Captives owned by multinational organisations have had to keep a close eye on the OECD’s BEPS project, and further developments are expected this summer that will require close inspection once more.
In July 2021 the OECD/G20 Inclusive Framework[1] of 137[2] countries and the G20 finance ministers are due to reach the next milestone in seeking to achieve consensus with respect to the latest OECD Base Erosion & Profit Shifting (BEPS) project. Widely known as “BEPS 2.0” this project has been underway for the last few years and now appears likely to supersede many aspects of the original BEPS project.
Eight years on from the original BEPS project, which itself had some significant impacts for captives, many jurisdictions are still implementing the initial proposals. Like all good sequels BEPS 2.0 promises to be even more action-packed and ultimately could completely overhaul the international tax system. Most notably for captive owners, the proposals introduce the concept of a minimum tax rate such that multinationals owning entities in low and zero tax jurisdictions may be subject to a top-up tax up to an as-yet undecided minimum tax rate. This will result in a fundamental shift in tax policy for many of the countries expected to adopt the rules.
So, what does this mean for captive owners? Will this result in a significant rise in tax cost? Will captive owners undo what they have put in place as a result of BEPS 1.0?
We explore some recent trends in the captive market and where the future path might lead considering these new developments.
Timing is everything….
Of course, we should not lose sight of the fact that at the same time, and probably of far greater concern for multinationals is that the commercial insurance market has been and is continuing to harden at levels not seen for decades. Many risk directors are facing astronomical pricing hikes for coverage. In certain industries some are facing portfolios of uninsurable risks. Many groups that have not previously owned a captive are now considering doing so. Groups with existing captives are considering increasing retentions. Brexit may bring regulatory challenges to the commercial insurance market which could also further exacerbate operational costs reflected in programme pricing.
So, the need for a captive is probably greater than ever. New and existing captive owners may therefore need to keep a close eye on these potential tax changes which could bring additional tax cost.
Déjà vu??
In the context of the OECD proposals, this is not the first rodeo for many captive owners. We saw under the original BEPS project that the drive for more substance in captive locations led to captive owners reconsidering their strategy – faced with increased operational cost it often made sense to increase the scale of the captive through writing more business. We also saw other BEPS actions lead to more scrutiny on the transfer pricing of captive arrangements and the need to support the commercial rationale; this resulted in behavioural change as smaller, less commercial captives became unsustainable.
Particular tax challenges included changes to Controlled Foreign Company (“CFC”) rules, the UK Diverted Profits Tax (the UK legislative enactment of some of the original BEPS actions), targeted transfer pricing rules and increased controversy around transfer pricing of captive arrangements, and of course the US Tax Reform (The Tax Cuts and Jobs Act of 2017) introducing the Base Erosion and Anti-Abuse Tax, or BEAT.
All of these pressures may have played some part in the overall movement in the total numbers of captives in 2016-2018 as smaller, less commercial captives became unsustainable. However, the volumes of premium written and assets under management became larger as captive owners used their increased substance to write more risk.
For some captive owners these tax challenges presented too much uncertainty and, potentially, reputational risk. Some captive owners instead opted to pay more tax by taxing their captives in the parent location thus mitigating many of these areas of challenge. In many OECD countries this can be undertaken by moving the “central management and control” or “place of effective management” of the captive to the parent location. This generally entails having some substance through holding board meetings in the parent jurisdiction, instead of in the captive location.
This concept originally derives from case law but was latterly enshrined in OECD Model Tax Convention guidance around 20 years ago. It is followed in many countries, however, the most notable exception to this is the US which does not currently observe this concept. However, as an aside, it should be noted that some members of the US Congress have again introduced a proposal for legislation that would refer to this concept of management and control being an indicator of residence, though it remains far from clear whether this proposal will be seriously considered later this year as the US Congress considers numerous international tax law changes aimed at raising revenue to help fund new spending on infrastructure and other programs.
In any case, the US already has a mechanism in place which allows certain insurance companies to be elected as US taxpayers, which has the same effect.
What next?
Broadly speaking, if the BEPS 2.0 proposals are implemented into local law, captive owners holding captives with an effective tax rate below the proposed minimum tax rate will be subject to tax in the parent jurisdiction on the profits of the captive at a ‘top up’ to the minimum rate. For those multinational corporations whose parent jurisdictions do not adopt this top up tax, a back-stop proposal somewhat like the US BEAT could be used by other countries to deny deductions for payments to low-tax jurisdictions.
These rules are intended to operate after the various other international rules mentioned above. However, this does bring into question whether some of the existing substance-based rules will become obsolete if captive owners will be subject to tax in the parent location anyway. Since the substance rules were initially introduced to change behaviour and substantiate commercially rational conduct it would be unfortunate if the new BEPS rules simply disregard that.
How, when and whether the rules will actually be implemented in various countries remains to be seen. Many commentators would observe that there are some significant political barriers to be overcome in doing so, not least ensuring relief for double-taxation and dispute resolution. For the previous BEPS Actions this was achieved (after a lengthy process) through a Multilateral Instrument essentially designed to overlay approximately 3,000 double-tax treaties globally in place and signed up to by many jurisdictions. However not all countries signed up to this and implementation has been inconsistent.
We would also expect the EU to publish its version of the proposals and could expect to see local countries issuing their own consultations later this year or next year. Captive owners should continue to monitor the situation.
This Publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Member firms of the global EY organization cannot accept responsibility for loss to any person relying on this article.
[1] In 2016 the OECD/G20 Inclusive Framework on BEPS (IF) was established to ensure interested countries and jurisdictions, including developing economies, can participate on an equal footing in the development of standards on BEPS related issues, while reviewing and monitoring the implementation of the OECD/G20 BEPS Project [https://www.oecd.org/tax/beps/flyer-inclusive-framework-on-beps.pdf]
[2] As at 21 January 2021 – https://www.oecd.org/tax/beps/oecd-g20-inclusive-framework-on-beps-to-meet-at-plenary-level-on-27-28-january-2021.htm