September 2011

ABI RESPONSE TO THE HM TREASURY AND HMRC CONSULTATION DOCUMENT:

Consultation on Controlled Foreign Companies (CFC) Reform

The ABI is the voice of insurance, representing the general insurance, investment and

long-term savings industry. It was formed in 1985 to represent the whole of the industry

and today has over 300 members, accounting for some 90% of premiums in the UK. The

UK insurance industry is the third largest in the world and the largest in Europe. It is a

vital part of the UK economy, managing investments amounting to 26% of the UK‟s total

net worth and contributing the fourth highest corporation tax of any sector. Employing

over 290,000 people in the UK alone, the insurance industry is also one of this country‟s

major exporters, with 28% of its net premium income coming from overseas business.

_______________________________________________________________________

EXECUTIVE SUMMARY

The ABI welcomes the opportunity to comment on the Government consultation document

Consultation on Controlled Foreign Companies (CFC) reform. This response builds on

the discussions we have had with officials throughout this consultation period and over the

years leading up to this document.

The ABI is supportive of CFC reform which is part of the overall aim of the Government to

make the UK the most competitive tax system in the G20, as well as the best location for

corporate headquarters in Europe. However we are concerned that as the proposals in

the consultation document stand, the new CFC rules will be more complicated than the

current rules, more burdensome to comply with, and will give insurance companies less

certainty, not more. This is because the proposed rules build on the current CFC regime‟s

broad brush approach to tackling avoidance, rather than specifically targeting the mischief

that we all agree is harmful. This approach puts UK headed groups at a significant

disadvantage to their competitors. It is one of the main reasons why the UK is not

attracting insurance companies to domicile in the UK and, more worryingly, is why over

the last few years we have seen an exodus of insurance companies from the UK.

This approach also creates anomaly bias within the insurance sector that favours globally

diversified businesses, over UK focused businesses. This approach, if not changed,

could have the opposite of the intended effect and actually encourage UK focused

businesses to re-domicile offshore. To avoid this, as a minimum, the new rules should be

no more complex to comply with than the current rules and should not result in insurance

companies being in a worse off position.

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If the reform is to improve the competitiveness of the UK as a location for the insurance

industry then the Government needs to create simpler CFC rules that are less

burdensome to comply with and provide greater certainty. A key element to achieving this

is that the reform of the CFC rules should not be considered in isolation. Instead it should

be looked at in light of existing defences such as transfer pricing, the various anti-

avoidance provisions that can apply and the limitations imposed by the prudential

regulatory regime.

The core of the new regime should be based around:

a simple gateway which will let out companies posing little or no risk of diversion

of UK profit;

an insurance specific exemption based on objective, measurable factors; and

a general purpose exemption to deal with cases that do not meet the objective

test above but nonetheless are not cases representing diversion of UK profit for

tax reasons.

More specifically, we are not supportive of the general purpose exemption (GPE) being

used as a “quick get out” for some of the simpler cases or as a gateway to the regime.

The GPE, as outlined in the consultation document and built upon during discussions with

officials throughout the consultation period, does not offer the certainty and simplicity to be

used in such a manner. Simple objective gateway tests upfront, would send a clearer

message of the Government‟s intentions. Such exemptions could include:

A white list of countries with no added conditions

Basic accounts measure de minimis

The profits rate safe harbour (as described in the territorial business exemption)

X% of the CFCs profits are foreign to foreign.

On the insurance exemption, while we very much welcome clarification from officials

during the consultation period, on why they believe a capitalisation test is needed, we do

not agree. There is no capitalisation test in the current rules and no evidence that

insurance group CFCs are typically over-capitalised. As capital is the life blood of

insurance and our shareholders demand a level of return on their capital that cannot be

met through passive investment alone, it is highly doubtful that a subsidiary will be

overcapitalised to a level which represents a diversion of UK profits.

It is important that any insurance business exemption is even-handed in its outcome

between those insurers who are mainly UK focused and those more global focused.

Furthermore, those in the Lloyds market, writing global risks, are not able to take

advantage of the foreign to foreign exemption like other general insurers. This is because

by the very nature of the market, the risks have to come to the UK and into the Lloyds

Member. If the CFC rules do not change then those still here will consider leaving or

simply decide not to write the business through Lloyds.

Making such changes will not result in an increased cost to the Exchequer. Many general

insurers, for example, are no longer headquartered in the UK and therefore not within the

current CFC regime. Our proposals are aimed at making the UK an attractive Head Office

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location for insurers, to attract economic activity to the UK. Therefore our proposals are

likely to be revenue positive.

On the general features of the proposals we would also like to see the following changes:

No Local Management Condition throughout the exemptions: This is not

needed in a regime that reflects a movement towards a more territorial basis.

Its inclusion in the GPE, while not currently in the motive test, provides an

additional level of complexity and has the potential to make the regime worse

than the current system.

White list and excluded countries exemption (ECE): There should be a white

list of countries in which subsidiaries and permanent establishments (PE) based

in a county on the list, would be explicitly excluded from the rules, with no need

to do any further investigations. This would be complemented by an additional

list that provides a “subject to tax” test for countries that may have special

regimes for certain types of income.

Definition of control: The current test needs be amended to deal with specific

concerns such as joint ventures and mutual funds.

Lower level of tax: This test needs to be included in the new rules and

simplified. This could be done by basing it on accounting profits adjusted to

take out capital gains and losses.

De minimis: A simple, no conditions added de minimis in excess of the existing

£200,000.

Profits rate safe harbour: We consider this to be a very valuable test, especially

for local companies. It should be extended to apply to insurance companies.

Finance Company Partial exemption: There is no valid reason why insurance

companies should not be able to access this exemption. Our exclusion would

result in an uneven playing field, which could present potential state aid issues.

Finally, we are very much concerned about the impact this reform will have on the branch

exemption legislation. The final outcome of the branch exemption was very positive for

the insurance industry, but the importation of the new CFC rules proposed in the

consultation document could reverse that. The overall result of this reform should provide

economically equivalent outcomes for PEs and subsidiaries. Simply applying the same

rules and treatment will not achieve the right result. Therefore the following needs to be

taken into account:

The local management test is not a relevant test for PEs, the only test that is

required is whether a PE exists in line with OECD principles.

