The Changing Landscape of Captive Taxation

Transcription

1 The Changing Landscape of Captive Taxation

2 Paul H Phillips III Ernst & Young Partner Rick Irvine PwC Partner

3 Insurance Framework Case Law Overview Insurance Risk Risk Shifting Risk Distribution Common Notions of Insurance IRS View CCA Rev. Rul Rev. Rul IRC 831(b) Captives BEPS FATCA Direct Placement Tax Illinois Tennessee Overview

4 Insurance Framework

5 Case Law: Overview Insurance is not defined by the US Internal Revenue Code ( IRC or Code ) or the US Treasury Regulations Judicial precedent provides the following framework for evaluating whether a scenario is an insurance arrangement: Presence of insurance risk Risk shifting Risk distribution Commonly accepted notions of insurance All elements must be met to have an insurance arrangement The 7th and 9th Circuit Courts of Appeal have noted that there are no set criteria as a test, and stated suppose we ask not what is insurance?, but is there adequate reason to recharacterize the transaction?

6 Case Law: Overview The IRS recently lost three cases which impact long held views regarding the insurance framework, namely: RVI Guaranty Co., Ltd. & Subsidiaries v. Commissioner, 145 T.C. No. 9 (September 21, 2015) Rent-A-Center, Inc. v. Commissioner, 142 T.C. 1 (2014). Securitas Holdings, Inc. and Subsidiaries v. Commissioner, T.C. Memo

7 Case Law: Insurance Risk Basic to any insurance transaction must be risk. An insured faces some hazard; an insurer accepts a premium and agrees to perform some act if or when the loss event occurs. If no risk exists, then insurance cannot be present. If parties structure an apparent insurance transaction so as to effectively eliminate the effect of insurance risk therein, insurance cannot be present. The risk transferred must be risk of economic loss. The risk must contemplate the fortuitous occurrence of a stated contingency, and must not merely be an investment or business risk. If the only risks borne by an insurer are (1) that it will be required to make payments with respect to a known loss earlier than expected and (2) that the available investment yield between the time of payment of the premiums and the time of the payment of the claims will be lower than expected, then such risks are investment and not insurance risks.

8 Case Law: Insurance Risk - RVI Guaranty Co., Ltd. & Subsidiaries v. Commissioner Key Facts: Taxpayer sold residual value contracts to insureds (leasing companies, manufacturers, and financial institutions), who were the lessors of the assets or provided financing for the leases Assets insured included passenger vehicles, commercial real estate, and commercial equipment When pricing a lease, lessor must estimate what residual value the asset will have when it is returned to him at the end of the lease Taxpayer insured against the risk that the actual value of the asset upon termination of the lease would be significantly lower than the expected value

9 Case Law: Insurance Risk - RVI Guaranty Co., Ltd. & Subsidiaries v. Commissioner Internal Revenue Service View Insured s purchased policies to protect against investment issues Similar to a put option Not a pure risk, but an investment risk

10 Case Law: Insurance Risk - RVI Guaranty Co., Ltd. & Subsidiaries v. Commissioner Tax Court s Decision Must look at both the insurer s and the insured s perspective States have regulated contracts that provide coverage against market decline as insurance contracts State regulators and Bermuda regulators recognize this is insurance risk and as insurance External auditors following statutory accounting principles ( SAP ) recognize as insurance Insured s not investors, i.e., the assets were not purchased to gain appreciation Both parties agree the policies are not derivative products for US federal income tax purposes; not regulated as derivative products as the products are regulated as insurance A product can be insurance even though competing products exist in the financial market place Did not accept pure risk requirement Mortgage guaranty insurance and lease guaranty insurance recognized in the Internal Revenue Code as insurance IRS attempting to split hairs between investment risk and speculative risk. IRS views are metaphysical.

11 Case Law: Risk Shifting/Risk Distribution The seminal case for defining an insurance contract is Helvering v. Le Gierse, 312 U.S. 531 (1941), where the US Supreme Court established that a contract of insurance must involve risk shifting and risk distribution Historically and commonly insurance involves risk-shifting and risk-distributing. That life insurance is desirable from an economic and social standpoint as a device to shift and distribute risk of loss from premature death is unquestionable. That these elements of risk-shifting and risk-distributing are essential to a life insurance contract is agreed by courts and commentators.

