by Robin Pilgrim, LawAndTax-News.com, London Friday, May 14, 2010

The South African Treasury has announced an ongoing review of tax issues relating to offshore captives and protected cell companies.

Although these issues were raised in the 2010 budget review, it was decided that they should be investigated further rather than be inserted for inclusion within the Taxation Laws Amendment Bills, 2010.

The Treasury is concerned that captive subsidiaries, especially offshore captive subsidiaries, may be used to undermine the tax base. The Income Tax system does not generally permit deductions for reserves against future risks, but the tax base is only at risk when payouts are less than premiums received or the time delay between the two events becomes too far apart.

In terms of tax avoidance, the Treasury's main concern is the use of offshore captive insurers. Offshore captive insurers often remain untaxed when receiving premiums, even if the insurer fails to make corresponding payouts after a long period. In some instances, these insurers may distribute the excess premiums back to the insured free of tax.

Although the Treasury's statement on the matter admits that current tax rules relating to controlled foreign companies curtail this practice, the controlled foreign company tax rules have obvious weaknesses:

• Not all offshore captives are under indirect South African control (a precondition for applying the controlled foreign company rules); and
• The current tax rules allowing for short-term deductions may be too permissive; if these rules are too permissive, a tax problem for the fiscus may even exist in respect of onshore captives.

With regard to protected cell companies, the statement notes that some jurisdictions segregate the liquidation of the cells, and other jurisdictions even segregate tax consequences. South Africa does not offer cell companies in a true sense, lacking true cell limited liability. Claimants against a South African cell can recover from all South African cell company assets, but a cell owner is contractually required to refund the cell for any shortfalls.

The Treasury acknowledges the legitimate non-tax commercial uses of protected cell companies, offering as they do, a strong middle-ground alternative to outsourced insurance and captive insurance subsidiaries.

Cells allow the insured to limit costs associated with the service premium attendant with typical outsourced insurance without incurring the cumbersome regulatory costs associated with a controlled captive subsidiary (e.g. the annual license fee and upfront registration with the Financial Services Board), says the statement.

However, the Treasury notes that most jurisdictions offering cell legislation can also be viewed as "tax haven or low-tax/no tax jurisdictions". Cells can easily circumvent offshore tax avoidance legislation, such as the rules relating to controlled foreign companies, according to the statement.

Given the range of issues and the need to balance legitimate commerce against anti-avoidance concerns, the Treasury has decided that immediate tax legislation for 2010 is premature.

The statement lists the following tax proposals as still under consideration:

• The ownership criteria for controlled foreign companies could be tightened. Under this scenario, each cell in an offshore protected cell company would be measured as a deemed separate company. In addition, the effective management test could be measured cell-by-cell rather than company-by-company. The goal of these changes would be to neutralize the tax benefits of an offshore cell versus an onshore cell.
• The current tax rules are designed to ensure that short-term insurance premiums should generally be taxable in the hands of the short-term insurer unless claims relate to the year of receipt. However, a growing number of exceptions appear to be emerging in this regard. Co-ordination will also be required with new insurance regulatory criteria so that over-conservative principles are not utilized to undermine the tax base.
• Tax avoidance cycle schemes appear to exist involving the over-funding of captive insurers. Under this practice, the captive is over-funded to reduce the tax base of the insured; the over-funded insurer then repatriates the funds back to the insured via tax-free dividends. One option would be to create a deemed recoupment for dividends recycled in this manner.
• Deductible premiums may have to be limited in the case of captive insurance relationships to prevent over-funding. In addition, the timing rules for insurance premium deductions may have to be reviewed so that insurance premium deductions more closely match the income of captive short-term insurers.

In order to facilitate ongoing consultation with relevant stakeholders, the South African Treasury has formally requested public comments in respect of the above-mentioned proposals.

A comprehensive report in our Intelligence Report series which studies the 20 main offshore jurisdictions which offer captive insurance regimes is available in the Lowtax Library at http://www.lowtaxlibrary.com/asp/subs_reports.asp and a description of the report can be seen at http://www.lowtaxlibrary.com/asp/description_report11.asp

All content on this site has been provided by BSIRN.