INTM489813 - Diverted Profits Tax: application of Diverted Profits Tax: examples and particular situations: insurance/reinsurance
Example 1 – Intragroup reinsurance
Facts
- The group is a large multinational insurer employing over 2000 people worldwide. It has an extensive network of local subsidiary insurance companies across America, Asia and Europe. All of the local insurance companies are licenced by their local regulator.
- The UK company employs 350 people and is one of the largest of the local insurance subsidiaries, it employs its own actuarial and underwriting staff and can write insurance business within generous limits without seeking approval from the parent.
- The UK insurance risk requires £1,000m of capital to support an A credit rating. It reinsures 50% of its written business to the group reinsurer under a standard whole account quota share (WAQS) contract. As a result, the UK company’s capital requirement reduces to £500m (also based on an A credit rating).
- The group reinsurer writes 25 WAQS reinsurance contracts with its major subsidiaries including the UK and has a staff of 20 including senior underwriters and actuaries capable of assessing the risks it reinsures from the rest of the group.
- The reinsurer outsources investment management and claims handling functions but the key entrepreneurial risk-taking function of assumption of risk is performed by the officers of the group reinsurer. In calculating its capital requirement, the reinsurer gets credit for the geographic diversity of its risks.
- The credit rating agency determines that the group reinsurer only requires £300m additional capital to support the newly acquired risk and maintain its A credit rating. By reinsuring the capital required to support the reinsured UK risk has been reduced by 40% (£500m - £300m)
- There is no UK-resident reinsurer in the group that could be used to achieve the same capital reduction.
Analysis
For the purposes of section 80, the UK company is ‘C’ and provision has been made between C and the group reinsurer (‘P’) by means of the transactions under the WAQS contracts. The participation condition is met as between C and P and the material provision results in an effective tax mismatch outcome that is not an excepted loan relationship outcome. Neither C nor P are SMEs. Although there were a number of reasons to set up the arrangements in this way, tax considerations figured heavily in the detail and from the facts it is reasonable to assume that the transaction and involvement of the reinsurer were designed to secure the tax reduction.
It is then considered whether, at the time of the making of the provision, it was reasonable to assume that the non-tax financial benefits referable to the WAQS reinsurance outweigh the financial benefit of the tax reduction (transaction based test). In this case the more efficient capital structure is a quantifiable non-tax financial benefit and, where the facts show that this would be greater than the tax saving throughout the life of the provision, there will be no DPT charge. In this simple example, the non-tax financial benefit could be calculated by determining the difference between the capital requirements following the diversification credit and the capital requirements absent the diversification credit and then multiplying the resultant figure by the cost of capital to arrive at a figure of non-tax financial benefit.
If in this case the tax saving outweighs the non-tax benefits it would then need to be considered whether a DPT charge would arise based on the computational rules at sections 82 to 85. Given the capital efficiency through diversification credit and the lack of a more commercial alternative arrangement within the group at the time the provision was made, there does not seem to be a relevant alternative provision (RAP) in the sense of a differently structured provision. There may still be DPT considerations around the pricing and terms of the arrangements.
In this sort of case the chief potential RAP is usually that the insurance risk would not be ceded by the UK insurer. For a RAP of no reinsurance it would be necessary to assume that the UK has sufficient capital to support the retained risk. While it is possible to hypothesise that the capital held by the reinsurer to support the assumption of the UK risk could have been held by the UK company, it would generally not be reasonable to hypothesise additional group capital.
In this case no other way of achieving capital efficiency through diversification credit has been identified, but if the capital efficiency could be achieved by reinsuring to another UK insurer in the group there would be a RAP and a potential DPT charge depending on the outcome of other tests.
Example 2 - Intragroup insurance within a non-insurance group
Facts
- This is a multinational group that manufactures specialist high value plant in a number of European countries. Failure of its products can give rise to significant catastrophic loss. However, the group has excellent quality control systems and it has been 15 years since the last customer claim.
- The parent has oversight of group risk and determines insurance policy for the group. It also negotiates a group wide insurance policy for product indemnity with one of the largest insurance multinationals. The policy has a cover limit of €500m in any one year. The parent has determined that further cover of €50m is placed with the intragroup insurer, established in a low tax jurisdiction.