12 Case Law: Risk Shifting Risk shifting is viewed from the presence of the insured The Supreme Court of the United States has explained that in order for an arrangement to constitute insurance for federal income tax purposes, both risk shifting and risk distribution must be present Risk shifting occurs if a person facing the possibility of economic loss transfers some or all of the financial consequences of the potential loss to the insurer, such that a loss by the insured does not affect the insured because the loss is offset by a payment from the insurer Risk shifting generally does not occur if the insurer is undercapitalized and (i) the insurer is indemnified by another entity, e.g., its parent company, to encourage an unrelated third-party to enter into the transaction, or (ii) if the insured agrees to contribute additional capital. Must look to the substance of any guaranty. The balance sheet test is applied to determine whether an insured has shifted its risks to the insurer (under this test, a sole shareholder generally cannot shift its risks to its wholly-owned captive subsidiary)

13 Case Law: Risk Shifting - Common Structures Parent/Subsidiary Risks Brother/Sister Risks Third-Party Risks Premiums Parent Captive Parent has not shifted its risk to Captive (balance sheet approach). Premiums paid from Parent to Captive are not deductible. Captive is not considered an insurance company. Parent Parent has not shifted its risk to Captive (balance sheet approach). Premiums paid from Parent to Captive are not deductible. Subs Subs generally shift risk to Captive. Premiums paid from Subs to Captive are generally deductible provided certain bona fides are satisfied: premiums are arm s length, the Captive is adequately capitalized, the Captive is not propped up and risk distribution is present. Captive Subs Subs Parent Premiums Premiums Captive Generally treated as an insurance company. Subs Subs Parent Parent generally shifts its risk to Captive, provided sufficient third-party risk is present. Third-party risk benchmark > 30% of total premium. Premiums paid from Parent to Captive are generally deductible, provided bona fides are satisfied. Subs Subs generally shift risk to Captive. Premiums paid from Subs to Captive generally deductible, provided bona fides are satisfied. Captive Parent Premiums Third-party Risk Premiums Premiums Captive Generally treated as an insurance company.

14 Case Law: Risk Shifting - Rent-A Center v. Commissioner Key Facts Rent-A-Center Inc. ( RAC ) is a US based company and the parent of 15 affiliated subsidiaries. RAC subsidiaries own and operate more than 2,500 rent to own stores throughout the US In 2002, RAC formed a captive insurance company, Legacy Insurance Co Ltd ( Legacy ) in Bermuda to mitigate its risk related to workers compensation, and other general liability insurance policies Legacy charged RAC a premium based on actuarially determined expected total losses of the insured group (i.e., arm s length). RAC paid the premium and allocated the expense among the operating subsidiaries using the same formula used to allocate the expense when premiums were being paid to a third party insurer. None of the premium was allocated to RAC Legacy was registered as a Class 1 insurance company (only insures risk of owners and affiliates) in Bermuda and was required to meet certain minimum capitalization thresholds. Legacy s capitalization well exceeded this threshold and was based on a study performed by third party risk consultants Legacy received permission form the Bermuda Monetary Authority ( BMA ) to treat Deferred Tax Assets ( DTA ) and the treasury stock purchased from RAC as general business assets when calculating its minimum solvency margin and liquidity ratio, respectively RAC guaranteed payment of all amounts reflected as DTAs on Legacy s balance sheet; RAC never made any payments with respect to the parental guaranty

15 Case Law: Risk Shifting - Rent-A Center v. Commissioner Captive Structure Public RAC Partial guaranty Subs Subs Subs Op Cos (15) BDA Legacy 953(d) election