A capitalisation test for a PE is not needed due to the OECD allocation of

capital principles.

When considering the application of the white list or ECE, a PE should be

looked at as if it were a separate legal entity, in that if it is established in a white

list or an ECE country then the profits attributable to it should be exempt.

Likewise, if the PE is not established in a country on any list, but is a PE of a

subsidiary that is, the profits of the PE need to either be excluded under another

exemption or apportioned on a proportional basis.

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PART 1 GENERAL COMMENTS

1. Introduction

2. A competitive tax system

3. The UK insurance industry

Reinsurance

PART 2 ABI PROPOSALS

4. ABI proposed design of the regime

5. Insurance Specific Exemption

Definition of Insurance Group

Qualifying conditions

Operation of the test

Life business and large risks

Capitalisation test

6. General exemptions

Lower level of tax

De minimis

Excluded Companies Exemption

Territorial business exemption

General purposes exemption

Finance Company Partial Exemption

Intellectual Property Exemption

7. Other issues

Local management condition

Definition of control

Holding Companies

8. Permanent Establishments

Irrevocable election

Local management tests and profits commensurate with activities

Operation of the rules to service PEs of UK insurance companies

Operation of rules to PEs of a CFC

Capitalisation test

PART 3 ABI RESPONSE ON LATEST OFFICIALS THINKING

Annex Movement of Insurance Group Domiciles

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PART 1 GENERAL COMMENTS

1. INTRODUCTION

1.1 The ABI is supportive of the overall aims of the CFC reform to make the UK the

most competitive tax system in the G20, as well as the best location for corporate

headquarters in Europe. We agree that the principles outlined in paragraph 2.2 of

the consultation document are the right principles to base the reform. However, on

our reading of the document, the proposed implementation of those principles

does not appear to strike the right balance. The proposals are too much weighted

towards protecting the tax base and thus will not achieve the objectives of the

reform.

1.2 For insurers, the proposals will increase the complexity of the CFC regime, are not

aligned with modern business practice and do not create a level playing field

between sectors or within the insurance sector. While the proposals in the

consultation document may give a better tax result for some, than the current

regime, the compliance burden associated with the proposed regime will likely

negate this slight benefit. A worse result for some may well be possible,

depending on the extent of the ECE, the detailed rules for the insurance exemption

and the GPE. As a minimum, the new rules should be no more complex to comply

with than the current rules and should not put companies in a worse position.

However, such a target for the reform would obviously not be sufficient to advance

the Government‟s policy aims.

1.3 If the reform is to improve the competitiveness of the UK as a location for the

insurance industry then the Government needs to create simpler CFC rules that

are less burdensome to comply with and provider greater certainty. A key element

to achieving this is that the reform of the CFC rules should not be considered in

isolation. Instead it should be looked at in light of existing defences such as

transfer pricing, the various anti-avoidance provisions that can apply and the

limitations imposed by the prudential regulatory regime.

1.4 This paper responds to both the proposals in the consultation document and

officials‟ developing thinking, as set out in various meetings. This response is

separated in three parts. Part 1 outlines our general comments on the reform.

Part 2 provides specific comments on the insurance exemption and the other

exemptions. Finally Part 3 provides a supplementary response on officials‟

developing thinking that has been expressed to us in various meetings.

2. A COMPETITIVE TAX SYSTEM

2.1 While tax is not the sole determinant of the success of insurance centres, (the

biggest two insurance industries are the US and Japan, both of which have less

favourable tax regimes) for a smaller open economy, such as the UK,

competitiveness of the tax system is an important factor in maintaining the

competitiveness of the UK as a global centre of insurance. Furthermore, the

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biggest reinsurance centres in the world (Bermuda, Switzerland, Luxembourg and

Ireland for example) all have more competitive tax regimes, and have built their

insurance systems around this.

2.2 In light of this, the ABI is generally supportive of the overall aims of the corporate

tax reforms, and in particular the CFC reform. However, simply improving the

competitiveness of the UK relative to the G20 will not improve the overall

competitiveness of the UK for the insurance industry, as these countries are not

necessarily those that we compete with.

2.3 The key locations that the UK competes with for insurance business are all more

competitive in their tax systems. In particular, the tax regimes of locations such as

Ireland, Netherlands, Switzerland, and Bermuda are significantly more competitive

as locations from which to hold and run a global insurance business. Increasingly

the likes of Hong Kong, Singapore and Dubai are also becoming serious

contenders. A recent poll of our members showed that over half (54%) did not put

the UK in their top three business locations, based on tax and regulatory regimes.

The UK has fallen down the “league table” over the last decade or so. While the

recent WEF report on competitiveness has seen the UK rise from 12th to 10th, the

report identifies tax as the most problematic factor for doing business in the UK.

We have stood still while others have lowered tax rates and/or narrowed their tax

bases with better tax reliefs and more favourable regimes.

2.4 The competition for insurance business is not a theoretical concern of the industry,

it is a practical reality. The UK‟s ability to attract capital into its insurers and to

retain and attract insurers has diminished. Following Hurricanes Katrina, Rita and

Wilma and the recapitalisation of the industry that followed, Bermuda attracted

US$8.8bn of capital – eight times what Lloyd‟s attracted. In the last five years half

a dozen insurers have re-domiciled their holding company from the UK and several

others have moved from Cayman or Bermuda to European centres other than the

UK. See the annex for details.

2.5 The competitiveness of the UK tax system will be very significant in determining

whether these trends continue. It is important that the reforms are the right ones

and send the right message; otherwise the effect could be the opposite of what is

intended by Government. A third of insurance industry executives have said that

the UK tax changes announced in this year‟s Budget make it less likely they would

choose the UK as a base for their business. With 56% very neutral on the issue

this is far from a ringing endorsement of the Government‟s plans and should give

pause for thought to Ministers. The CFC reform will need to be bolder than the

proposals in the consultation document. A lighter touch and much simpler regime

is needed to be truly competitive for insurance businesses.

2.6 We therefore do not agree with the conclusion, outlined in the impact assessment

at paragraph H.7 of the consultation document that the proposals, as they stand,

will encourage more businesses to be headquartered here. Indeed unless the

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proposals are altered, the intended reform may have the opposite effect in terms of

encouraging some UK based insurance businesses to leave.

