Controlled Foreign Companies: The CFC charge gateway chapter 7 - captive insurance business: interaction with other chapters
It will be unlikely that a captive insurance CFC will be able to benefit from the entity based CFC exemptions, with the possible exception of the Low Profits Exemption. As a result, and to the extent that the Chapter 3 “initial filter” does not apply to exempt the captive insurance CFC’s profits, it will have to consider whether the other gateway chapters apply to its profits as well as Chapter 7. Only in a case where all the CFC’s profits pass through the CFC charge gateway because they are in Chapter 7 will no other Chapters need to be considered (as a CFC’s assumed total profits can only pass through the CFC charge gateway once).
Captive insurance CFCs can be complex in respect of the application of TIOPA10/Part 9A because they have more potential than any for profits passing through the CFC charge gateway by way of a number of chapters. When risk assessing a captive insurance CFC it is very important to think about the various chapters within which its profits might fall.
Does Chapter 4 apply?
The significant people functions (SPFs) (see INTM200300) for most insurance business will be the “assumption of risk”. This risk will usually be represented by the insurance underwriting function and thus for some type of insurance business there may be UK SPFs and the potential for profits to fall within Chapter 4. However, where this function is performed within the UK, it may give rise to a UK permanent establishment, the taxation of which would take precedence over a CFC charge (see TIOPA10/S371DA(3)(g)).
Does Chapter 5 apply?
Chapter 5 applies to non-trading finance profits (see INTM203200). It will apply to a captive insurance CFC to the extent it is carrying on a separate activity of intra-group financing outside of its own insurance business. Any profits from loans made by the CFC that form part of the free assets (i.e. those that are part of its insurance business and not part of a separate business activity) will fall to be trading profits and not non-trading finance profits.
For example, a captive insurance CFC has excess free assets and has decided (as its local regulatory authority permits it) to carry on a separate investment business alongside its insurance activity. As these assets are being held for an activity that is not part of the insurance business, those assets are no longer free assets for the purposes of Chapter 6. This investment business involves the up-streaming of loans to UK connected companies. In these circumstances it is likely that TIOPA10/S371ED (arrangements in lieu of dividends etc. to UK resident companies) will apply to the CFC’s investment income profits on the basis that;
- they arise from the separate investment business and so comprise non-trading finance profits, and
- it is reasonable to suppose that the CFC has chosen to upstream cash rather than pay dividends in order to reduce the UK borrower’s UK tax liability.
Does Chapter 6 apply?
This chapter applies a two step self assessment capitalisation test to determine whether an insurance company is overcapitalised. The test assesses the extent to which the CFC’s free capital (Step 1) and free assets (Step 2) are in excess of what they would be were the CFC not controlled by any other company (see INTM207300).
Where excess free capital and/or free assets are identified, the test goes on to establish whether the CFC has capital contributions from a connected UK company. To the extent both are present, the Chapter 6 profits are the amount of trading finance profits it is reasonable to suppose is attributable to the investment, or other use, of:
- that excess free capital and/or free assets, or if lower,
- the UK connected capital contributions.
Where a captive insurer derives “trading finance” profits from being overcapitalised, those profits (subject to there also being UK connected capital contributions - INTM207100) will also be largely captured by Chapter 6. There will not be a complete correlation with Chapter 7 as that chapter will bring into charge any investment profits generated from retained profits that were themselves generated from UK business.
In contrast to Chapter 6, Chapter 7 includes within its scope all of the profits a captive insurance CFC derives from its insurance business. This means that both underwriting profits (those profits arising from the underwriting activity) and investment profits (those profits generated from the investment of the premiums received, including those generated from retained profits) are within the scope of Chapter 7. However, this is only to the extent that they relate to premiums from a UK person, or capital used to support reserves for contracts of insurance that were written with UK persons.
The possibility of profits passing through the CFC charge gateway either through Chapter 6 or Chapter 7 creates a potential overlap and what might appear on the face of it to be the possibility of double taxation.
