Survival of the Fittest - Captive insurance companies seem to survive regardless of various Revenue onslaughts, says MALCOLM FINNEY BSc, MSc(Bus Admin), MSc(Org Beh), MIMgt, C Math MIMA

A CAPTIVE INSURANCE company is generally defined as an insurance company which is owned by a non-insurance company parent and which only underwrites the insurable risks of its parent company and/or sister subsidiaries. For example, Tesco plc, the supermarket chain, may set up its own wholly owned captive subsidiary to insure its property risks (i.e. its stores and warehouses). Over the years, however, the business of some captives has expanded to not only underwriting parent and subsidiary company risks, but third party customer risks as well. In addition, so-called 'rent-a-captives' have also entered the scene primarily designed to offer the advantages of captive ownership, but without the attendant relatively high costs of set-up and operation.

Not only have captives offered the 'in-house' risk manager an effective risk control device, they have also proved extremely tax efficient. One reason for this tax efficiency is that many, but not all, captives have been located in relatively low taxed areas such as Bermuda, Guernsey, Gibraltar and the Isle of Man. It is therefore perhaps hardly surprising to find that for many years the Inland Revenue (and its United States Internal Revenue Service brethren) have shown great interest in their activities. Unfortunately, this interest has been a little more than just passing! In this regard it is probably fair to say that the Revenue has tried everything in its power to eradicate such companies off the face of the earth; they are seen as nothing short of hard core tax-avoidance vehicles.

The last significant assault came about 18 months ago, on 6 October 1999, when the Revenue launched its 'designer tax régime' exocet. Its primary targets were heavily localised: Gibraltar, Guernsey, Ireland, Isle of Man and Jersey. The Revenue, however, made it clear that while the exocets launched were short range in this instance, it did possess the ability and wherewithal to launch more long range attacks if necessary.

The designer tax régime attack represents yet another nail in the captive coffin and is contained in the controlled foreign company legislation (originally introduced in the Finance Act 1984). Realistically, it might have happened earlier than late 1999 but, for whatever reason, it did not. For tax purposes, a controlled foreign company is a non-United Kingdom resident company, 'controlled' by United Kingdom residents and subject to a 'lower level of taxation'. Thus, a wholly owned captive subsidiary of a United Kingdom parent company resident in, say, the Isle of Man and subject to a lower level of tax in the Isle of Man would be categorised as a controlled foreign company for United Kingdom tax purposes.

The lower level of tax condition is met if the non-resident company (in the current example, the Isle of Man captive) pays tax in its territory of residence (in the example, the Isle of Man) on its profits of an amount that is less than 75 per cent of the United Kingdom tax which would have been payable by the company, i.e. captive, had it been United Kingdom resident. Assuming comparability of computation of profit, this means that the captive will fall foul of this element of the three conditions, if the rate of tax in the captive's territory of residence is below 22.5 per cent, i.e. 75 per cent of the United Kingdom's current rate of 30 per cent.

In simple terms, controlled foreign company status could simply be avoided by ensuring that the amount of tax paid in the overseas territory of residence was at least equal to, or greater than, 75 per cent of the equivalent United Kingdom tax. Whether this strategy was preferable to accepting controlled foreign company status, e.g. by paying no or little tax in the country of residence, with the consequent implications depended upon a number of factors, but certainly to pay locally more tax than was arguably strictly necessary became a not uncommon strategy.

Initially, however, simply choosing to pay local tax at the appropriate rate was not always feasible in the jurisdiction although informal arrangements were often entered into enabling the requisite amount of local tax to be paid. Ingenious as ever, a number of offshore territories thus decided to formalise these informal arrangements. It was this move that probably finally incensed the Revenue and action to defeat the moves seemed inevitable; thus arrived the designer rate tax provisions legislation.

Now contained in section 104 of, and Schedule 31 to, the Finance Act 2000 and effective for accounting periods beginning after 5 October 1999, the new provisions apply to captives resident in any of the five territories referred to above, but only if advantage is actually being taken of the so-called local designer tax régime legislation.

Under the régime even if a captive pays tax of the same or greater amount than 75 per cent of the equivalent United Kingdom tax, it will still continue to be classified as a controlled foreign company (assuming the other conditions  are satisfied) with all the attendant consequences. Furthermore, what is and what is not a designer rate tax régime is a matter exclusively for the Inland Revenue. Thus, the legislation at paragraph 3(2) of Schedule 31 to the Finance Act 2000 provides that such a régime is one:

These régimes are also specified in regulations issued by the Board.

This type of approach to combating perceived tax avoidance is for taxpayers somewhat worrying. It seems to violate one of the perceived basic tenets of any tax system, namely, that it must offer certainty. This would certainly not seem to be the case here.

However, as remarked above, the designer rate régime legislation is here to stay and many United Kingdom owned captives now have to decide where to go from here. One option may be simply to sit tight and await the response of those régimes 'caught'. Presumably, if these territories fix their local rate of tax for insurance companies at, say, 23 per cent without a captive having the option to elect to pay this rate then the new legislation ought not to apply. However, whether this is viable for any of these territories remains to be seen.

A more proactive approach will involve comparing the United Kingdom tax consequences of the effects of being caught under the new legislation versus, for example, simply electing to pay a zero rate of tax (and accepting categorisation as a controlled foreign company) in the jurisdiction; reviewing the existing other tax options available in the jurisdiction; or possibly moving to a territory which is unlikely in the future to be categorised as a designer régime. It may also be an appropriate time to ascertain if any of the other let-outs contained in the controlled foreign company legislation are capable of satisfaction.

The issue is a little more complex, however, as any decision in this regard may not be capable of being taken in isolation. In particular, the recently introduced changes to the method of granting double tax relief, the new provisions relating to reserving for tax purposes, and the new corporation tax payment rules all interact, and a holistic approach is necessary.

While the new legislation is certainly unhelpful (to say the least), captives have for many years had to contend with ever changing and increasingly punitive anti-captive tax legislation; yet offshore captives still survive and there is no reason to believe that this will not continue. This, one would have thought, ought to demonstrate to the Revenue clear proof that first and foremost captives are risk management and not tax avoidance vehicles. As a consequence, there is no reason to believe that this latest United Kingdom onslaught, damaging though it may be, will do anything further to undermine their continued use for risk management purposes.

Malcolm Finney is an international tax consultant. This article is based on the author's new book Captive Insurance Companies A UK Tax and Financial Analysis, priced £275, available by e-mail from malcfinney@aol.com, or tel: 01727 863701.

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