It's a question of substance: Captive insurance and Bermuda's economic substance regime
Introduction
In December 2018, Bermuda enacted the Economic Substance Act 2018 and related Regulations. This created an entirely new regulatory regime in response to the requirement, set out by the OECD Forum on Harmful Tax Practices and the European Union Code of Conduct Group on Business Taxation, that jurisdictions cannot be used to “facilitate the use of structures which attract profits but which do not reflect real economic substance in the jurisdiction”. In broad terms, what this means is that if an entity is legally domiciled in a jurisdiction, it ought to be able to demonstrate - substantively - that it is carrying on business there.
This OECD/EU expectation, and the implementation of measures to address it, is certainly not unique to Bermuda. Every jurisdiction deemed by the OECD and EU to be a “no or only nominal income or corporation tax” regime was required to adopt substantially identical principles, and all subject to the same deadline. The result is the adoption of a new regulatory regime across all comparable jurisdictions that is more or less identical both in its application and in its monitoring and enforcement requirements.
The “level playing field” principle was a key guiding factor for the OECD and the EU as they oversaw the implementation of the new requirements, ensuring that there was no jurisdictional arbitrage based on the requirements themselves. Underpinning that level playing field principle is, implicitly, the principle of fair competition. In effect, jurisdictions should compete for business based on the substantive merits of the jurisdiction from a business perspective, and not simply because there are tax savings to be had.
From the perspective of entities impacted by the new requirements, the effect of the new regulation is that it is now even more important for them to consider whether or not a jurisdiction is one in which substantial economic activity can be effectively carried out. There is now a greater focus on the practical question of “can the jurisdiction effectively accommodate and foster substantive operations, beyond simply providing a tax-efficient solution?”. Boards of existing entities must necessarily now take a fresh look at what activities that entity is undertaking, where those activities are being undertaken, and who is undertaking them on the entity’s behalf. They must carefully assess if or to what extent the economic substance requirements are met, or whether they must adopt revised business practices in order to comply.
Of course, these questions have always been key jurisdictional considerations for any entity, especially in the global captive insurance industry, but the new requirements (and the potential penalties associated with non-compliance with them) do add significance to them.
Who do the economic substance requirements apply to?
The new regime is focused on those industries that the OECD and EU deemed to be at higher risk of generating “geographically mobile income”. As such, the requirements apply only to those entities carrying on specified “relevant activities”. There is a total of nine relevant activities identified, including: banking, financing and leasing, fund management, shipping, headquarters, distribution and service centers, intellectual property, holding entity and - most importantly for the purposes of this article - insurance. Every entity in Bermuda carrying on one or more of these relevant activities (whether or not it is earning any gross revenue from that activity) will be required to demonstrate that it satisfies the economic substance requirements in Bermuda in respect of that activity(1).
What are the economic substance requirements?
Where an entity is in scope of the new regime, the economic substance requirements that must be satisfied are that the entity must:
- be managed and directed in Bermuda;
- undertake all of its “core income generating activity” in Bermuda;
- have adequate physical presence in Bermuda;
- incur adequate expenditure in Bermuda; and
- have adequate full time employees with suitable qualifications in Bermuda.
What are the activities that must be performed in the jurisdiction?
Managed and directed
First and foremost, an entity that is scope of the regime must demonstrate that it is managed and directed in Bermuda. In practice, this will usually mean that board and committee meetings - and especially meetings at which strategic decisions are taken - will be held in Bermuda(2).
The frequency of such meetings should be proportionate to the nature, scale and complexity of the entity’s business, and as many of the participants as possible (generally, at least a majority) should attend while physically present in Bermuda. Captive insurers with relatively straightforward business lines and contract renewals may be able to satisfy the requirement with substantive meetings held in Bermuda annually, while more complex captives may require more frequent meetings (semi-annually or quarterly).
Having Bermuda resident directors on the Board, able to attend meetings as well as to assist with management matters between meetings, will also assist in demonstrating compliance with this requirement. In order for this to be of substantive value, of course, it is important that the entity is able to evidence that the directors have the requisite skill and experience to manage the affairs of the company. Ensuring that suitably qualified directors are appointed, who have both the skill and the time to focus on the company’s business, will help to ensure that the “managed and directed” requirement is met.
Core income generating activities
As described above, the purpose of the economic substance regime is to ensure that, where profits are generated in a jurisdiction, they are reflective of real economic activity in that jurisdiction. As such, the focus of the regime is on core income generating activities (CIGA) of the entity being performed in the jurisdiction.
