Flash News: OECD discussion draft on financial transactions. What's new for Luxembourg captive (re)insurers?


In brief

On 3 July 2018 the OECD released a discussion draft paper on the transfer pricing aspects of financial transactions. Its main purpose is to clarify the application of the principles included in the 2017 edition of the OECD Transfer Pricing Guidelines to financial transactions (e.g. treasury functions, intra-group loans, cash pooling, hedging, guarantees, and captive insurance). For captive insurance arrangements, the discussion draft provides guidance for their accurate delineation and pricing. In the light of the additional guidance provided by the discussion draft, Luxembourg (re)insurers - which are already subject to domestic and OECD transfer pricing rules - are recommended to re-assess the delineation and pricing of arrangements that potentially fall within its scope.

In detail

The OECD discussion draft on the transfer pricing (“TP”) aspects of financial transactions (“Discussion Draft”) released on 3 July 2018, follows the mandate for further work on this topic contained in the OECD’s 2015 final report on Actions 8-10 of the BEPS Action Plan (“Aligning Transfer Pricing Outcomes with Value Creation”).

The Discussion Draft, which does not yet represent a consensus position of the Committee on Fiscal Affairs or its subsidiary bodies, aims to clarify the application of the principles included in the 2017 OECD TP Guidelines to financial transactions, addressing specific issues pertaining to their pricing.

With particular reference to captive insurance arrangements, the Discussion Draft provides guidance for the accurate delineation of such transactions. It also provides guidance for assessing their arm’s length price, including specific considerations for captives set-up to access the reinsurance market, and for those involving sales agents.

Delineation of the captive (re)insurance arrangements

Captive (re)insurance is depicted as an arrangement in which a member of a multinational (“MNE”) group provides (re)insurance-type services exclusively or mainly to members of the MNE group.

The Discussion Draft recognises that there might be several reasons for an MNE group to set up a captive (e.g. stabilise premiums paid; benefit from tax and regulatory arbitrage; access to the reinsurance market; expected cost effectiveness for the group; insure certain risks for which insurance coverage is difficult to get).

The primary focus of the Discussion Draft is to establish whether a captive arrangement is genuinely a transaction of (re)insurance. In this respect, the Discussion Draft lists certain indicators that would typically be expected in an independent (re)insurer, as follows:

  • diversification and pooling of risk;
  • improvement of the group economic capital position as a result of diversification;
  • both the insurer and any reinsurer are regulated entities;
  • possession of requisite skills and expertise; and,
  • real possibility of suffering losses.

In addition, to establish whether a transaction is genuinely one of (re)insurance, the Discussion Draft indicates that it would be important as a first step to demonstrate the following:

  • risk assumption: the (re)insurer has a realistic prospect of being able to satisfy claims in the event the risk materialises; and,
  • risk distribution: the (re)insurer pools a portfolio of risks, with the result that the impact of individual claims is reduced.

To support both these risks, the captive should also have a capital reserve based on regulatory needs and rating agency requirements.

The lack of these characteristics might indicate that the captive is operating a business other than one of (re)insurance. However, the Discussion Draft also acknowledges that due to their related party status, captives might be subject to lighter regulatory regimes, and/or be self-managed within a group or by unrelated service providers.

Notwithstanding the above, the Discussion Draft reiterates that the accurate delineation of captive arrangements should follow the principles set out in Chapter I of the OECD TP Guidelines, as the Discussion Draft provides only additional guidance.

Fronting arrangements

Fronting arrangements are regularly observed in MNE groups. In fronting arrangements the first contract of insurance is between the insured member of an MNE group and an unrelated insurer (the fronter). The fronter then reinsures with the captive most or all of the risk of the first contract. The fronter retains a commission to cover its costs and to compensate for any portion of the insured risk which it retains. The majority of the fronter’s premium passes to the captive as part of the reinsurance contract.

Despite the interposition of a third party fronter, the Discussion Draft clearly qualifies such arrangements as controlled transactions. Taxpayers having this type of fact pattern should be prepared to revisit their structures to ensure that: i) transactions are those of insurance/reinsurance as outlined above; and ii) the premiums ultimately received by the captive are on arm’s length terms.