16 Case Law: Risk Shifting - Rent-A Center v. Commissioner Subs Subs Subs Op Cos (15) Public RAC Legacy BDA 953(d) election Partial guaranty The balance sheet and net worth analysis provides the proper analytical framework to determine risk shifting in a brother-sister arrangement - Conclusion: the policies at issue shifted risk from RAC s insured subsidiaries to Legacy (the Captive) The parental guaranty did not affect the balance sheet or net worth of the subsidiaries, was limited or did not shift away the ultimate risk of loss back from the captive, did not involve an undercapitalized captive; and was not requested by an unrelated insurer Conclusion: the parental guaranty did not negate risk shifting Netting, or the use of journal entries to account for intercompany funds on a net basis, was deemed acceptable provided complete and accurate records are maintained

17 Case Law: Risk Shifting - Rent-A Center v. Commissioner Key Findings IRS sham argument rejected Legacy formed for valid non-tax business purposes Risk clearly shifted to legacy from subs (but not parent) Brother-sister theory accepted Limited parental guaranty not a fatal flaw Majority believed guaranty did not prevent risk shifting Captive was adequately capitalized $25m relatively small compared to premium levels (>$250m) Guaranty never used and removed after unnecessary for BMA

18 Case Law: Risk Shifting - Rent-A Center v. Commissioner Key Findings (cont d) New standard for risk distribution Majority opinion primarily focused on risks rather than entities No mention of entity theory as set forth in Rev Ruls , and Court addressed loan-backs with respect to treasury shares Majority - No circular cash flow as shares were not sold Dissent Legacy a holding tank for cash and loanback along with parental guaranty negated risk shifting

19 Case Law: Risk Shifting - Securitas Holdings, Inc. v. Commissioner Key Facts Securitas AB ( SAB ), a Swedish company, has operations in the US and throughout the world. The operations in the US are through Securitas Holdings Inc. (SHI), a U.S. company. SHI owned several US subsidiaries providing security services. Each subsidiary had various kinds of risk, including workers compensation, general liability, and automobile liability. During the years in issue, these subsidiaries had over 90,000 employees and operated over 2,000 vehicles in connection with these business activities. In an effort to manage the costs of each of SHI s domestic subsidiary s insurance retentions, SHI caused a long-dormant Vermont captive, Protectors, to issue insurance coverage for most of the domestic subsidiaries retentions. Coverage for SAB s foreign subsidiaries retention risks was purchased from an unrelated insurer. All of this risk (US & foreign) was reinsured with an Irish reinsurer, SGRL, owned by SAB. In the years at issue, the risk in SGRL came from 25 to 45 entities; however, in 2004 most of the risk came from one US entity. SHI also owned an insurance company, Centaur, which received no premium income and reported as tax-exempt under Internal Revenue Code section 501(c)(15). Because eligibility for this tax-exemption is determined on a controlled group basis, the receipt by Protectors of amounts qualifying as insurance premiums from its sister corporations would disqualify Centaur as tax-exempt. To prevent this from occurring, SHI guaranteed Protectors performance of its insurance obligations, which under existing IRS guidance would mean that the amounts received by Protectors would not qualify as insurance premiums. No amounts were ever paid under this guaranty. Upon examination, the Service determined approximately $30.3 million in deficiencies in tax for SHI, based on the Service s partial disallowance of interest expense deductions and deductions for insurance expenses involving a captive insurance arrangement. The only question at issue before the Tax Court was whether the amounts paid to Protectors were deductible as insurance premiums.

20 Case Law: Risk Shifting - Securitas Holdings, Inc. v. Commissioner Captive Structure Public Securitas AB (Sweden) SHI (US) Guaranty SGR Limited (Ireland) Non US Non US Op Cos Non US Illinois Centar SGR Limited Protectors Op Cos 501(c)(15) Reinsure ALL premium Commercial Insurance Company Premiums

21 Case Law: Risk Shifting - Securitas Holdings, Inc. v. Commissioner Centar Illinois 501(c)(15) SHI (US) Limite Op d Cos Guaranty Protectors Public Securitas AB (Sweden) SGR Limited (Ireland) Reinsure ALL premium Non US Non US Op Cos Non US Premiums Commercial Insurance Company Cited Rent-A-Center in stating that the Tax Court previously held that the existence of a parental guaranty by itself is not enough to justify disregarding the captive insurance arrangement Found that the captive was adequately capitalized and stated no payments were made with respect to the guaranty Addressed netting, restating that it is unrealistic for members of a consolidated group to cut checks to each other and using journal entries to keep track of the flow of funds is commonplace Accordingly, held the captive arrangement as a whole adequately shifted risk