For those entities, including captives, carrying on insurance as a relevant activity, the CIGA will include: predicting and calculating risk, insuring or reinsuring against risk, providing client services and preparing regulatory reports. To the extent that these activities are undertaken by the insurer, they must be undertaken in Bermuda.
If the insurer has full-time employees, care should be taken to ensure that those employees that are undertaking CIGA are doing so in Bermuda. For those entities that do not have employees of their own, as is commonly the case for captive insurers, they must instead rely on third party service providers, and the Board and committees themselves, to undertake the CIGA. In that case, the importance of having access to a full array of sophisticated and capable service providers, as well as a deep pool of skilled and experienced resident directors, becomes an even greater focus for the entity.
To be clear, the purpose of the new regime is not to create an environment in which cross-border structures are no longer possible or appropriate, nor one in which it is not possible to draw on resources from outside the jurisdiction. Entities may carry on some activities outside of the jurisdiction, provided that those activities do not constitute CIGA, and are not of central importance to the generation of income from the relevant activity. Back-office functions such as IT and finance may be performed outside of Bermuda, and support activities to the CIGA (e.g. the collection of claims data, supporting actuarial analysis, etc.) may be undertaken outside of Bermuda where it is necessary to do so, provided that the CIGA itself is undertaken in Bermuda.
The question of which activities constitute CIGA (to be performed in Bermuda), and which activities can reasonably be treated as being in support of CIGA (and able to be performed outside of Bermuda) can be challenging. The Board of the captive should carefully consider this question, analysing the activity, and ensuring that all service providers and other persons supporting the captive operations understand the importance of meeting the CIGA requirement in Bermuda.
Why does choice of jurisdiction matter?
As noted above, the economic substance regime is remarkable for the consistency with which it has been applied across jurisdictions. The effect of that level playing field approach, with the economic substance requirements being applied more or less equally across jurisdictions, is that the differentiating factors truly become considerations of substance.
When considering the jurisdiction in which to domicile a captive, owners must carefully consider not just whether the jurisdiction has an effective and appropriate regulatory framework, but also whether there are sufficient resources in the jurisdiction to support compliance with the economic substance requirements. Is there a pool of talented and experienced resident directors, with the skill and capacity to understand and assist in the management of the captive on the ground in the jurisdiction, and in the context of these economic substance requirements? Likewise, are there enough specialist service providers in the jurisdiction, qualified and sufficiently staffed to support the performance of the CIGA for the captive?
Those jurisdictions that are best able to provide good answers to those questions - in addition to the ‘traditional’ questions of regulatory oversight, access to reinsurance markets and high-quality infrastructure - will become even more attractive to new captive owners as well as existing captive businesses.
The more sophisticated captive jurisdictions, like Bermuda, are very well placed to meet that need, as indeed they have done for decades. With over 50 years of captive insurance experience, there is a deep pool of specialist talent on the island, experienced in the management and administration of even the most complex captive and commercial insurers across all business lines. There is real substance here, and captive owners - and captive Boards - can be confident that they will continue to respond to the evolving needs of the market.
Of course, care must still be taken not to become complacent. Captive insurers must continue to critically assess their activities, and be prepared to adjust where necessary, in order to maintain their economic substance in the jurisdiction. If there is uncertainty as to whether the activities being undertaken are appropriate in the context of the economic substance requirements, captive owners and boards should seek advice from those best able to support them. Knowing that such support can be found in the jurisdiction, and that the services can be effectively provided in a regulatory appropriate framework, will continue to be the driver of success in the global captive market, and jurisdictions like Bermuda are well positioned to support that.
[1] There is one key exception to this general principle. Where an entity can demonstrate that it is resident for tax purposes in a jurisdiction other than Bermuda (being a jurisdiction that is itself not deemed by the EU to be non-cooperative for tax purposes), it will not be subject to the economic substance requirements in Bermuda. An entity will fall within this exception if it is able to demonstrate that all of its income from its relevant activity is liable to tax in that other jurisdiction.
[2]Note that the Registrar of Companies is cognisant of, and sympathetic to, the ongoing Covid-19 travel and meeting restrictions limiting the ability for travel to Bermuda. These unforeseen and essential restrictions will be taken into account in assessing an entity’s compliance with this requirement. Entities should keep records of the extent to which such restrictions have limited their ability to meet, and otherwise ensure that the economic substance requirements are met.
An original version of this article was first published in Captive Review, June 2021.
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