell company (PCC) – a number of these have been incorporated, operating very much like a rent-a-captive but without the commercial risk that losses incurred in some cells could spill over into profitable ones. Revenue authorities appear to be still considering their view of PCCs and whether, for example, a cell might be considered to be a captive in its own right and, therefore “controlled”, even though the majority of the PCC's business overall is conducted with other groups.

Captives at Lloyd's
Carrying on business at Lloyd's through a “captive” operation has been technically possible since the advent of corporate membership and the single company syndicate. Being businesses carried on in the UK, profits are liable to UK corporation tax, although the current 30% rate is comparatively low. Costs are high but for those taking the plunge, the commercial advantages have been considered to outweigh tax considerations.

The best of all worlds
The closing or running down of an existing captive in order to write future business in a new more tax efficient operation, can cause tax and commercial problems. The captive may take a long time to run-off tying up substantial amounts of capital. Also, when the original operation is finally wound-up, tax is often leviable in the parent on the distribution of its reserves or on capital gains by reference to the original cost. A solution is to restructure in a way which enables the captive to continue exactly as before but to avoid being controlled. It is possible to achieve this so that it is no longer caught by the relevant CFC legislation and is enabled to accumulate reserves and develop its business without a tax charge being incurred in the parent group. This is likely to become a popular alternative for UK and European parent companies.

Transfer pricing
Ensuring that insurance premiums paid to a captive are at arm's length is very time consuming. Demonstrating that a premium is comparable to premiums being paid elsewhere in the market can mean trying to obtain information which is not by any means readily forthcoming; also, the concept of a comparable premium is only valid when the risk is comparable.

One of the fundamental benefits of a captive is that the risk is often not comparable because the captive offers cover not available elsewhere. The scene seems to be set for long, tedious arguments between tax authorities and tax payers. In practice, however, it is hoped that fronting by an unconnected company, which sets the rates, will solve many of the problems. UK companies, however, in signing their self-assessment tax returns, need to have satisfied themselves that the payments are, indeed, at arm's length.

Partly through lack of space and partly because there is not a lot of news to report, the question of deductibility of premiums paid to a captive is not dealt with here. Most of the issues of transfer of risk have been dealt with in correspondence and have only in a few cases, for example in the Netherlands and in Norway, reached the courts. Nevertheless, the European scene is continuously developing and is a constantly challenging area for captive owners and their tax advisers. There will always be room for legal but imaginative means of reducing tax bills, until such time as tax authorities generally come to realise that an in-house insurer is principally designed to provide insurance rather than tax avoidance to its group members.

David Ingmire is partner, corporate taxation, Mazars Neville Russell
Tel. +44 (0) 207 220 3312; e-mail: david.ingmire@mazars-nr.co.uk.