Transfer pricing guidelines on financial transactions – have captives been caught?

In February of this year, the Organisation for Economic Co-operation and Development (OECD) released guidance for multinational enterprises (MNE’s) and tax authorities, on applying the arm’s-length standard to controlled financial transactions. The guidance, which the OECD plans to include in the next publication of the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD TPG), is expected to reduce ambiguity in respect of transfer pricing methodology and help reduce transfer-pricing disputes and double taxation. 

The final copy of the Transfer Pricing Guidelines on Financial Transactions (‘Guidance’) only slightly modified the previous discussion draft released by the OECD. The OECD plans to use the report to form a new Chapter X of the OECD TPG.  Sections A to E of this report will be included in the Guidelines as Chapter X. The guidance in Section F of this report will be added to Section D.1.2.1 in Chapter I of the Guidelines, immediately following paragraph 1.106. 

In what may be portrayed as a shift in policy and focus, is it significant to note that this is the first time that guidance on financial transactions is included in the OECD TPG and the recognition of the importance for multinational enterprise (MNE) groups and tax authorities in applying the arm’s length standard to controlled financial transactions.   

The guidance recognises that transfer pricing analysis is highly dependent on facts and circumstances that may vary significantly between taxpayers. The guidance is not prescriptive but rather lists factors that taxpayers and tax authorities should take into consideration in reaching their conclusions. It makes two specific concessions in this area: first, that the financial services industry is subject to regulatory constraints or industry standards that should be acknowledged when concluding the arm’s length interest rates, and second, that thin capitalization analysis may defer to the domestic legislation of the borrower’s jurisdiction, which may differ from or be simpler than an exhaustive economic analysis. This should be one of the first factors considered as part of the loan analysis.  

The guidance covers the ‘accurate delineation’ of financial transactions, with respect to MNEs’ capital structures. The concept of accurate delineation is specifically addressed throughout the guidance. The concept goes to the heart of assessing how the actual behaviour of the parties to a transaction compares against what is expressly stipulated in the written contract. The guidance also addresses specific issues related to the pricing of intra group loans (e.g. including the importance of using credit ratings), cash-pooling arrangements, hedging transactions and different guarantees. In addition, the guidance also elaborates on captive insurance arrangements. Namely, it is the focus of transfer pricing related treatments of captive insurance and the concept of accurate delineation which has gathered much discussion and interest.  

The focus on captives  

Captive insurance arrangements have certainly felt the reach of the BEPS project as they continue to receive attention all over the world by tax authorities. They are perceived to be vehicles that encourage profit shifting. The OECD has taken the view in the BEPS Action Plan, that captive insurance arrangements are a major area of concern, but to date there has not been a thematic focus on captives or the operation of captives within the insurance industry.  

The guidance addresses captive insurance and also in particular, reinsurance captives. Intra-group reinsurance within an Insurance MNE group is also discussed and is distinguished from captive insurance within the OECD TPG. While the Report does not “carve out” reinsurance within an MNE insurance enterprise, it does treat such reinsurance as fundamentally different and less likely to be without substance. 

A captive by definition is a wholly-owned subsidiary insurer that provides risk-mitigation services for its parent company or a group of related companies. A captive insurance company may be formed if the parent company cannot find a suitable outside firm to insure them against particular business risks, if the premiums paid to the captive insurer create tax savings, if the insurance provided is more affordable, or if it offers better coverage for the parent company’s risks’. 

As such, captive insurance is a special form of intra-group insurance or reinsurance within a multinational group. The aim of the captive is (completely or partly) to cover insurance needs of their owners. A direct captive insurance entity issues policies to the operating entities of its group.  

In contrast, a reinsurance captive underwrites insurance risk of the group by partnering with a commercial third-party insurer, the so-called “fronter”. The fronter issues the local insurance policies to the operating entities, and then cedes part of the risk to the reinsurance captive entity. 

A range of insurance cover is bought from direct insurers. Direct insurers grant cover and in turn the businesses pay a premium. Direct insurers may decide to cede or pass on part of their insurance risk to a reinsurance company. The reinsurance company may also decide to further retrocede their risks to other retrocessionaire. In the EU, the industry is heavily regulated, and regulators demand a minimum amount of capital plus a security margin, for instance, under the commonly accepted Solvency II framework. 

The concern with captive insurance is whether the captive is just a moneybox or whether it is undertaking a genuine insurance business. The landmark case in this area is the Le Gierse Case which sets out that risk must be shifted and distributed for a transaction to be considered one of insuranceAs such, where risk is not transferred to a captive then it is difficult to argue that the business of insurance has been undertaken. The guidance recognises this and sets out specific factors or indicators to address the accurate delineation of captive insurance and reinsurance.  