- The UK company is one of three major manufacturing centres and manufactures the most technologically advanced products for sale around the world.
- The intragroup insurer employs three people part time including a senior underwriter. Most of the underwriting and actuarial risk pricing is outsourced to a specialist insurance consultancy based in the USA.
- The independent specialist insurance consultancy has produced a full actuarial report on the risk assumed by the captive. The insurance premium is paid at the arm’s length rate.
Analysis
For the purposes of section 80, the UK company is ‘C’ and provision has been made between C and the group insurer (‘P’) by means of the insurance transactions. The participation condition is met as between C and P and the material provision results in an effective tax mismatch outcome that is not an excepted loan relationship outcome. Neither C nor P are SMEs.
It is established that tax considerations figured heavily in the detail of the arrangements and it is reasonable to assume that the transaction and involvement of the group insurer were designed to secure the tax reduction.
It is then considered whether, at the time of the making of the provision, it was reasonable to assume that the non-tax financial benefits referable to the insurance transactions or involvement of the group insurer outweigh the financial benefit of the tax reduction.
This is not a regulated insurance group and the intragroup insurer is not being used to create capital efficiencies. The UK company has sufficient liquid assets to meet expected potential claims in excess of the cover.
The functions performed by the group insurer are minimal. Consequently, it is reasonable to assume that the non-tax benefits attributable to the functions of the group insurer will not exceed the financial benefit of the tax reduction arising from the insurance transactions between it and the UK company. The premium paid by the UK company is correctly priced but there are no commercial motives for the transaction other than the tax saving. It follows that absent the tax mismatch the UK Company would not have insured with the group insurer. The result is that the actual provision condition is not met and the UK company will be subject to a DPT charge on an amount equal to premium net of claims and any expenses related to services provided to the UK company. Certain fact patterns may also support the conclusion that investments funded by the premium would have been held by the UK company or that the funds would have been applied in some other way, for example if the intragroup insurer was applying some part of them to lend back to the premium payer.
The same analysis would apply if a third party fronter had been interposed between the UK company and the group insurer, with the third party reinsuring 100% of the risk it assumes to the group insurer. The provision for the purpose of DPT would be between the UK company and the group insurer. As all of the other facts are the same as in the example the provision is subject to a DPT charge.
There may be genuine non-tax commercial reasons for a non-insurance group to use intragroup insurance/reinsurance but there are likely to be very limited circumstances where the specific fact pattern would support the conclusion that DPT is not in point. The reinsurance of a very high proportion of the risk held by the group insurer out to a third-party reinsurer may be an indicator that the intragroup insurer has not been set up primarily to achieve tax reductions.
Example 3 - Life assurance offshore bond distribution
Facts
- A non UK headed multinational insurance group offers bonds from an overseas subsidiary to investors in the UK. The bonds are sold to customers via independent financial advisors and directly through the UK distribution agent. The offshore company has 20 employees. It employs a team of actuaries and underwriters who design the range of bonds offered by the overseas company. The investment management function has been subcontracted to third party managers.
- The UK distribution subsidiary introduces potential investors to the overseas company who issues the bond to the investors. It provides regular reports on the UK bond market to assist the overseas company in designing bonds that would appeal to UK investors. It also provides marketing and promotion services to independent financial advisors.
- The UK Company charges an arm’s length rate for its services.
Analysis
When investing, the investor contracts directly with the overseas company. The UK company is acting as an agent of the overseas bond company, but it only provides introductory services; it does not commit the overseas company to issue bonds to the investor. As the UK company has not concluded contracts binding the overseas company to issue bonds it has avoided becoming a dependent agent permanent establishment (DAPE) of the overseas company. For the purposes of section 86, the UK company is carrying on activity in the UK in connection with the supply of services made by the non-resident bond issuing company in the course of that company’s trade. It is also reasonable to assume that the activity (including any limitation to it) has been designed to ensure that the UK company falls short of being a DAPE of the overseas company. None of the exceptions in section 86 or 87 apply and the arrangement will be within the scope of DPT if either (or both) the mismatch condition or the tax avoidance condition is met.
