Nicole Henderson and Mikhail Raybshteyn of Ernst & Young LLP explore how transfer pricing can affect captive insurance arrangements, including a captive’s insurance premium tax and insured’s self-procurement tax obligations.

The tax considerations for captive owners and captive managers have increased over the years. While aware of the possible tax benefits of owning and insuring risks through a captive insurance arrangement, many owners and managers may be unaware of how transfer pricing can affect that arrangement. This article explores the effects of transfer pricing on captives’ determination and allocation of premiums, as well as its effects on a captive’s insurance premium taxes (“IPT”) and an insured’s self-procurement tax (“SPT”).

Overview of transfer pricing

Transfer pricing regulations require prices charged between related parties to be arm’s length (i.e., the price to which two related parties agree in a transaction is the same as the price to which two unrelated parties agree in a comparable transaction).

In the traditional insurance context, premiums paid by multinationals to a third-party insurance company are inherently arm’s length because the transaction is between two completely unrelated parties; in the captive insurance context, however, transfer pricing dictates that transactions between members of a group must be priced on an arm’s-length basis.

Intercompany transactions typically observed and analyzed in a captive insurance context primarily include the following:

• Arm’s-length premium for insurance policies placed through the captive (a related party)
• Arm’s-length allocation of premium amongst the members of a group based on the benefit received

Other intercompany transactions that can arise include sales commissions or referral fees paid. This is a common fact pattern for extended warranties insured by a captive when the multinational sells electronics, cars or other similar products.  

Focus on transfer pricing by tax authorities globally  

Multinational companies have generally not focused much attention on transfer pricing for their captives. As a general market observation, global tax authorities, in contrast, have steadily increased their transfer pricing focus.

This increased focus stems, in part, from a larger international effort, led by the Organisation for Economic Co-operation and Development (“OECD”), to ensure that multinational enterprises pay tax wherever they operate.

These efforts have been ongoing since 2013 through the release of 15 action items by the OECD intended to stem Base Erosion and Profit Shifting (“BEPS”).

In the US, the Internal Revenue Service (“IRS”) is increasing its headcount to be able to audit companies’ transfer pricing, according to Tax Notes article quoting Robin Greenhouse, LB&I division counsel during a January 18, 2023, meeting of the American Bar Association Section of Taxation.

If that happens, exam agents will likely assess whether intercompany transactions are conducted on an arm’s-length basis and whether the captive has enough substance to achieve the level of profit expected to be earned. Substance includes not only headcount employed by the captive (as majority of the captives actually use approved third-party management companies), but also a sufficient level of oversight and seniority to make decisions on behalf of the captive and accept risks assumed on the captive’s balance sheet.

To support the level of substance in a captive, companies must perform a functional analysis. This analysis addresses the end-to-end value chain of a group, including the functions performed, risks assumed and managed, and assets used and owned by the captive and its interaction with the broader multinational. Documenting this analysis places the burden of proof from the taxpayer back to the IRS.

Absent this support, US tax authorities could determine that a company has failed to demonstrate that its captive has adequate substance, resulting in potential tax assessments and/or penalties.

Transfer pricing analysis for captives

In addition to establishing an appropriate level of substance in the captive, companies must price premiums between the captive and insureds on an arm’s-length basis. This analysis is relevant to perform both when the captive is established and on an annual basis.

Most captives employ actuarial assistance to set the premium for risks they insure. Transfer pricing and actuarial analyses are not mutually exclusive; transfer pricing professionals look to the actuaries to price the premiums and rely on their assumptions, but an actuarial analysis does not replace a transfer pricing analysis.

Actuaries have to make significant assumptions that comply with actuarial standards but may not be consistent with arm’s-length behavior. For example, actuaries may use an industry-wide expense loading if historical data is lacking and the likelihood of paying a claim is high; however, the transfer pricing regulations stipulate a higher degree of comparability in the analysis.

As a result, additional benchmarking may be required from a transfer pricing perspective to support the expense loading for the same level of the market and comparable risks insured, or even to present the analysis in a clearer manner that the tax authorities can understand based on experiences outside of the captive insurance industry.

Absent historical data on certain risks insured by the captive, transfer pricing analysis can also be a useful resource for finding market comparables to establish market ranges for various components of the premium, including both the profit margin and expense loading. 

Allocation of premiums

Often times, multinational groups purchase an insurance policy by one entity for administrative ease, but that policy benefits the overall group. Once the premiums are determined to be arm’s length, they may then need to be further allocated amongst group members that benefit from the insurance policy on an arm’s-length basis.

