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30 Years of Captive Insurance Companies - Malcolm Finney BSc, MSc(Bus Admin), MSc(Org Beh), MIMgt, C Math MIMA meanders through captive insurance companies 1970 to 2000.

29 November 2000
Issue: 3785 / Categories:
30 Years of Captive Insurance Companies
Malcolm Finney BSc, MSc(Bus Admin), MSc(Org Beh), MIMgt, C Math MIMA meanders through captive insurance companies 1970 to 2000.
30 Years of Captive Insurance Companies
Malcolm Finney BSc, MSc(Bus Admin), MSc(Org Beh), MIMgt, C Math MIMA meanders through captive insurance companies 1970 to 2000.
Many years ago, I wrote an article for Taxation on captive insurance companies (see Taxation, 10 October 1991 at page 35). While barely being able to remember this, I do know that I became involved with captives over 20 years ago. At that time much of my time was spent on advising United Kingdom based parent companies as to the tax issues associated with setting up offshore (i.e. non United Kingdom) captives. Today it is spent defending many of these against Inland Revenue investigation.
In the mid-1970s, captives were only just beginning to offer an alternative and novel way for a company to manage its risks. Although they had taken off in the United States, they were still in an embryonic stage in the United Kingdom and virtually unheard of on mainland Europe.
At that time, the key tax issues I identified were residency, premium deductibility, transfer pricing, and the possibility of a 'trading within' situation. Of these, perhaps the issue of premium deductibility was arguably the least clear, mainly because in the United States at that time the Internal Revenue Service had decided that it was not possible, for United States tax purposes, for a United States parent to get a tax deduction for insurance premium payments made to a wholly owned subsidiary. The Internal Revenue Service based its approach on the so-called 'economic family' theory. At its core the approach argued that no risk shifting arose. In the event of loss, the 'insured' (i.e. the United States parent) itself and not the 'insurer' (i.e. the captive) bore the risk of loss because the value of the parent's shares would, in the event of loss, decrease as its shareholding in the captive would decrease due to the captive's funds being depleted on settling the claim. Indeed, even today – 30 years later – this approach in principle still stands, although it has been watered down due to some favourable court decisions for United States taxpayers.
Adopting the American view
A key question in the mid-1970s was therefore to what extent, if at all, might or could the Inland Revenue import this line of argument for United Kingdom tax purposes. In an article in the British Tax Review, circa late 1970s, I sought to argue that the Internal Revenue Service approach could not be imported and used by the Inland Revenue to disallow a tax deduction for insurance premium payments made to wholly owned captive subsidiaries of United Kingdom parents. Twenty years later, to the best of my knowledge, the Inland Revenue has not been successful at importing the Internal Revenue Service approach and indeed, generally speaking, has not tried to do so with any real commitment (at least in my experience).
Although the import into the United Kingdom of the economic family approach was unlikely to work, the threat of invocation of section 485, Taxes Act 1970 (for our older brethren) or section 770, Taxes Act 1988 (for the youngsters) was, on the other hand, much more likely to pay higher dividends; and it did. Typically, an arm's length level of premium was often, but certainly not always, difficult to arrive at in a captive scenario and thus compromises were the order of the day.
Attacks under the possibility of a trading within the United Kingdom situation were, much to my surprise, not all that common, although in the early part of any Inland Revenue investigation its opening barrage typically included some reference to the need to examine the possible application of what is now section 11, Taxes Act 1988. It may be, in hindsight, that section 770 offered, at least in practice if not in theory, the same end United Kingdom tax take and was easier to invoke.
Captive residency
Captive residency was certainly where the Inland Revenue saw its greatest opportunity. As most captives were (and indeed still are) tax haven bound (e.g. Bermuda, Cayman Islands, Guernsey, Isle of Man and Gibraltar), it was unthinkable as far as the Inland Revenue was concerned to believe that a United Kingdom owned captive could possibly be managed and controlled by any other means than by the United Kingdom parent pulling all the captive's strings. In short, although the captive might be registered outside the United Kingdom, and properly approved by the relevant local authorities, any strategic decisions concerning its business were, as far as the Inland Revenue was concerned, almost certainly taken in the United Kingdom by the parent's board and not the captive's board. Almost without fail this was the Inland Revenue's starting point at the beginning of any captive investigation.
So it was for many, many years until the case of Unigate v McGregor in 1995; a case before the tax commissioners. The Inland Revenue lost the case; decided not to appeal the decision of the commissioners; and many captive residency investigations at the time were quickly settled in the taxpayer's favour. In a nutshell one of the crunch points made by the commissioners was that even if the United Kingdom parent pulled the captive's strings, so long as the captive board acted legally and with care including giving thought and consideration to the requests of the parent, it did not matter that the captive followed the requests of its parent. In such cases management and control resided with the captive, that is, outside the United Kingdom, and not with its parent.
Controlled foreign companies
However, long before 1995 and the Unigate victory, a small cloud in the guise of the controlled foreign companies legislation had appeared on the horizon. The year was 1984. This legislation was specifically aimed at captives and although initially could be said to have offered no more than the odd drop of tax rain, it has in fact turned into a tax hurricane.
Certainly, the victory of Unigate was arguably short lived when, having lost its residency arguments, the Inland Revenue simply used the Finance Act 1996 to alter drastically how the 'acceptable distribution policy' let-out operated; a let-out used by many captive owners to try to ameliorate the full impact of the controlled foreign companies legislation in all its glory.
Thus, although the captive residency battle may have been lost by the Inland Revenue, the greater captive war was slowly but surely being won.
Year on year, albeit with intermittent breathers, the controlled foreign companies' screws have slowly but surely tightened around the captive neck. One only has to look at the Finance Acts 1993, 1996 and 2000 in particular.
The last battle
That brings us to the latest onslaught on captives which is contained in the Finance Act 2000, namely the closing down of designer tax régimes. No longer will captives in, among others, Guernsey and the Isle of Man taxed according to certain local tax provisions escape the tag of controlled foreign companies.
When combined with the newly introduced double tax relief changes, the new self-assessment provisions, and the new transfer pricing rules to name but three, captive insurance companies are having to seriously re-examine their current strategies.
However, as in the past, you cannot keep a good captive down. The raison d'être for captives is to help United Kingdom parents manage their risk exposures, not as a mechanism for tax avoidance as the Revenue would have you believe. If this was not their prime reason for existing, the never ceasing onslaught of the Revenue would have caused their demise many years ago.
Looking for respectability
Although a little late in the day, it really is time that captives were no longer perceived as the continued bad boy of the offshore tax world and left to contribute to the profitability of their United Kingdom parents which in the medium to long term benefits all, including the good old Inland Revenue.
Malcolm Finney is an international tax consultant and author of the recently published book 'Captive Insurance Companies: A UK Tax and Financial Analysis' priced £275. For further information contact Malcolm on malcfinney@aol.com or call Management Dynamics on tel: 01727 863701.


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