22 Case Law: Risk Distribution Risk distribution is viewed from the insurance company s perspective Based on the actuarial principle of the law of large numbers, risk distribution entails spreading risks among a large group allowing the insurer to reduce the possibility that one claim will exceed the premiums collected The Tax Court looks to a large enough pool of statistically, independent risks The IRS looks to the number of legal entities involved in the arrangement

23 Case Law: Risk Distribution - Rent-A Center v. Commissioner Subs Subs Subs Op Cos (15) Public RAC Legacy BDA 953(d) election Partial guaranty Legacy insured three types of risk: workers compensation, automobile and general liability RAC s subsidiaries owned between 2,623 and 3,081 stores; had between 14,300 and 19,740 employees; and operated between 7,143 and 8,027 insured vehicles RAC s subsidiaries operated stores in all 50 States, D.C., Puerto Rico and Canada Risk distribution occurs when an insurer pools a large enough collection of unrelated risks * * * RAC s subsidiaries had a sufficient number statistically independent risks. As such, Legacy achieved adequate risk distribution

24 Case Law: Risk Distribution - Securitas Holdings, Inc. v. Commissioner Centar Illinois 501(c)(15) SHI (US) Limite Op d Cos Guaranty Protectors Public Securitas AB (Sweden) SGR Limited (Ireland) Reinsure ALL premium Non US Non US Op Cos Non US Premiums Commercial Insurance Company Protectors, and ultimately SGRL, insured five types of risk: workers compensation, automobile, employment practice, general and fidelity liabilities Securitas AB Group employed over 200,000 people in 20 countries, and the SHI Group, alone, employed approximately 100,000 people each year and operated over 2,250 vehicles Risk distribution is viewed from the insurer s perspective. As a result of the large number of employees, offices, vehicles, and services provided by the U.S. and non U.S. operating subsidiaries, SGRL was exposed to a large pool of statistically independent risk exposures Statistically independent risk exposures do not change merely because multiple companies merged into one The risk associated with those companies did not vanish once they all fell under the same umbrella Court held that by insuring the various risk of U.S. and non U.S. subsidiaries, the captive achieved risk distribution

25 Case Law: Risk Distribution - RVI Guaranty Co., Ltd. & Subsidiaries v. Commissioner Internal Revenue Service View No risk distribution because systematic risk could cause insureds assets to decline in simultaneously Decision of the Tax Court Insurance from the insurer s perspective is a risk distribution device Other insurers face systematic risks Mortgage guaranty insurers; municipal bond insurers; financial guaranty insurers Legal requirement is that there be meaningful risk distribution; perfect independence of risk is not required. RVIA spread its risk four ways Business segments (passenger vehicles, real estate, commercial equipment) Asset types Geographic location Lease duration

26 Case Law: Risk Distribution - RVI Guaranty Co., Ltd. & Subsidiaries v. Commissioner Internal Revenue Service View No risk distribution because systematic risk could cause insureds assets to decline in simultaneously Decision of the Tax Court Insurance from the insurer s perspective is a risk distribution device Other insurers face systematic risks Mortgage guaranty insurers; municipal bond insurers; financial guaranty insurers Legal requirement is that there be meaningful risk distribution; perfect independence of risk is not required. RVIA spread its risk four ways Business segments (passenger vehicles, real estate, commercial equipment) Asset types Geographic location Lease duration

27 Case Law: Common Notions of Insurance Courts have looked to the following items to determine the common notions of insurance Technical indicia of insurance, e.g., risk shifting and risk distribution Substance of the transaction Regulatory environment Adequate capitalization Arm s length premiums Validity of the policies issued All the facts and circumstances are considered, not only terms of the arrangement, but also entire course of conduct of the parties