The mismatch condition is not met, because there is no provision creating or increasing expenses or reducing income of the non-resident company resulting in a tax mismatch, and a DPT liability can therefore arise only if the tax avoidance condition is met.
If the offshore company were resident in the UK its business would be classed as Basic Life Assurance and General Annuity Business (BLAGAB). The investor’s share of profit would be subject to the I-E regime and the shareholder’s share would be subject to the normal corporation tax regime. The I-E regime still results in a corporation tax charge so selling the bonds from the offshore company results in a potential reduction in a charge to corporation tax.
A tax reduction will arise if any of the profits of the overseas company would have been attributed to the UK if the avoided DAPE were a UK PE of the non-resident company. To determine whether any profits of the overseas company would be attributed to the UK PE the authorised OECD approach to attributing profit to PEs (AOA) applies. Under the AOA profits are attributed based on the location of the key entrepreneurial risk taking function (KERT). For insurance the KERT is generally the assumption of insurance risk; depending on the nature of the bonds, investment management may be the KERT or may form part of the KERT. In this arrangement the KERT is the design and origination of the bond products which is performed by the overseas company and not by the UK distributor.
There is therefore no additional profit to attribute to the UK activities, over and above the arm’s length reward paid to the UK company for its services and no avoidance of UK corporation tax. As no additional profit is attributable the arrangement cannot have had a main purpose of avoiding UK corporation tax so no liability to DPT will arise.
Example 4 - Intragroup fronting
Facts
- The group is a multinational insurer with an extensive network of insurance companies around the world.
- A UK company in the group has a substantial insurance business but does not have any expertise or experience in underwriting product X.
- Product X is a core offering of the underwriting company resident in a low tax territory.
- All of the underwriting function for product X is undertaken by the underwriting company.
- The UK company fronts the insurance contracts relating to product X and the risk is 100% reinsured to the underwriting company. The UK fronter undertakes the necessary risk management activities to meet local regulatory requirements and provides contract administration assistance.
- The UK fronter receives an arm’s length fronting commission for its activities.
Analysis
For the purposes of section 80, the UK fronter is “C” and provision has been made between C and the underwriting company (“P”) by means of the transactions under the fronting arrangements. The participation condition is met as between C and P and the material provision results in an effective tax mismatch outcome that is not an excepted loan relationship outcome. Neither C nor P are SMEs.
The latter part of the economic substance tests in sections 110(4), (5) and (6) do not need to be considered where it is not reasonable to assume that either the transaction(s) or the involvement of a party is designed to secure the tax reduction.
The UK fronter does not have the expertise to underwrite product X business and its function with regard to product X is restricted to the functions required to meet the local regulatory requirements. The fronting arrangement is designed to enable the producing company to underwrite UK risks and not to secure the tax reduction.
For the purposes of section 86, the UK fronter is carrying on activity in the UK in connection with the supply of services made by the underwriting company in the course of that company’s trade. There is no wider provision involving another person and the producing company so the tax mismatch condition is not met. None of the specific exceptions in section 86 or 87 apply so the arrangement will be within the scope of section 86 if the tax avoidance condition is met.
In considering whether the main purpose or one of the main purposes of the arrangements is to avoid or reduce a charge to corporation tax it is important to consider what reduction of tax would have been expected. A tax reduction will arise if any of the profits of the non-resident underwriting company would have been attributed to the UK fronter if it had been treated as its dependent agent PE. The location of the key entrepreneurial risk-taking (KERT) functions is central to the attribution under the authorised OECD approach. In this context the KERT function is generally the assumption of insurance risk which is performed by the underwriting company outside the UK.
On that basis there is unlikely to be any additional profit to attribute to the UK activities, over and above the arm’s length reward (commissions) paid to the UK company for its services and therefore no avoidance or reduction of UK corporation tax.
It should be noted that although the specific fact pattern in the above example points to there being no DPT charge, fronting arrangements in general can be put in place for a variety of reasons, some of these will be designed to achieve a reduction of tax or tax mismatch. In particular arrangements where the UK fronter or other UK company provides underwriting services through subcontract arrangements with the non-resident underwriting company can attract a DPT charge.