Determination of the arm’s length price

The Discussion Draft confirms that the most appropriate method to price captive arrangements needs to be selected using the guidance of Chapter II of the OECD TP Guidelines.

The Discussion Draft recognises that comparable uncontrolled prices (“CUP”) may be available, although adjustments may be needed to account for differences between controlled and uncontrolled transactions. Alternatively, for the determination of an arm’s length premium, an appropriate approach may be to perform an actuarial analysis.

The Discussion Drafts suggests that a CUP can be the arm’s length profitability of the captive to be computed on the basis of a two staged approach, which takes into account both the profitability of claims and return on capital. This reflects a convergence of TP standards towards regulatory requirements, where those types of indicators are already computed under Solvency II. As a practical effect, in the context of TP analyses, captives may rely on the work already performed for regulatory purposes, although adjustments to the level of capital may be required to account for the generally lighter regulatory regime foreseen for captives “intragroup”.

Group synergies

Frequently, a captive accepts the risks of an MNE group’s members, and reinsures an already-diversified risk with independent reinsurers.

The Discussion Draft indicates that when benefits arise as a result of such “collective negotiation”, these should be allocated among the group’s members by means of discounted premiums, whereas the captive should receive an appropriate reward for the basic services provided. From a TP perspective, quantifying the benefits of collective negotiation and determining of the discounted premiums and their allocation mechanism might be challenging. Indeed, such an analysis might need to begin with the pricing of the reward attributable to the captive, as the “least complex” party.

Sales agents

The final paragraph of the section in the Discussion Draft on captives deals with insurance contracts sold through sales agents.

An example describes in some detail a case where insurance policies are sold in conjunction with consumer goods to cover damage/theft risks, and where the retailer (sales agent) and the insurer (captive) are related parties.

The Discussion Draft indicates that the profit stemming from such arrangements should be allocated based on the contribution of each of the parties to the value creation, and considers that the retailers in this type of framework might very well be the main profit drivers.

Take away

The Discussion Draft raises the profile of the TP aspects of financial transactions in general.

With respect to captive-type arrangements, there is now some much more specific guidance, suggesting that it might be prudent and appropriate to revisit existing arrangements in the light of this Discussion Draft text. In particular, the following themes might warrant additional attention:

  • the full and accurate documentation of the delineation (in accordance with the much more rigorous approach taken in Chapter I of the 2017 edition of the OECD TP Guidelines) of each transaction, to validate  the characterization of each as genuinely being that of insurance/reinsurance. This might entail revisiting the capital structure of the captives and should be followed by a TP analysis to assess whether arm’s length pricing is being applied;
  •  the fronting arrangements and commissions paid to the captives;
  • the allocation of collective negotiation benefits in reinsurance arrangements involving a captive; and,
  • the remuneration of sales agent when insurance contracts are sold through them and involve a captive.    

As noted above, the Discussion Draft does not represent a consensus position. The remarkable volume of comments received by the OECD (published on 14 September 2018, more info here) suggests that the final OECD text could differ significantly from the Discussion Draft. Nevertheless, the specific focus on captives is unlikely to disappear from the final version and, thus a review of all existing captive arrangements is still recommended.

PwC Luxembourg (www.pwc.lu) is the largest professional services firm in Luxembourg with 2,850 people employed from 77 different countries. PwC Luxembourg provides audit, tax and advisory services including management consulting, transaction, financing and regulatory advice. The firm provides advice to a wide variety of clients from local and middle market entrepreneurs to large multinational companies operating from Luxembourg and the Greater Region. The firm helps its clients create the value they are looking for by contributing to the smooth operation of the capital markets and providing advice through an industry-focused approach.

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Géraud de Borman

Insurance Partner, PwC Luxembourg

Tel: +352 49 48 48 3161

Caroline Goemaere

Partner, PwC Luxembourg

Tel: +352 49 48 48 3002

Christophe Hillion

Transfer Pricing Partner, PwC Luxembourg

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Loek de Preter

Transfer Pricing Leader, PwC Luxembourg

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Marc Rasch

Partner, Transfer pricing

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