However, profits can only pass through the CFC charge gateway once. The structure of the CFC charge gateway in TIOPA10/S371BB (see INTM194300) means that those parts of the CFC’s assumed total profits (the CFC’s profits calculated by reference to UK tax rules) that are within any of Chapters 4 to 8 (and in some cases Chapter 9) pass through the CFC charge gateway. While an amount of profit may be within both Chapter 6 and Chapter 7 it only appears in the make up of the assumed total profits once. There is no rule of priority and if an amount of profit is within Chapter 7 and passes through the CFC charge gateway then there is no need to consider that profit under Chapter 6 (or vice versa) where it is clear the same profits would be caught.
The key point here is whether the profits giving rise to a potential charge under either Chapter 6 or 7 are in fact the same profits. Where a captive insurance CFC’s profits can be within Chapter 6 and Chapter 7, it will be necessary to establish whether they are in fact the same profits, or whether for example some of the profits arise from the investment of excess capital contributed by the UK by way of share capital, rather than from profits generated by the captive insurer from writing business with the UK. In practice, determining whether they are in fact the same profits cannot be done without actually working out which of the assumed total profits arise under both Chapters 6 and 7 and which of the assumed total profits relate to UK business or support UK risks.
The following is a simple example of how the allocation of profits arising from UK and non-UK premiums could be determined. The allocation of profits arising from UK and non-UK premiums is likely to be more complicated than the straight line apportionment used in this example. Alternative allocation methods are permissible, to the extent they are shown to be the most appropriate method and provide a just and reasonable allocation.
A captive insurance CFC is established with capital of £200m that is wholly provided by the CFC issuing shares to its UK parent. During the first year of trading the CFC receives premiums of £60m from UK group companies and £40m from non-UK group companies. It makes the following profits during the first year:
- Underwriting profit of £20m, of which £12m relates to business written with the UK. This reflects the general proportion of business, 60%, written with the UK.
- Investment profits of £15m, of which £10m relates to the initial capital and £3m relates to the investment of UK premiums.
Out of the assumed total profits of £35m, the profits of £21m generated from business written with the UK (£12m underwriting profit, £6m investment profit from the initial capital that supports the UK business and £3m from the investment of UK premiums) pass through the CFC charge gateway by way of chapter 7. All of the assets that the CFC invests in are free assets as the CFC has no loan capital. The group considers that 75% of the free assets are excess and so 75% of the profits generated from the free assets attributable to the initial capital (75% of £10m giving £7.5m) pass through the CFC charge gateway by way of Chapter 6.
So out of the £10m investment profits earned from the initial capital, £6m falls within Chapter 7 and £7.5m falls within Chapter 6. There is no way of establishing whether the excessive capital relates to capital supporting the UK business or the capital supporting the non-UK business. In such a case, the amount that potentially falls within both chapters is taken as £6m. And so the amount that passes through the charge gateway is £21m + £7.5m - £6m = £22.5m.
At the end of the first year, the underwriting profits are retained and invested. During the second year the CFC makes the following profits:
- Underwriting profit of £25m, of which £15m relates to business written with the UK
- Investment profits of £17m, of which £10m relates to the initial capital, £3.6m relates to the investment of UK premiums earned in year 2 and £0.6m relates to the investment of the retained profits earned from UK business in year 1 (60% of the retained profits come from UK business)
Out of the assumed total profits of £42m, the profits of £25.2m generated from business written with the UK (£15m underwriting profit, £6m investment profit from the initial capital that supports the UK business, £3.6m from the investment of the year 2 premiums and £0.6m from the investment of profits generated from UK business in year 1) pass through the CFC charge gateway by way of chapter 7. All of the assets that the CFC invests in are still free assets as the CFC has no loan capital. The group again considers that 75% of the free assets are excess and so 75% of the profits generated from the free assets attributable to the UK capital contributions (which is the initial capital of £200m), in total £7.5m, can pass through the gateway by way of Chapter 6.
However as with year 1, as £6m of the profits that fall within chapter 6 are part of the profits of £25.2m that fall within chapter 7, the £6m only passes through the CFC charge gateway once. And so the amount that passes through the charge gateway is £25.2m + £7.5m - £6m = £26.7m.
In conjunction with Chapter 7, the above rules prevent the use of UK financed captive insurance CFCs operating as “money boxes”.