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.
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:
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:
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 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.
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”.
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.
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.
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:
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.
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Géraud de Borman
Tax Partner, PwC Luxembourg
Tel: +352 49 48 48 3161
Transfer Pricing Partner, PwC Luxembourg
Tel: +352 49 48 48 3002
Transfer Pricing Partner, PwC Luxembourg
Tel: +352 49 48 48 2031
Loek de Preter
Transfer Pricing Leader, PwC Luxembourg
Tel: +352 49 48 48 2023
Partner, Transfer pricing
Tel: +352 49 48 48 3712