28 Case Law: Common Notions of Insurance - RVI Guaranty Co., Ltd. & Subsidiaries v. Commissioner Internal Revenue Service View Residual value policies are atypical, e.g., (i) policies do not pay on the happening of a specific event; (ii) fortuitous only if pay immediately or shortly after an event occurs; and (iii) the premiums are non-refundable Decision of the Tax Court The US Supreme Court observed, the absence of a statutory definition of insurance from the Internal Revenue Code strengthens the assumption that Congress used the insurance in its commonly accepted sense. Factors to consider insurance in its commonly accepted sense. Organized and operated in States as an insurance company Adequate capital Policies are adequate and binding Premiums are reasonable in relation to the risk of loss Premiums are duly paid and claims are duly paid Congress delegated to the States the delegation of insurance Municipal bond insurance is recognized as insurance for US federal income tax purposes The IRS did not provide authority to support its view of fortuity for state regulatory or federal income tax purposes Non refundable premium is an outgrowth of the underlying business transaction. In place to stop wait-and-see approach of an insured.

29 IRS View CCA Taxpayer is a multinational enterprise. Taxpayer has a domestic captive that writes a wide variety of insurance business, e.g., automobile liability, credit guarantee, earthquake damage, retiree medical cost, etc. Captive began insuring loss of earnings arising from foreign currency ( FX ) transactions. Loss of earnings was defined as the percentage increase or decrease in the rate of exchange of the US dollar against the specified foreign currency between the effective and expiration dates multiplied by the coverage limit. Contracts were issued for 12 months, and each contract started at a different month, e.g., January, February, March, etc. Contracts were retrospectively rated contracts. Policy premium was determined using a specific formula and option market data was used in calculating the premium. The contracts had many features commonly found in insurance policies. No one insured had more than 15 percent of the premium paid to the captive. No mention of any parental guarantee, premium loan back, or other aspect that would be inconsistent with a bona fide insurance arrangement.

30 IRS View CCA Service s Position The Service concluded the arrangement was not insurance because the contracts lacked insurance risk, are not insurance in the commonly accepted sense, and lacked risk distribution. Insurance risk The Service stated one should take into account such things as i. the ordinary activities of a business enterprise, ii. the typical activities and obligations of running a business, iii. whether an action that might be covered by a policy is in control of the insured within a business context, iv. whether the economic risk involved is a market risk that is part of the business environment, v. whether the insured is required by law or regulation to pay for the covered claim, and vi. whether the action in question is willful or inevitable.

31 IRS View CCA Service s Position (cont d) Common notions of insurance The Service used similar arguments as were used in the residual value ruling to conclude the contracts were not insurance in the commonly accepted sense. Namely, (i) all products sold by insurance companies are not insurance contracts for US federal income tax purposes, (ii) a casualty event is required to damage or impair an asset or income to have an insurance contract, and (iii) that a contract termination date does not provide the type of event that gives rise to a casualty event. Risk Distribution The Service noted a number of contracts were sold, but under the principles of Revenue Ruling , risk distribution did not occur.

32 IRS View Rev. Rul Revenue Ruling Service presents four (4) scenarios pertaining to a domestic corporation with a large fleet of vehicles: 1. Facts: 2. Facts: X places its risk to Y, an unrelated entity Y assumes no other risk Y meets general insurance bona fides; arm s length premiums, adequate capital, etc. Holding: No insurance as risk distribution is not present Same as Scenario 1 except, Y enters into an arrangement with Z, an unrelated party to X and Y, to accept Z s risk Z s premium constitutes 10 percent of Y s total premium Holding: No change in holding with respect to X premiums, as 10 percent of the premium is an insufficient pool of risk to distribute X s risk 3. Facts 4. Facts X has 12 single member LLCs which are disregarded for tax purposes Y contracts with 12 LLCs Y meets general insurance bona fides Holding: No insurance. Similar to Situation 1 X has 12 separate subsidiaries Y contracts with X s separate subsidiaries Holding: Arrangement is insurance as both risk shifting and risk distribution are present

