Originally published in Captive & ART Review Guernsey supplement, May 2007
It is reputed that the first captive insurance company was established in Guernsey in 1922. Since that humble beginning, Guernsey has established itself as the leading European captive domicile. Despite a succession of challenges posed by onshore regulators and tax authorities along with emerging rival domiciles, the Bailiwick maintains that pre-eminent position, by some margin. The last few years have witnessed some particularly stiff challenges; now I look at two of the challenges arising from European developments and consider how Guernsey has retained its attraction, from a tax perspective, as the European location of choice.
EU Code of Conduct
One of the most pressing challenges facing policy-makers in Guernsey in recent years has been developing a response to the EU Code of Conduct on Business Taxation. This was a challenge faced by governments across Europe and was particularly pertinent to Guernsey and all the other captive domiciles. Guernsey’s historic success has in large part derived from its ability to offer favourable tax regimes to captives, in particular the exempt company regime. Indeed, any jurisdiction that sought to establish itself as a domicile for captives in Europe, in addition to an attractive regulatory regime and infrastructure, had to offer some form of tax advantage to potential owners. This ability for onshore businesses to utilise preferential tax regimes to their advantage lay behind the Code of Conduct which required all EU Member States and associated territories (such as Guernsey) to eliminate such preferential regimes.
Guernsey’s response to the Code of Conduct was ratified by the States of Deliberation (Guernsey’s Parliament) in June 2006. The States decided to abolish the exempt company regime and all other similar preferential regimes with effect from 1 January 2008. In its place, a general corporate income tax rate of 0% will be introduced, into which all insurance companies will fall. With the exception of income from Guernsey rents and profits of utility companies carrying on regulated business in Guernsey, the only corporate income tax that will arise will be on specified regulated banking business.
Therefore, from 2008 onwards, a captive incorporated and managed in Guernsey will be regarded as a normal Guernsey tax resident company but will pay no Guernsey income tax. In many ways, this leaves the most captives in no different a position than they currently stand. For a business considering setting up a captive, the new regime in Guernsey offers simplicity and clarity; the business then only has to deal with their home jurisdiction tax position. The States’ policymakers believe that this simplicity and clarity will help Guernsey retain it attraction as a captive location.
When the European Court of Justice gave its judgement in the Cadbury Schweppes case in September 2006, many commentators raised concerns about the ramifications of the judgment for the offshore captive sector. The case concerned the application of controlled foreign company ("CFC") rules which affect many offshore captives.
The Cadbury Schweppes case is one of a series of cases taken to the European Court of Justice over the last few years where the appellant has sought to demonstrate that the tax laws of a particular EU Member State are incompatible with the Treaty of Rome. In Cadbury Schweppes, it was claimed that the UK controlled foreign companies rules effectively restricted the taxpayer’s right to the freedom of establishment. The ECJ’s judgement and, more importantly, the UK government’s response to that judgement, was expected to have a significant impact on UK-owned subsidiaries across the EU and further afield, including Guernsey.
Facts of the Case
Cadbury Schweppes Plc had established two Irish resident group finance companies in the Dublin International Financial Services Centre, which at the time enjoyed a special tax rate of 10%. Under the UK CFC rules, both companies were CFCs and as a result the UK parent was taxed on the profits of the Irish companies.
Decision of the ECJ
When their decision was published in September 2006, the ECJ gave a narrower judgement than many had hoped. In determining whether or not the UK CFC rules did indeed constitute a restriction of the freedom of establishment, the ECJ established a number of principles including:
- It is valid for a Member State to impose CFC rules on wholly artificial tax avoidance arrangements.
- It is not valid for CFC rules to apply where a company has been set up in another Member State and that company has an actual establishment and carried on genuine economic activities there.
- The fact that a company may be set up in a Member State in order to benefit from a more favourable tax regime is not in itself an abuse of the freedom of establishment.
In short therefore, the UK CFC rules as drafted did restrict an EU person’s freedom of establishment.
The Response of the UK Government
Whilst the judgement set out some important principles, the practical implications for UK multinationals, including those operating captive insurance companies, would not be known until the UK Government reacted to that judgement. This happened in the Chancellor’s Pre-Budget Report on 6 December 2006.
HM Revenue and Customs had no choice but to amend the CFC rules. However, in so doing they sought to restrict the impact of any changes as far as possible and thus adopted a very narrow interpretation of the Cadbury Schweppes judgement.
Under the revised rules which take effect from 6 December 2006, a UK parent of a CFC will be able to reduce the chargeable profits apportioned to it, when the CFC has individuals working for it in a genuine business establishment in virtually all EEA territories. (EEA territories concerned are all the EU Member State, plus Norway and Iceland.)
Clearly, this relief will not apply to a captive insurance business, or indeed any business, operating in Guernsey. However, a closer examination of the detailed rules raises the question as to whether this reduction in profits can apply to any captive insurance company, including any set up in Malta, Ireland or Gibraltar. Even if the rules did apply, the actual tax effect of such a reduction may be quite limited.
The reduction can only apply when there are individuals working for the CFC. According to draft HMRC guidance, these individuals must be employees of the CFC, of another group on secondment to the CFC or agency staff. Self-employed individuals or employees of an outsourcing contractor do not qualify. It is not certain but it seems likely that this will exclude a captive manager’s staff.
Assuming that this condition is satisfied, the UK parent can only reduce the apportioned chargeable profits by an amount equivalent to the net economic value created by the employees. The term "net economic value" is not defined in the legislation. However, in their draft guidance, HMRC say that net economic value should equate to what the group would be prepared to pay to a third party to undertake the work done by staff working for the CFC in the relevant territories, after allowing for the full economic costs of undertaking the work (as this reflects the creation of profits by the CFC). In their view it should not include the profits arising from capital or assets (such as IP and intra-group loans) placed or retained artificially in the CFC as these do not reflect net economic value to the group created directly by the work of the staff in the CFC (but rather the diversion of profits to the CFC).
Relevance to Captives
Applying this interpretation, it would appear that the UK parent of a captive insurance company that did meet the various criteria would only be able to reduce its chargeable profits by an amount equal to a modest mark-up on their direct costs. Under the usual arrangements in place for captives where much of the actual activity is outsourced to a captive manager, it is unlikely that they would be able to exclude the underwriting profits or investment income from apportioned profits.
Therefore, assuming that the draft legislation published on 6 December is enacted without significant change, it would seem that the UK tax treatment of captive insurance companies will be largely unaffected by the repercussions of the Cadbury Schweppes judgement. They are likely to have been CFCs before and they will continue to be until further changes in UK legislation, regardless of where they are domiciled, be it Guernsey, Malta, Gibraltar or Ireland.
Guernsey has never taken its position as the pre-eminent European captive domicile for granted. As seen in its response to the EU Code of Conduct, it continually has to respond to external challenges. By ensuring that its responses retain flexibility and simplicity, Guernsey has been able to keep abreast of its traditional and more recent competitors. The intention behind its 2008 tax strategy is that it can build on its position and maintain the prosperity of the Island as a whole.
For more information about Guernsey's finance industry please visit www.guernseyfinance.com.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.