2.7 If the Government is to ensure that the UK is a competitive location for insurance

business, the three things the tax system needs to help us do are:

1. Attract capital to the UK; 2. Retain and attract the holding companies of insurance groups; and 3. Retain and attract senior and high quality insurance professionals.

2.8 To achieve this, the tax system needs to be stable and aligned with modern

business practice. Throughout this document, in addition to responding to the

proposals as per the consultation document, we outline how we believe a new

CFC system could result in the UK once again reclaiming its competitive edge. In

the next section we outline more about how insurance operates.

3. THE UK INSURANCE INDUSTRY

3.1 The UK insurance industry plays a crucial role in developing a healthy UK

economy. Our total tax contribution is now higher than it was before the

recession.1 This shows the important role the insurance industry is playing in the

recovery and how resilient the industry is during tough times. Corporation tax paid

by insurers was £2.7bn in 2010 – or 6.4% of total Government corporation tax

receipts. This is a 50% jump in corporation tax paid out by ABI members since

2009. This further underlines the benefits of supporting growth and attracting and

retaining insurance companies.

3.2 The UK insurance industry is currently undergoing regulatory changes, which will

have flow-on effects for tax purposes. For example, insurers currently get tax relief

on claims equalisation reserves. This was to provide some additional tax relief in

respect of the amounts set aside by insurers to deal with large losses. When very

large losses are incurred, the normal rules for tax relief do not necessarily work as

well for insurers as they do for other businesses. Solvency II will see the end of

the reserves as a regulatory concept. The release of the reserves will be taxable

and we have asked that this be spread on a transitional basis. However, even

spreading this over six years, with the loss of new relief, will likely cost general

insurers £100-200m a year.

3.3 However, despite this backdrop of rising tax contributions, we are concerned that

at a number of points in the document, the proposals discriminate against

insurance activities, despite an acknowledgment elsewhere that insurance is not

considered high risk. The approach taken towards insurers, in that we are not

considered as undertaking genuine commercial activities, creates an uneven

playing field with other sectors. The cumulative effect of all tax changes is

1 The insurance industry current total tax contribution is £10.4bn across all taxes borne and collected.

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penalising one of the UK‟s most successful sectors. Given that insurance has a

vital role to play in the recovery of the UK economy, this is unjustified.

Reinsurance

3.4 Reinsurance is critical to the commercial success of the UK insurance industry. As

such reinsurance should not be treated as profits diverted from the UK and thus

should not be taxed under the CFC rules.

3.5 Reinsurance is an extension of the concept of insurance, in that it passes on part

of the risk for which the original insurer is liable, to a second insurer. Reinsurance

contracts are more specialist than insurance contracts but for the most part they

work in exactly the same way. A contract of reinsurance is between the insurer

and reinsurer only and legally there is no direct link between the original insured

and any reinsurer. The insurer is still the one who must pay any claim from the

original insured. The insurer must then make its own separate claim against the

reinsurer and the insured has no claim against the reinsurer.

3.6 Reinsurance is important for a number of reasons, including:

To protect against large claims. For example, in the case of a fire in a

large oil refinery or a large city hit by an earthquake, insurers will have

spread the risk by reinsuring part of what they have agreed to insure

with other insurers so that the loss is not so severe for any one insurer.

To avoid undue fluctuations in underwriting results. Insurers strive

for a balanced set of results each year without „peaks and troughs‟.

They can therefore get reinsurance which will cover them against any

unusually large losses. This keeps a cap on the claims the insurer is

exposed to having to meet from its own resources.

To obtain a geographical spread of risk. This is important when a

country or region is vulnerable to natural disasters and an insurer is

heavily committed in that area. Risks may be reinsured to achieve

adequate diversification.

To increase the capacity and profitability of the direct insurer.

Sometimes an insurer wants to insure a risk but lacks sufficient capital to

do so on its own. By using reinsurance, the insurer is able to accept the

risk by insuring the whole risk and then reinsuring the part it cannot keep

for itself to others.

To improve solvency margins. Reinsurance allows companies to plan

operations more effectively and strengthen their balance sheets.

3.7 Like the insurance market, reinsurance usually involves specialist brokers who

have expert knowledge of the market and access to reinsurance underwriters on

behalf of their clients. Therefore the pricing of reinsurance is generally done on an

arm‟s length basis, in accordance with transfer pricing.

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3.8 As outlined in the figure 1 below, the moving of the risk does not equate to moving

100% of profits. Please note, that this is an example relating to general insurance.

Fig 1: Quota Share – 30%

CustomerInsurance Company(cedant)

Reinsurerpremium

30% ofpremium

claim 30% of claim

Profit commission

Ceding commission

Ceding commission – Includes cost of writing business e.g. Valuation, internal expensesMay include a profit element

Profit commission – calculated at end of contract takes into account projected profit/loss ratio

3.9 In this example, in terms of the profits attributable to the UK:

70% of the premium remains in UK – reinvested.

Ceding commission – this tends to be calculated by reference to the net

premiums ceded and typically takes account of the cedant‟s budgeted

cost base. The specific percentages will depend on the terms of the

contract considered as a whole.

Any profit commission.

Reinsurance within a group

3.10 Reinsurance within a group is primarily a means of making the most efficient use of

group capital. It also offers a number of other very significant commercial benefits

for a group.

3.11 The principal benefit is that it enables insurance groups to pool and diversify their

risks such that the group‟s overall regulatory capital requirements are reduced. By

doing so the group can reduce the costs of capital and be more competitive. Risks

attaching to one entity or jurisdiction can be pooled with and offset against

complementary risks relating to another entity or jurisdiction. This pooling of risks

reduces the amount of capital that the group as a whole needs to retain in respect

of those exposures and will be increasingly important when the Solvency II

Directive comes into force. Solvency II will determine capital requirements by

reference to the risks retained at an individual entity level and will not look to the

position of other members of an insurance group. Group reinsurance will,

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therefore, be one of the main means of effecting efficient allocation of regulatory

capital within a group, where businesses are retained in separate entities.

