Author: Roxanna Nyiri, Director, BDO Tax.
Insurance in todays world is no longer limited to a single country and has over the last few decades seen interesting global developments. Reinsurance and cell captive insurance have become an integral part of enterprise risk management. Reinsurance and cell captive insurance not only provide business with tools to manage their risk, limit their cost of insurance, but also to hedge against currency fluctuations. These developments, of course, also have their own unique tax consequences, especially where they span jurisdictional borders. With the advent of the Organisation of Economic Cooperation and Developments (OECDs) Base Erosion and Profit Shifting (BEPS) initiatives, tax authorities across the globe are scrutinising insurance structures from a tax perspective, especially with regard to transfer pricing. This increased scrutiny often leads to the cross border pricing related to intercompany insurance related transactions being challenged.
Although South Africa has a well-developed financial services and insurance industry, it lags behind in certain respects when compared to some more favourable tax jurisdictions such as Mauritius. South African businesses often make use of inter-jurisdictional risk management opportunities which include reinsurance and cell captive arrangements. Tax free or low tax jurisdictions such as the Isle of Man, Bermuda, or Mauritius are often part of these arrangements. Reinsurance companies in these jurisdictions often reinsure part of the South African reinsurers risk. These arrangements could expose the local reinsurer to transfer pricing risk, where it can be demonstrated that the local reinsurer premiums or commissions paid to its foreign counterpart are in excess of what they would have been if charged between unrelated parties. Alternatively, South African businesses may opt to self-insure through a cell captive which, in turn, may reinsure with a foreign cell captive. Again, a transfer pricing risk could exist.
Transfer pricing is primary guided or informed by the arms length principle, which is based on the arms length standard. The arms length standard is an internationally accepted concept which requires the price of an intercompany transaction to be consistent with the price that would have been charged between unrelated parties. The OECD released its final report on its BEPS action plans on 5 October 2015. The report of Action 8-10 Aligning Transfer Pricing Outcomes with Value Creation equally applies to the insurance industry. The six-step risk framework is summarised below.
|1||Economically significant risks||Identify economically significant risks with specificity|
|2||Contractual risk allocation||Determine how each economically significant risk is contractually assumed under the terms of the contract|
|3||Functional analysis||Perform functional analysis of each economically significant risk. Attend to (i) control and risk mitigating functions (ii) risk actually borne by each enterprise and (iii) financial capability of each enterprise to bear the risk|
|4||Consistency between functional conduct and contract terms||Decide whether the contractual assumption of risk identified in step 2 is consistent with entities conduct identified in step 3|
|5||Risk allocation||Reallocate risk based on conduct established in step 3 if required|
|6||Transfer pricing analysis||Conduct transfer pricing risk analysis based on allocated risk from Step 5|
This framework adds the further complexity of supporting the substance of the reinsurance or cell captive operation. This requires that the reinsurance or cell captive operation has sufficient people, resources, and management expertise on the ground to manage risks. The capital infrastructure and financial capacity to bear the risk must also be evident. This needs to be evidenced in the day-to-day operational activities of the reinsurer or cell captive. Since no two insurance contracts are identical, to demonstrate arms length intercompany contract pricing can be a challenge. The Comparable Uncontrolled Price Method (CUP) is commonly used and is based on contract comparisons. In terms of CUP it needs to be established whether a comparable transaction exists in the open market between independent parties. If not, it would need to be considered whether the local insurance entity insures risk of third party unrelated entities, which are comparable to the intercompany transaction (referred to as internal CUP). Using the local insurance entitys reinsurance pricing model may be appropriate to determine a comparable price (internal CUP). An actuarial approach can also be followed to calculate the net present value (NPV) of future profits pre- and post-reinsurance. The difference may be attributable to a theoretical commission. The actuarial model is based on a number of key inputs and assumptions including premium income, cost of claims, payment patterns of premiums and claims (legacy data), acquisition and other costs, returns on investments, capital considerations, and applicable discount rates.
As the onus is on the taxpayer to ensure correct transfer pricing, it must ensure that it builds up relevant supporting documentation and price determination models. Robust transfer pricing documentation and relevant economic analyses and modelling can prevent costly pricing adjustments and penalties.
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