These indicators need to be satisfied in order to be considered a genuine insurance transaction, including the existence of risk, diversification of risk, or the insurability of the risk outside the MNE group. The guidance highlights the importance of the captive insurance entity’s assumption and management of economically significant risks. This would require a determination of whether the captive assumes and controls the insurance risk contractually transferred to the captive insurance entity. Where the management of these risks is outside the captive insurance entity, the value generated by the risk diversification should accrue to the entity managing that risk rather than to the captive insurer itself. Going forward it is paramount that all captive insurance companies consider the six indicators set out in the report to ensure the captive is undertaking genuine insurance business.  

The appropriate methodology  

The CUP method is a difficult methodology to apply to captive insurance entities. The guidance is silent on the use of quotes in the captive insurance context, prior comments about the unreliability of quotes to price intercompany debt are reasonably assumed to apply to captive insurance. One suggested alternative to the CUP method is the actuarial analysis.  

For profitability-based methods, the guidance suggests performing a two-staged approach, taking into account both the profitability of claims and return on capital for the captive. The guidance recognizes the importance of capital adequacy requirements, noting that the requirements for captives are likely to be significantly lower than for an insurer writing policies for unrelated parties. This may require the performance of appropriate adjustments to account for differing capital adequacy requirements, which is consistent with the US transfer-pricing rules and our experience with these transactions. 

Where the captive is not providing a service, as opposed to a genuine insurance business, it should be remunerated based on its functional profile. The benefit arising from the group synergy (portfolio of risk) should not be solely allocated to the captive, this is reached collectively by the Insurance MNE operating entities and therefore such benefit should be allocated correctly to the MNE operating entities. If the functional profile indicates that the captive, which has received regulatory approval to act as an insurer/reinsurer, acts as a service provider then that captive should be entitled to a lower remuneration. This would typically be a service fee in the form of a cost-plus remuneration. For instance, such an approach was followed by the Dutch Courts in the Dutch Holiday Resort and Dutch reinsurance cases. 

The Le Gierse Case – Implications for Captives  

In distributing risk to captives, one must consider this landmark case. In January 2021, the US Supreme Court case of Helvering v. Le Gierse will celebrate its 80-year anniversary as one of the headline judgements in the area of insurance risk shifting and risk distribution.  

The case concerned the deceased, Mrs. Gierse, who had executed two contracts with Connecticut General Life Insurance Company. One was an annuity paying the decedent $589.80 monthly for the remainder of her life. The insurer got lucky—her life ended less than a month after the annuity was purchased. The second contract was a single-premium life insurance policy with a face value of $25,000, payable to the decedent’s daughter, Edyth Le Gierse, the primary respondent. The other respondent was the decedent’s estate trustee, Bankers Trust Company. The life insurance policy cost $22,946 and was paid by the decedent in addition to the cost of the annuity.  

It was stated that the insurance proceeds must have been received by the estate as if they were the result of a transaction that involved an actual insurance risk at the time the transaction was executed. 

The two contracts were considered “together” because, as was conceded by all parties, the insurance policy would not have been issued without the annuity contract. Considered together, the court found that the outcome did not create any element of insurance risk. The court reasoned that the annuity and the insurance policy counteracted each other.  

In the Le Gierse case, the court expressly acknowledged that risk must be shifted and distributed for a transaction to be considered one of insurance, quoting that, “Historically and commonly, insurance involves risk-shifting and risk-distributing.” Here, the court found that the combination of the annuity and the insurance policy produced no insurance risk, and because insurance risk is dependent on risk shifting and distribution, the case is cited as the seminal case in the development of the risk shifting and distribution requirement for insurance to exist. 

When applying this view to captives it is imperative that risk is shifted and risk is distributed. Recent US judgements have lead to the introduction of a three pronged test for captive insurance companies – (1) whether the arrangement involves an insurance risk (2) whether the arrangement provides both risk-shifting and risk distribution; and (3) whether the arrangement is recognized as insurance in its commonly accepted sense. It remains to be seen whether a similar position will be taken in the European courts.  

The guidance on transfer pricing financial transactions is a welcomed development but it is just that, guidance. It remains to be seen at how closely it will be adhered to and how a lack of adherence will be monitored. The crux of the guidance in respect of captives is to demonstrate a transfer of risk and the exercise of control functions related to the risk associated with underwriting. Captives need to be seen to have more substance and the guidance sets out specifically at E2.2. where the captive does not have access to the appropriate skills, expertise and resources, and therefore the captive insurance is found not to exercise the control functions related to the risk associated to the underwriting, it may be concluded that the risk has not been assumed by the captive or that another MNE is exercising these control functions. A good housekeeping point to avoid such errors would be to establish two different boards comprised of different directors to avoid any overlap that may transpire or be perceived to question where control is held and whether risk has in fact been transferred or whether the captive is merely a regulated servicer.  

Overall, the approach and direction provided in the guidance is a good starting point from which captives may review their business. Substance must be evidenced within the captive to address the risk allocated from the MNE. However, correct allocation and accurate delineation of risk is of significant importance to avoid timely and costly questions as the industry continues to be kept under the microscope.