3.12 Group reinsurance also helps insurance groups to manage capital efficiently by

enabling them to minimise the risk of excess regulatory capital becoming „trapped‟

in a particular jurisdiction. Certain countries impose restrictions on the movement

of capital which can make it difficult to extract excess capital from local insurance

companies. This risk can be minimised by reinsuring risks elsewhere in the group

which removes the need to put capital into the local company.

3.13 Furthermore, it facilitates access to global retrocession markets (reinsurance for

reinsurers). Having a single purchaser of external retrocession makes for

economies of scale which can be reflected in the price or breadth of cover and can

simplify and reduce the costs of administration.

3.14 The local regulatory regime will be a key determinant of the jurisdiction in which a

group reinsurer is located. Different regulatory regimes will set different

requirements both in terms of the capital required to cover risk and the permitted

means by which specific risks might be hedged. The principal concern for

insurance groups in choosing where to locate a group insurer, will be determining

which jurisdiction offers a regulatory regime that provides the best fit for its

particular risk and asset profile.

3.15 There will be a number of other non-tax considerations relevant to determining the

optimum location of a group reinsurer including the availability of suitably skilled

local staff, the local regulatory system, the stability of the political regime and the

characteristics of the local legal system.

3.16 Because reinsurers do not typically share the tax residence of the cedant, there is

tax and often regulatory requirements to ensure that the pricing of such

transactions conforms to an arm‟s length basis.

3.17 Reinsurance is critical to the commercial success of the UK insurance industry. As

such reinsurance should not be treated as profits diverted from the UK and thus

should not be taxed under the CFC rules.

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PART 2 ABI PROPOSALS

4. ABI PROPOSED DESIGN OF THE REGIME

4.1 The proposed reform of the CFC rules follows the same structure as the current

rules. In the consultation document it is suggested that the GPE could also be

used as a “quick get out” for some of the simpler cases. However, we consider

that simple gateway tests upfront would send a simpler, clearer message that the

UK was indeed looking to attract business and would provide a much greater

degree of certainty of treatment. Furthermore, if such tests were available, it would

significantly reduce the number of companies that would be subject to the more

burdensome tests outlined in the insurance exemption and the GPW. This would

be consistent with the aims of simplicity and certainty of treatment.

4.2 This could be achieved by creating a few additional tests and also by pulling out

some key exemptions embedded in the design of the proposed rules. In Figure 2

below, we outline how we see such an approach working. While a company

should be able to go to any exemption first, steps 2, 3, 4, and 5 below are the likely

practical hierarchy.

Fig 2 – General design

STEP 1 - Do any of these apply?

A) White listB) X% of profits foreign to foreignC) Profits rate safe harbourD) Basic Deminimis

EXEMPT

Yes

No

STEP 2 - ECE Subject to tax test

Yes

STEP 4 - Insurance exemption

APPORTIONMENT

STEP 5 - General purpose exemption

STEP 3 - Lower level of tax test

No Yes

No

Yes

No

No

Yes

4.3 As outlined in paragraph 6.6 of this response, we consider that a white list with no

conditions would greatly simplify the regime.

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4.4 As the main difference between the proposed rules and the current rules is the

explicit exclusion of foreign to foreign transactions, a simple test upfront that

focused on this would send a very positive signal of the Government‟s intention.

4.5 Furthermore, we consider the profits rate safe harbour, outlined as part of the

territorial business exemption in the consultation document, to be a very useful

exemption. Irrespective of whether you adopt this approach, we would strongly

urge that this test can be applied to all companies, including insurance companies.

4.6 Lastly a very basic de minimis (i.e. no additional conditions), as outlined in

paragraphs 6.2 and 6.3 of this response, should also be included.

5. INSURANCE SPECIFIC EXEMPTION

Definition of Insurance Group

5.1 The definition of insurance group contained in the consultation document would

result in very few insurers being eligible for this exemption. We understand that

this was not the policy intention and would propose that the definition of insurance

group contained in the world wide debt cap provisions should be used.

Qualifying conditions 5.2 Provided that the definition of insurance group is altered accordingly, we are

generally supportive of the qualifying conditions outlined in the consultation

Key Points

The rules need to create a level playing field within the sector. Therefore there needs to be workable exemptions for:

o London Market o Globally focused businesses; and o Domestically focused businesses.

Tests for life business and large risks need to be included.

No capitalisation test is required.

The definition of insurance group should follow that used in the world wide debt cap legislation.

The qualifying condition limiting the exemption to insurance companies in insurance groups should be included in the legislation, thus negating the need for a capitalisation test.

If these changes are made, then insurance companies will look favourably on the UK as a headquarters location.

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document, subject to comments made about the local management condition in

paragraph 7.1 and 7.2 of this response.

5.3 The first qualifying condition outlined in the consultation document, that the CFC

must be a member of an insurance group, should be included. We consider there

is a good case for this to be EU compliant. The exclusion of a sector or class of

companies from an anti-avoidance rule on the objective grounds that those

companies do not represent a risk of avoidance does not create a state aid. That

judgement has already been made in the exemptions for other sectors in the CFC

proposals. We believe this judgement should apply to the insurance sector as

there is no evidence of insurance companies in insurance groups being over-

capitalised.

5.4 The inclusion of this condition would mean that no capitalisation test would be

required which would greatly simplify this exemption and reflect the true nature of

insurance. If officials consider there is a specific legal issue here, we would

welcome the chance to help work through it.

Operation of the test

5.5 The writing of insurance over UK situs risk and the reinsurance of UK situs risk by

a foreign (re)insurance company (whether that company is connected or

unconnected with the cedant) are genuine commercial activities. Our view

therefore, remains that any concerns you have over the potential for risks of

artificial diversion of profits, is best dealt with using existing protections such as

transfer pricing.

5.6 However, we recognise to make progress and provide certainty for Ministers on the

potential costs of the reforms, it might be appropriate to include some limitation in

the insurance exemption. Having said that, it must be recognised there is a fine

balance with the need to effectively manage capital to enable UK insurers to be

competitive in the global business market.

5.7 The Government‟s preferred restriction, as outlined in the consultation document,

on the amount of insurance income that can be exempted, will create an uneven

playing field within the sector between those whose business is largely

domestically focussed and those whose business is more globally focussed. This

may make those UK groups with significant UK business more likely to redomicile

or more attractive takeover targets for foreign domiciled groups or private equity,

which may be keen to reduce taxes through redomicile. For this reason we are not

supportive of either option contained in the consultation.