33 IRS View: Rev. Rul Revenue Ruling Facts Parent has 12 subsidiaries that provide professional services Parent forms a captive insurance company Each subsidiary has a specific geographic territory The 12 subsidiaries have a significant volume of independent, homogeneous risks No subsidiary has less than 5 percent or more than 15 percent of the risk placed into the captive Captive is adequately capitalized for the risks assumed No guarantee arrangements are in place Premiums are arm s length Holding Arrangement is insurance for federal income tax purposes

34 IRC 831(b)

35 IRC 831(b) Captives Background Section 831(b) captives or Micro captives are small insurance companies that qualify for a special election under section 831(b). Section 831(b) applies when: Net written premiums (or, if greater, direct written premiums) for the taxable years do not exceed $1.2M, then the company is only subject to tax on its investment income The election must be timely made and cannot be revoked without the permission of the Service Section 831(b) captives must meet all the requirements to be an insurance company Insurance Risk Risk Shifting Risk Distribution Common Notions of Insurance Section 831(b) captives are under increased scrutiny from the Service as a result of perceived abuse

36 IRC 831(b) Captives Legislation Proposed changes to section 831(b) rules include: Legislation in the U.S. House of Representatives and Senate to increase threshold for premiums written from $1.2M to $2.2M Joint Committee on Taxation proposal to address estate and gift tax abuse by restricting certain ownership On 2/9/15 the Joint Committee on Taxation summarized a proposed IRC 831(b) bill that would: Increase the IRC 831(b) limit from $of maximum premiums from 1,200,000 to $2,200,000 Require no more than 20% of net written premium be attributable to any one policyholder Preclude reinsurance (i.e. the captive can only write direct business) The proposal was subsequently amended to contain only the increase in the maximum premium level A study with respect to the above is to be completed in early 2016

37 IRC 831(b) Captives IRS Publications IR The IRS annual issues warnings to taxpayers about abuses such as identity theft, phishing, tax scams, etc. (known as the dirty dozen ) For the first time, it references captives electing section 831(b) with tax shelters IRS comment on abusive tax structures Recognizes valid captives Criticizes poorly drafted binders and policies, implausible risks, exorbitant premiums While maintaining commercial coverages with traditional insurers Underwriting and actuarial support missing or insufficient Hefty fees for promotors Use of trusts/estate planning

38 IRC 831(b) Captives Case Law Avrahami v Commissioner, Feedback Ins. Co. v. Commissioner Premium paid by 4 companies owned by Benyamin and Orna Avrahami to Feedback Insurance Co. Ltd (FICL), a St. Kitts/Nevis entity owned by Orna, FICL had made a IRC 953(d) election and its premiums were within the IRC 831(b) limits For 22009/2010 years at issue, FICL offered coverages to the 4 companies that IRS described as business income, litigation expense, loss of key employee, tax indemnity, business risk and administrative actions No payments/claims in 2009/2010 No outward reinsurance

39 IRC 831(b) Captives Case Law Avrahami v Commissioner, Feedback Ins. Co. v. Commissioner (Cont d) Participated in a terrorism pool in each of 2009/2010 administered by Pan- American Reinsurance Co. Premium ceded on funds withheld basis (33% in 2009 and 31% in 2010) All but about $6,000 loaned to Belly Button Center LLC, owned by 3 children of Avrahami. No principal or interest paid on loans. IRS argues No economic substance and as such all transactions should be disregarded Transactions with 4 companies not insurance Trial held

40 BEPS

41 Base Erosion Profit Shifting (BEPS) Initiative On October 5, 2015 the OECD released the final reports on the 15 action points. Some have immediate effect and others to be implemented over the coming months/years The reports have the potential to significantly impact captive insurers The reports contain several negative references to captives as the OECD regards them as potential sources of profit shifting Immediate next steps: Review operating models and remediate where necessary. Assess the capital or other commercial benefits arising from the arrangements for the insured, captive and the group as a whole. Review transfer pricing approaches and update/revise where appropriate Maintain robust documentation of above

42 Base Erosion Profit Shifting (BEPS) Initiative Key BEPS Action Points for Captives Action 3: CFC Rules Recommendations are not minimum standards, but instead, revert to individual territories to decide whether to adopt any design elements they do not already have Definition of CFC income Specific reference is made to insurance income which derives from contracts or policies with a related party which is treated as attributable CFC income. Some jurisdictions already have specific CFC measures relevant for insurance companies (e.g., the UK -CFC rules distinguish between captive insurance in a non-insurance group versus intragroup reinsurance in a regulated insurance group, and assess the CFC position of a captive based on the location of underlying risk and by applying a tax purpose test under certain circumstances. RECOMMENDATION: Monitor local tax developments and respond to proposals to implement rules which target captive arrangements.

