Over the past two decades’ insurance companies are increasingly operating on a global level. As part of an overall global business strategy, many companies utilize intercompany reinsurance to manage risk and capital more effectively while ultimately improving profitability. As such, tax authorities in many jurisdictions are challenging the pricing related to intercompany transactions.
A reinsurance contract is an agreement between an insurer and reinsurer. The insurer writes the policy for the policyholder and is contractually liable for any payments to the policyholder that become due under the policy even if those insured risks are eventually covered by another insurer as part of the reinsurance contract. The insurer markets the policy, received the premium income and bears the cost of its sale and ongoing administration.
In a reinsurance contract the insurer (cedant) cedes the insured risks to a reinsurer who receives a corresponding reinsurance premium from the cedant. In return the cedant will receive a payment (referred to as a cedant’s commission) to cover the costs that it incurred in obtaining the policy and make a profit. The result is a net payment made by the cedant to the reinsurer. A common circumstance arises where South African based companies have subsidiaries in jurisdictions such as the Isle of Man or Bermuda where there is no corporate tax or in favourable tax jurisdictions such as Mauritius. In such cases the South African Revenue Service (‘SARS’) may challenge the South African company in its pricing of reinsurance ceded to such subsidiary with a view to demonstrating that the SA company is paying insurance premiums that are greater than what would have been established between unrelated parties.
The arm’s length principle is the single most important guiding principle of transfer pricing and is based on the arm’s length standard. The arm’s 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. On 5 October 2015, the Organisation for Economic Co-operation and Development (OECD) released its final 2015 reports under its Action Plan on Base Erosion and Profit Shifting (BEPS). The report of Action 8-10, Aligning Transfer Pricing Outcomes with Value Creation (the Final Report (contains Revisions to Chapter VII of the OECD Transfer Pricing Guidelines for low-value-adding intragroup services which would apply equally to the insurance industry. A summary of the six-step risk framework is set out below.
|01.||Identify economically significant risks||Identify economically significant risks with specifity. Non-significant risks do not need to be considered|
|02.||Determine contractual risk allocation||Determine how each economically significant risk is contractually assumed under the terms of the contract|
|03.||Perform functional analysis||Perform functional analysis of each economically significant risk. Attention to be given 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|
|04.||Consider whether functional conduct is consistent with contract terms||Decide whether the contractual assumption of risk identified in step 2 is consistent with entities conduct identified in step 3|
|05.||Allocate risk||Reallocate risk based on conduct established in step 3 if required.|
|06.||Transfer pricing analysis||Conduct transfer pricing risk analysis based on allocated risk from Step 5|
This new framework adds a further complexity in terms of the requirement to support the ‘substance’ of the reinsurance operation. This would mean that the reinsurance operation would need to have people and resources with sufficient management expertise on the ground who manage the risks, and in addition, the capital infrastructure and financial capacity to bear the risk. This would need to be evidenced in the day to day operational activities of the reinsurer. From a pricing perspective since no two reinsurance contracts are identical, demonstrating arm’s length intercompany contract pricing can be challenging.
A commonly used method is the Comparable Uncontrolled Price Method (CUP) which is based on contract comparisons. In terms of the CUP method one would need to establish whether a comparable transaction exists in the open market between independent parties. If not, one would look to whether the ceding entity underwrites business with third party unrelated entities similar to the intercompany transaction (internal CUP). It may be appropriate to use the cedant’s reinsurance pricing model to determine a comparable price (internal CUP). Another method involves an actuarial approach to calculating the net present value of future profits from the cedants book of business before and after the reinsurance. The difference would equate to a theoretical cedant’s commission.
This actuarial model is based on a number of key inputs and assumptions including premium income, cost of claims, payment patters of premiums and claims, acquisition costs and other expenses, return on investments, capital considerations and choice of discount rate. The onus is on the taxpayer to ensure that transfer pricing is correct and supporting documentation is in place. Intragroup transactions should be reviewed especially reinsurance premiums and ceding commissions to make sure that the pricing is supportable with robust transfer pricing documentation and an economic analysis to prevent costly adjustments and penalties.
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