5.8 Furthermore, those in the Lloyds market, writing global business, are not able to

take advantage of the foreign to foreign exemption like other general insurers.

This is because by the very nature of the market, the risks have to come to the UK

and into the Lloyds Member. Therefore, this becomes UK connected income.

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Under both the current and proposed rules, any UK headquartered Lloyd‟s

members will be left on an uneven playing field with foreign headquartered

insurers who can reinsure out as much as they wish, subject to regulatory

restrictions.

5.9 If the CFC rules do not change then those still here will consider leaving or simply

decide not to write the business through Lloyds. Both outcomes are not ideal for

the Government, as it will reduce the influence of Lloyds and the overall UK tax

take.

5.10 However, as outlined in Figure 3 below, we do consider that the options can be

worked on to achieve an outcome that will take into account all types of insurance

business, while maintaining adequate protection of the tax base.

Fig 3 – Insurance exemption Step 1 – Qualifying conditions met?

Step 2 – Are one of the following conditions met?

A) Is the majority of the CFC’s GTR with third parties? OR

B) Does the majority of the GTR of the CFC relate to (re)insurance of non-UK situsrisk or property? OR

C) Are the CFC’s GTR from the UK less than 50%? OR

D) Are less than 50% of the aggregate GTR from all UK tax resident insurance companies and UK PE’s of foreign insurance companies being reinsured to CFCs with which each such company is connected? OR

E) Does the majority of GTR of the CFC relate to life business and large risks?

Look for other exemption

No

Yes

EXEMPTYes

GPENo

5.11 Connection should be based on both the situs of the risk and where the property

being insured is located. It should be presumed that if the (re)insurance is from a

foreign insurer then it is non-UK situs risk and property. For life assurance,

connection should be based on the residence status of the insured person. For

group schemes it should be the residence status of the trustees or body taking out

the contract. This provides the Exchequer with added protection in that insurers

cannot place all risks offshore when insuring UK people or property.

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5.12 Within the Step 2 box, there are five options available:

A) This is focussed at excluding CFCs whose majority of dealings is with

third parties, including global programme insurance. This reflects that

third party (re)insurance, by its very nature, is done on an arm‟s length

basis. Therefore there is no risk of any artificial diversion of UK profits.

B) This is mainly focused on exempting London Market insurers writing

global insurance risks. The risk is not wholly retained in the UK as the risk

aggregation/management functions are carried out elsewhere. This test is

consistent with continuing to make London a centre for global insurance

business. Linking the test to property as well as risk, provides protection

for the UK tax base, as this will ensure that there is no fiscal incentive for

UK insurers to cede a book of predominantly UK-situs risk offshore.

C) This test preserves the current position for larger international insurers

and applies the same principles outlined above in paragraph 5.11.

D) This test ensures that mainly UK focused insurers are not disadvantaged

by the rules, and can access reinsurance in the same way as those with

more internationally diversified businesses. As acknowledged in the

consultation document FSA capital requirements already provide a

restriction on the amount of UK risk that can be reinsured offshore. This

provides adequate protection to the UK tax base. Making this an

aggregated test will provide further protection to the UK tax base and

reassurance for the Exchequer.

E) This preserves the current test for life business and large risks.

5.13 We disagree with the contention outlined in the consultation document that a test

that looks at the proportion of UK situs risk reinsured out will add complexity and

create significant practical difficulties in obtaining data from the UK company. On

the contrary, obtaining data on the UK business is generally far easier than

obtaining data from foreign subsidiaries for both the insurance company and

HMRC.

Life business and large risks 5.14 It will be important to continue the exemption in relation to life business and large

risks, and that these are considered when calculating the gross trading receipts of

a CFC. A number of existing insurance subsidiaries of UK headquartered groups

rely on the existing restricted exemption, and the new rules should not withdraw an

existing exemption which has not been used for artificial avoidance. In future there

may be more reliance on the exemption as a direct result of insurers needing to

restructure their businesses to optimise solvency capital in response to Solvency II.

The new rules should not introduce a change to make that more difficult where,

again, there is no evidence of the rules being used for artificial avoidance. Indeed,

16

we do not consider there to be a logical case for continuing to exclude protection

business from life assurance.

5.15 The current 'relaxation' for large risks and life business is a restricted version of the

exempt activities exemption which existed prior to Finance Act 2003. The

restrictions made to the exemption in 2003 were to target specific perceived abuse

in relation to the reinsurance of warranty business and the reinsurance of certain

types of protection business. At the time, these restrictions were felt to be drawn

too widely to counter the perceived abuse. Given transfer pricing developments

since then and the potential exclusion of captive insurance companies of non-

insurance groups, we believe that there is a good case for revisiting the restrictions

to see whether the CFC exemption for particular types of insurance business

should be wider.

Capitalisation test

5.16 Capital is essential to the insurance business model. Insurers must hold capital to

ensure that they are sufficiently solvent to meet their obligations to policyholders.

The key determinants of the level of capital held by insurers are regulatory

requirements, rating agencies and counterparty/policyholder requirements and

confidence.

5.17 Maintenance of capital is one of the principal costs of insurance business and the

efficient management of capital is key to the UK maintaining its competitiveness.

The objectives of shareholders and the need of management to fully utilise capital

to meet the commercial needs are a barrier, in addition to tax legislation, to the

hoarding of excess capital in lower-tax jurisdictions. The rates of returns expected

by the providers of capital are greater than what passive returns can provide.

Inefficient capital management will not deliver returns on capital that are

competitive and will limit the capital that can be raised, which in turn will limit the

amount of business that can be written. Insurance companies must fully utilise

their capital to grow and prosper.

5.18 There is no capitalisation test included in the current CFC regime and there is no

evidence that this has been abused. For these reasons a capital test is not

required, other than to exclude captives of non-insurance groups. Therefore, if the

qualifying conditions can be included, no capitalisation test need be included in the

legislation. The addition of such a test is a high price to pay in terms of complexity.