43 Base Erosion Profit Shifting (BEPS) Initiative Key BEPS Action Points for Captives Action 4: Interest Deductions Recommendations to prevent base erosion through the use of interest expenses. fixed ratio rule group ratio rule Any exclusion of the rules should not apply to captive insurance companies. fixed ratio corridor of 10% to 30%, meaning that interest deductions would be limited to between 10% and 30% of an entity s or group s EBITDA. RECOMMENDATION: Groups with captives should monitor to see if countries where they operate have thin-cap or interest limitation rules.

44 Base Erosion Profit Shifting (BEPS) Initiative Key BEPS Action Points for Captives Action 7: Permanent Establishment Definition has been widened beyond the traditional authority to conclude contracts to where a person habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification. To the extent individuals are dealing with these third-party providers when outside the captive location, even in a Group Risk role, this could give rise to PE risk. Final report also includes changes to the definition of an independent agent, so that an agent who acts exclusively or almost exclusively for a related entity will no longer be regarded as independent. This could create The changes to the PE definition will be given effect through the multilateral instrument that is due to be negotiated in RECOMMENDATION: Groups with captives should review their operating models in light of the new definitions and changes and amend or establish operating guidelines accordingly

45 Base Erosion Profit Shifting (BEPS) Initiative Key BEPS Action Points for Captives Actions 8-10: Aligning transfer pricing outcomes with value creation Amendments are intended to ensure that a transfer pricing analysis is based on an accurate delineation of what the associate enterprises actually contribute in the transaction, (i.e. risks actually assumed and functions undertaken) Authorizes the non-recognition of transactions which are commercially irrational. Sets out the criteria for non-recognition of a transaction: Whether the actual transaction possesses the commercial rationale of arrangements that would be agreed between unrelated parties, and not whether the same transaction can be observed between independent parties. The final guidance on non-recognition includes a negative captive insurance example:

46 Base Erosion Profit Shifting (BEPS) Initiative Key BEPS Action Points for Captives Actions 8-10: Aligning transfer pricing outcomes with value creation (cont d) Emphasis on demonstrating control over risk in the entity taking on risk. There must be within the entity competent and experienced decisionmakers who have access to information relevant to the decision to take on or lay off a risk. Where an entity cannot demonstrate control over a risk, the return from that risk will be allocated to the group entity that does in fact control the risk and the return to the first entity will be limited to a risk-free return. RECOMMENDATION: Review operating models and remediate where necessary. Assess the capital or other commercial benefits arising from the arrangements for the insured, captive and the group as a whole. Review transfer pricing approaches and update/revise where appropriate.