Companies should allocate premiums based on the following considerations:

• The risk covered by the policy
• The beneficiaries of the insurance ( i.e., entities benefiting from the coverage actually pay for the coverage)
• The global supply chain of the company
• Global transfer pricing policies of the group

No single method is the answer. The allocation methodology needs to consider multiple aspects of the insured group and its operations, resulting in the most prudent approach to allocate premiums.

If we take business interruption risk as an example, multiple entities throughout a  multinational could be impacted by a business interruption and benefit from the associated insurance policy. The extent to which each entity benefits from a policy’s coverage may depend on the group’s global supply chain and the general transfer pricing policy to remunerate related-party transactions.

For example, an entity that is an entrepreneur and receives residual profits and losses will be affected disproportionately by the business interrupted compared to entities that are remunerated on a fixed return regardless of the profits (or even losses) of the overall business.

Captive premiums need to be allocated based on each individual risk and the respective beneficiaries.

Similarly, while addressing the correct premium pricing and loss reserve corridor, actuarial analysis will most likely not address the appropriate premium allocation between multiple insureds, especially if any other specific facts are present that may negate a general way of allocating premiums that may be used by the market broadly, such as number of cars or square footage of a property.

If premiums are not allocated, or not allocated correctly, deductions taken on tax returns for the premiums paid to the captive could be challenged or even disallowed. More so, certain countries explicitly prohibit deductions for premiums that at some point end up in an affiliated captive insurance company. Not fully documenting how and where premiums are allocated may generate tax controversy in those jurisdictions.

Domestic-only captives: does TP matter?

While there is higher focus on transfer pricing for multinationals, it is still relevant in domestic-only groups and their captive programs.

For many US-headquartered companies, the captive is taxed as a US taxpayer, even if it is domiciled in a foreign jurisdiction. In these cases, transfer pricing can (1) demonstrate arm’s-length behavior between the captive and insureds, (2) support risk transfer, and (3) show a captive abides by the notions of commonly accepted insurance principles.

This test is an important factor to demonstrate that the captive meets the definition of an insurance company from a US tax perspective. Transfer pricing supports the accelerated tax deductions in year one as an insurance company or when a new product is added to the captive.

In addition, many states apply transfer pricing principles under the Internal Revenue Code in their state laws. Many times, the answer at the state level may be that the captive itself is not subject to tax.

While that may be the correct answer, the impact of properly allocated premiums to each insured sometimes goes overlooked, even though that allocation may impact state tax liability.

Certain states actively audit groups with captives to ensure that those taxpayers are computing the correct amount of state tax.

How transfer pricing affects the Insurance Premium Tax

Insurance companies are subject to a variety of taxes. As captive programs focus mainly on federal taxes, some of these additional, indirect taxes may not be intuitive. One such example is IPT, which is a tax that may be levied by governments on the premium charged to an insured entity.

If premiums are not allocated, or are allocated incorrectly under transfer pricing principles, it can result in misreporting or underpayment of certain taxes, such as IPT. In certain cases, premiums for centrally purchased global coverage may be allocated through appropriately computed recharges.

Such recharges may align well with transfer pricing principles and have well-documented support on the recharge methodology.

While transfer pricing in those cases may be well documented, a liability for IPT may still exist, as certain jurisdictions request details on corporate recharges to assess whether insurance premiums have been included.

Taxes such as IPT are mainly in place to mitigate the loss of revenue that occurs when a premium is recharged to a subsidiary in a particular jurisdiction versus having the subsidiary buy coverage locally, which would result in a local insurance carrier paying tax on its profits or premiums collected.

Generally, captives (or captive owners or local insured subsidiaries) must self-assess the amount of IPT due and file a tax return in well over 30 jurisdictions that have IPT requirements. The underpayment of taxes may carry a financial and, in some cases, a reputational risk.

How Self-Procurement tax relates to TP

SPT is assessed on the insured that procures coverage directly from an affiliated insurer, such as a captive. 

While different states have varying laws on SPT and how SPT applies, the general rule is that (1) SPT is based on a policy-by-policy approach, (2) SPT requires understanding the location of the home state for each policy, and (3) the home state for affiliated groups may actually vary from policy to policy.

Properly allocated premiums, taking into account transfer pricing rules and considerations noted previously, may shift the home state under a particular policy depending on specific facts and circumstances. 

Conclusion

While accepted industry standards and actuarial analyses have their place in premium determination and allocation, the role of transfer pricing should not be overlooked.

As there is no one-size-fits-all approach to how to balance the three, each company needs to consider its specific facts, technical merits, and its ability to support a position that will ultimately be taken – including the efforts needed to pull together an appropriate and defensible position.

When in doubt, or help is needed, seek assistance from a competent advisor specializing in the captive insurance industry.

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The views expressed are those of the authors and do not necessarily reflect the views of Ernst & Young LLP or any other member firm of the global EY organization.