5.19 Nevertheless, if legal reasons mean that the qualifying condition that the company

must be part of an insurance group cannot be included in the legislation, and the

Government therefore concludes that a capital test is appropriate to carve out the

riskier captives of non-insurance groups, this will further complicate the exemption

as outlined in Figure 4 below.

17

Fig 4: Insurance Exemption with capital test

Step 1 – Qualifying conditions met?

Step 2 – Is the majority of the CFC’s GTR with third parties ?*

Step 4(a): Are the CFC’s GTR from the UK less than 50%?*

Step 4(b): Are less than 50% of the aggregate GTR of all UK tax resident

insurance companies and UK PE’s of foreign insurance companies being reinsured to CFCs with which each

such company is connected?

Step 5: Is the CFC part of a publicly quoted insurance group?

EXEMPT

Look for other exemption

GPE

Step 6: Is the CFC appropriately capitalised?

No

Yes

No

No Yes

Yes

Yes

Yes

No No

Yes

Self assess

Safe harbours

*Relaxations for life assurance + large risks applied when calculating GTR

No

Third party

business

UK risk Large

international groups

UK risk

Mainly UK based

(para B.15)

Step 3 – Does the majority of the GTR of the CFC relate to

(re)insurance of non-UK situs risk or property?*

No

YesGlobal risk

(Non-UK situs)

exclusion (para

B.25)

5.20 To reduce the reliance on the capitalisation test, a publicly quoted test, as outlined

in Step 5 in figure 4 above, should be included. This will be a simple yes or no test

that recognises that for publicly quoted insurance groups inefficient management

of capital would not occur. As market forces and a group‟s duty to its shareholders

dictate that capital is utilised to support insurance business to maximum returns,

with such groups there is no risk to the UK tax base. This would also help meet

the Government objective of reducing complexity of the regime.

5.21 Groups who do not meet the gross trading receipt tests and are not publicly quoted

would need to apply the capitalisation test. As discussed at length in the HMT

working group, there is no simple capital test that would work for the entire

industry. Regulatory requirements, plus solvency I and II capital requirements,

focus on minimum levels of capital. Due to market volatility, it would not be

prudent to maintain capital at minimal levels. Indeed, regulators may informally

indicate that a higher level than the minimum is required in order for regulatory

engagement to be less than would otherwise be the case. For European based

insurers the trend globally, under Solvency II, will very much focus on internal

models for ensuring capital adequacy.

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5.22 For life assurance companies, the capital level is set by the local regulator, and the

regulatory regimes can vary significantly between jurisdictions. A higher level of

capital will, in practice, be held and this will be driven by one or more of the

following factors:

To support the writing of new business.

To provide a buffer against market volatility.

For marketing purposes in terms of demonstrating financial health of a

company (particularly important in Asia post 2008 financial crisis).

Where the life company is rated, then the rating agency requirements

will drive a higher capital requirement for similar reasons to that outlined

in the following paragraph.

5.23 For, other than life assurers, counterparties and rating agencies also drive the

need for capital and usually to an amount in excess of the regulatory minimum,

without which it would not be commercially possible for an insurer to carry on

business. Rating agencies have proprietary capital models which they use to

assess available capital resources against capital requirements as a component of

their overall criteria for assigning ratings. In addition, rating agency measures and

targets in respect of gearing and fixed charge cover are important in evaluating the

level of borrowings utilised by groups. So while not mandatory requirements as

imposed by regulators, in practice the rating agency capital measures tend to act

as one of the primary drivers of capital requirements, reflecting the capital strength

required in relation to target ratings. Counterparties will look at agency ratings in

determining both whether to place their risks with an insurer and the amount of risk

they are prepared to place with any particular insurer. The rating can also affect

the level of the premium that can be charged and so profitability. Under Solvency

II there will be self-regulating constraints on internal reinsurance of UK business

due to internal reinsurers being non-rated. This also introduces counterparty credit

risk which leads to increased capital requirements.

5.24 Therefore, if the Government really believes that a capital test is appropriate, the

best option is to have general wording in the primary legislation to the effect of “the

CFCs capital is appropriate to the business need.” This could be satisfied either

through the company being within safe harbour levels of capital or by the company

being able to demonstrate it as a matter of fact.

5.25 There would need to be a variety of safe harbour levels of capital to reflect the

differences in business activities and models. They will also need to be set as

medium to long-term averages in order to cover any short term changes due to, for

example, investment market volatility, catastrophes and the insurance cycle.

These safe harbours would not be hard and fast, but will be there to provide

certainty to those who prefer this method. Below is an indication of what safe

harbours may look like:

300% of local or UK regulatory capital;

A margin over the rating agency capital required for the rating targeted

by the company or group;

19

A margin above the level of capital required by the counterparty for its

own security purposes;

The capital is no higher than the average held in the worldwide group; or

5.26 A company should not be considered to be in breach of the safe harbour test

where within 12 months of the end of the accounting period in question, it pays a

dividend at least equal to the amount by which the level of capital exceeds the safe

harbour amount.

5.27 The margin we have proposed for regulatory capital is based on experience. We

consider at this level the majority of insurance companies applying the test would

be within the safe harbour. We will do further work over the next few weeks to

provide evidence to support or modify this margin, in addition to providing figures

for the other safe harbours.

5.28 Of those above these levels the most common reasons will be companies based in

particularly politically unsettled areas, intragroup reinsurance pooling vehicles,

companies holding additional capital for a temporary period (e.g. for acquisitions or

start-ups) and companies based in countries where there are dividend restrictions.

5.29 Insurance companies who are above these safe harbours or with more complex

capital structures should be able to self-assess that their capital is appropriate to

the needs of the business, at this point without the need to fall into the GPE and all

the added complexities that may come with that. This will probably be done in

conjunction with the CRM or HMRC head office specialists. To support this, long-

term rulings would be needed to provide the right amount of certainty in order to

attract companies back to the UK.

20

6. GENERAL EXEMPTIONS

Lower level of tax

6.1 Our evidence suggests that a number of insurance companies do use this

exemption. Its inclusion in the overall design of the reform will therefore be vital.

We are disappointed that the Government has not considered making the test

easier to calculate and apply. We suggest that the lower level of tax test could be

based on accounting profits adjusted to take out capital gains and losses and the

local tax or relief arising on them.