47 FATCA

48 FATCA General Principles What is the Foreign Account Tax Compliance Act (FATCA)? How will FATCA impact you? What is the cost of non-compliance? FATCA is a new US tax law designed to prevent US taxpayers from avoiding US tax on their income by investing in the US through non-us financial institutions and offshore investment vehicles. FATCA was enacted on March 18, 2010, and became effective in 2014 FATCA requires reporting to the IRS regarding offshore accounts and investments held by US persons. IRS issued final regulations in January of 2013 and providing updated guidance from that point forward on how the they would administer FATCA. The US entered into Intergovernmental Agreements (IGAs) with numerous jurisdictions to facilitate the implementation of FATCA. FATCA generally requires financial institutions (both US and non-us) to classify all account holders as either US or non-us and as individuals or entities, which are further broken down as financial and non-financial. Foreign Financial Institutions (FFIs) must enter into agreements with the IRS to identify US accounts and report certain information about those accounts to the IRS, or to a local competent authority in jurisdictions having a Model 1 IGA with the United States, on an annual basis. FFIs must report certain information to the IRS, or local competent authority in Model 1 IGA jurisdictions, about substantial US owners of non-financial foreign entities (NFFEs). Thirty percent withholding will apply to all US source dividend and interest payments plus the gross sales proceeds resulting from the sale of an asset that gives rise to US source income if paid to either a recalcitrant account holder, nonparticipating FFI or an NFFE that has not disclosed its substantial US owners. However, USFIs and FFIs will always be liable for any tax that they failed to withhold, plus interest and potential penalties. What are some possibly impacted business units and functions? Investment Banking Private Wealth/Banking Retail Banking Custody Prime Brokerage Corporate tax Tax operations Compliance (e.g., AML/KYC) On-boarding and customer data Information technology (IT) Finance Relationship management Payment processing settlement

49 FATCA General Principles Cayman Islands entered into a Model 1 IGA with the United States on November 29, Cayman issued final FATCA Regulations on July 4, 2014 Cayman issued initial IGA Guidance Notes on July 22, The most recent updated version (2.1) was issued on July 1, 2015 and available on Cayman Islands DITC website - The Cayman Islands competent authority for FATCA is the Department for International Tax Cooperation (DITC) The Cayman Islands announced on March 19, 2015 the opening of the AEOI (Automatic Exchange Of Information) Portal for the Notification & Reporting for FATCA. An AEOI Portal User Guide was also issued in March 2015 with the most current version (1.2a) issued on May 17, 2015 There is a Notification requirement via the AEOI Portal for FIs. The Notification due date was ultimately May 29, 2015 for the 2014 tax year. It will be April 30 for future years. The FATCA Report submission date was May 31, 2015 for the 2014 tax year, however a notice was issued allowing submissions as of June 26, 2015 not to attract adverse consequences or enforcement. It will be May 31 for future years. No Nil return filing is required for FATCA, however Notification process via Cayman AEOI portal is required to be done by Reporting regardless of whether any reportable accounts. September 15, 2015 notice issued by DITC alerting POCs of Cayman Reporting Fis that submitted FATCA returns may require edits/upates & resubmission by September 21, 2015.

50 Direct Placement Tax

51 Direct Placement Tax In General Direct placement tax is imposed on an insured when directly procuring coverage from a non-admitted insurer (i.e. captive) Payable based on rates, varying by states, on the net written premiums paid to the captive Note, some states do not impose any direct placement tax Several States have been making changes to their non-admitted tax rules in recent months No State, other than the Home State of an insured may require any premium tax payment for non-admitted insurance.

52 Direct Placement Tax In General Key Drivers Determine who the insured is Insured not defined in federal law, look to state law and regulations Determine state in which insured has principal place of business Principal place of business not defined in federal law, look to state law, federal and state judicial precedent Determine location of risk within a specific non-admitted insurance contract If less than 100% of insureds risk is outside the state with the principal place of business, the Home State is the state with the principal place of business If 100% of insureds risk is outside of the state with the insured s principal place of business, determine which state the insured has the greatest percentage of risk and this is the Home State The principles are based on an insurance contract If the contract has multiple insureds, the insured with the greatest percentage of risk is the insured for the purposes of determining the home state

53 Direct Placement Tax Illinois In 2014, Illinois enacted legislation imposing a 3.5% self procurement tax on nonadmitted insurance In 2015, Senate Bill 1573 which provides an exemption from the 3.5% selfprocurement tax for contracts of insurance with a captive insurance company was passed If passed by Illinois House of Representatives, bill would be effective January 1, 2016

54 Direct Placement Tax Tennessee Previously Tennessee imposed self-procurement tax only on limited lines of insurance (e.g., marine insurance) In 2015, Tennessee expanded its direct placement tax to include all lines of insurance Non-admitted insurance is subject to tax at a rate of 5% on gross premiums, less premiums allocated to Tennessee and returned to the insured therein Only applicable to Tennessee risk

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