De minimis

6.2 Both option A and B outlined in the consultation document are over-elaborate and

would be complex to apply. Any investment income condition would provide a

headache for insurers, due to the nature of insurance business. A de minimis rule

should be simple and able to be quickly applied. We are therefore supportive of a

single threshold with no conditions.

Key points

The lower level of tax test could be simplified by basing it on accounting

profits adjusted to take out capital gains and losses and the local tax or

relief arising on them.

A simple de minimis, with no added conditions, in excess of £200,000 should be adopted.

There should be a white list of countries with no conditions.

The ECE should only include a “subject to tax test”.

The profits rate safe harbour should be able to be accessed by all companies undertaking any activity.

The GPE should not include a local management condition or require a complex transfer pricing functional analysis.

Insurance groups should be able to access the finance company partial exemption (FCPE), provided that the exemption is not applied to insurance companies within the group. Lending to insurance companies should be permitted.

Global brands and solvency models, by default, should be viewed as ancillary to trade.

21

6.3 The ABI was pleased that the de minimis in the current rules was increased to

£200,000 in Finance Act 2011. However, it is our view that this is still not high

enough. We would like to see this threshold increased further in order to remove

more companies from the compliance burden of the CFC rules where the risk to

the Exchequer is extremely low.

Excluded Companies Exemption

6.4 The ECE proposals outlined in the consultation document are onerous and more

restrictive than the current excluded countries list (ECL). As proposed the ECE will

significantly increase the burden for insurance groups and place more pressure on

the insurance exemption and other exemptions.

6.5 We have welcomed the discussion thus far with officials on these points, and

especially welcome the positive words relating to removing the investment income

condition. However, as the ECE is designed to provide a “proxy for the lower level

of tax test by exempting CFCs that are located in jurisdictions with tax regimes that

have broadly similar rates and bases to the UK”, there is also no need to maintain

the UK connection element. It does not fit with the principle of avoiding complexity,

as companies will then have to look to one of the other more burdensome

exemptions and complex double tax relief computations may be required. Nor are

such rules needed to maintain a sustainable tax base, as it is highly unlikely that

companies would seek to avoid UK tax by putting money into other high tax

jurisdictions.

6.6 With this in mind we would like to propose the following:

a. A white list with no conditions: Any white list, however small, would

offer significant compliance benefits if no further work was required.

The longer the white list the more certainty the new regime will

provide and the less burdensome the whole regime will be. A white

list would send a very positive message about the ease of doing

business in the UK.

b. A second list with a subject to tax test: This list would include

countries that have special tax rules for certain income streams.

Questioning whether the income is subject to tax, at normal rates,

would provide exclusions only for companies which have broad local

tax exemptions or „holidays‟.

6.7 The lists should cover all countries which have a tax rate similar to the UK and a

comparable tax base. This would be broadly similar to the current ECL; however

newer States also need to be considered, for example the former Soviet Bloc

countries. We would expect the United States and most countries in Part 1 of the

ECL, for example, to be on the white list. In order for the second list to be longer,

a targeted anti-avoidance rule could be applied to dis-apply the exemption in the

case of unacceptable avoidance.

22

6.8 It would be useful if officials could issue draft lists as soon as possible.

6.9 As outlined in paragraphs 8.7 and 8.8 of this response, in order to protect the tax

base and level the playing field between using a branch structure over a subsidiary

structure, when considering the application of the ECE to a company, one should

consider the foreign PEs and the Home State operations of the CFC separately.

Territorial business exemption

6.10 As outlined in paragraph 4.5 of this response, the profits rate safe harbour test,

should be able to be accessed by all companies undertaking any activity.

6.11 As the insurance exemption can only be accessed by companies that undertake

80% or more insurance activity, we assume that other companies within an

insurance group will be able to apply for any of the other exemptions.

General purposes exemption

6.12 We welcome the overall statement that the GPE will not be based on a default

assumption that profits received by a CFC would have arisen in the UK if the CFC

did not exist. Despite this though, the GPE as outlined does cause concern.

6.13 The GPE asks a company to decide what profits are commensurate with the CFC‟s

activity as if the CFC was operating under “uncontrolled circumstances”. Such

conditions are those that would exist if the CFC was an independent entity and not

a member of a group. However, what is not clear is whether the intention is to look

at the subsidiary/PE per se or the activities of the subsidiary/PE. We assume it is

the latter as if it was the former then reinsurance pooling companies within a group

could never be exempt, even though they are commercial, the pricing is done on

an arm‟s length basis and provide a vital role in managing capital in an insurance

business.

6.14 Furthermore, we are concerned that the GPE is heavily focused on the people

function. The consultation document outlines that the number of people employed

are an indication of the profits that would have arisen under uncontrolled

conditions. This condition clearly cannot be applied to financial services as the

number of people required to perform high value activity is less, than say a human

capital intensive business such as manufacturing and call centres.

6.15 In addition, activity is often outsourced, to either a third party or intra-group.

Outsourcing in itself is a way of maximising group profits and providing efficiency.

Therefore it should not be viewed as a high risk activity.

6.16 Following on from this, as outlined below in paragraphs 7.1 and 7.2 of this

response, the local management condition should not be included in the GPE. Not

only does it not fit with a move towards a more territorial regime, it is an additional

condition not found in the current motive test. Its inclusion would therefore, make

23

the regime tougher and not fit with the Government‟s objective to increase the

competitiveness of the UK.

6.17 In paragraph 7.23 of the consultation document, it is suggested that if profits

formerly earned by a UK person are now earned by the CFC they may not be

'commensurate' with the CFC‟s activity. We do not consider this to be consistent

with Article 7 and it is a hangover from the motive test. Indeed if applied strictly all

reinsurance would be caught by this, thus failing to recognise how insurance

operates in the modern business world.

6.18 Lastly we are generally concerned about the potential compliance burdens

associated with the operation of the GPE. The reference to the OECD report on

the attribution of profits to PEs suggests a full, ground up, detailed functional

analysis is required for the CFC to estimate commensurate profits. If this is the

case then this would be more costly and burdensome than the current motive test,

especially if a full transfer pricing study is required.

6.19 Given these concerns we would appreciate clarification from Government on what

exactly their target is in terms of the insurance sector and financial services

generally.

6.20 As with the current motive test, we would expect any clearances given under the

GPE to last until circumstances change.

Finance Company Partial Exemption

6.21 There is no valid reason for insurance groups not to be able to access the FCPE.

For insurance companies the heavy dependence on cross-border finance in the

sector, both by groups importing capital into the UK and those exporting capital to

overseas locations, is commercially driven and tied to capital issues. It is difficult

to extract cash from regulated entities by way of dividend and therefore we need

the facility to access this exemption in order to enhance group liquidity.

6.22 Our exclusion would create a distortion and result in an uneven playing field which

may have legal consequences. There is potential for this to cause a state aid

issue in that captive insurers of non-insurance groups can currently access the

exemption under the proposals.

6.23 We do not consider extending the FCPE to insurers, poses a risk of artificial

diversion of profit from the UK. The UK already has extensive defences against

abuse, including the unallowable purpose rules in the loan relationships legislation,

thin cap, and transfer pricing rules. Furthermore, the consultation document was

clear that the FCPE will not apply to finance income arising from upstream loans to

UK group entities. However, to provide further assurance to the Exchequer, the

exemption could be restricted to non-insurance companies providing financing

within insurance groups.

24

6.24 Officials have asked us how we will use this exemption, if it was available. While

very few insurance groups currently have such a company, the simple answer is in

the same way as any other business.

6.25 We would use a finance company to provide capital and liquidity funding to all

operations within the group, including insurance companies. Providing this sort of

funding via debt is attractive for several reasons:

It can be more accessible in terms of repatriation from a regulatory

perspective and therefore more readily available at Group level if

required;

It does not tie up Group capital in a form that is difficult to access;

It provides subsidiaries with a lower weighted average cost of capital

than pure equity funding;

It could be more capital efficient under Solvency II as debt capital in

subsidiaries may be more available (and thus count towards group

capital) than equity capital; and

Liquidity funding would not normally be provided by way of equity – this

form of funding can be a feature, for example, where broker commission

payments are common (still a common feature of many overseas

markets).

6.26 Some may prefer in future to set up a pure finance company. However, more

typically we would probably look to finance overseas operations via a local holding

company. Typically these may be under a regional hub and spoke model. The

"hub" could take a variety of forms but could be more than just a holding company.

For example it could be a regional service provider, intellectual property owner or

real estate holding company and so using it as a finance company would be a

logical step. Having said this we are supportive of Option C as outlined in the

consultation document.

Intellectual Property Exemption

6.27 While we are not heavily reliant on IP, we would appreciate clarification that the

use global brands and solvency models will be ancillary to trade, and not subject to

any apportionment.

7. OTHER ISSUES

Local management condition

7.1 The local management condition is included in the TBE, the GPE and the

insurance exemption. However, this condition is contrary to the focus of the new

CFC regime – to move towards a more territorial basis of corporate taxation that

better reflects the way that businesses operate in a globalised economy.

7.2 The key test should be that the day to day management of the business sits

outside the UK. If the day to day management is in the same country as the

25

subsidiary/PE or in a third country, then there is no possibility of an artificial

diversion of profits from the UK.

Definition of control

7.3 A test other than a mechanical test, would give rise to uncertainty and additional

complexity. We would therefore prefer option C based on the current test.

However the current test should be amended to deal with specific concerns such

as joint ventures. In many cases joint ventures are deemed “controlled” by the

current test even though the UK parent is unable to access the information or does

not in fact have the power to direct the company. Any new rules will need to

ensure that such joint ventures are not treated as controlled and subject to the

CFC rules. Furthermore, we would like to see the test disregard mutual funds.

Due to the relationship between the funds and investment manager the UK parent

does not generally have control over the decisions of these funds.

Holding companies

7.4 The industry believes that non-local holding companies and intermediate holding

companies which provide a range of intra-group services do not present problems

for HMT/HMRC, provided financing is not a major part of the activities of the

holding company.

7.5 UK groups hold overseas investments through local companies, irrespective of

whether they are located in low-tax jurisdictions. For example, investments in land

and buildings in particular may be made through corporate vehicles for a variety of

reasons unrelated to relative corporate tax rates. Establishment of a local

corporate entity to hold local assets may be required due to restrictions on

ownership to local entities or because the local property market does not transact

in properties directly. It also enables the investor to limit their liability in relation to

the properties held. Where property is held for leasing there will usually be strong

practical reasons for establishing a local company to hold the property, such as

access to local banking facilities or to enable leases and contracts with property

managers to be entered into without cross-jurisdictional complications. There may

also be local, non-corporate, tax considerations including stamp duty efficiencies

or the requirement to establish a local entity to register for indirect taxes.

7.6 The reduction of overseas withholding taxes on investment returns is a legitimate

commercial purpose for the establishment of intermediate holding companies in

other jurisdictions. In the context of a life and pensions group this makes overseas

investment cost effective for policyholders and allows them to access a more

diverse range of assets. This is particularly relevant in the context of approved

pension business where UK policy is to allow retirement savings to grow free of

tax.

26

7.7 Where there is some financing income received in a holding company, a

reasonable solution would be to allow the receipt of „incidental finance income‟ for

holding companies where the main activity is one or more of the following:

the co-ordination of businesses,

the holding of participations in businesses and

the provision of management or professional services.

7.8 Then finance income over and above this should be able to access the finance

company partial exemption.

7.9 There should be a specific exemption for UK intermediate holding companies

which are wholly owned by non-UK parents. The only reason to set up such a

holding company is for operational or regulatory efficiency not the avoidance of UK

tax as the non-UK parent often has the choice to put its regional holding company

in a variety of jurisdictions. Currently such groups will put their EU intermediate

holding companies elsewhere rather than the UK because of the CFC tax risk. If

that risk could be removed then the UK would benefit as the preferred choice for

the establishment of such holding companies.

8. PERMANENT ESTABLISHMENTS

8.1 The underlying theme should be one that results in equivalence of outcome as

between PEs and subsidiaries, and does not simply apply the same rules and

treatment. Any attempt to apply the same rules and treatment indiscriminately to

CFC and PEs will fail because of the real legal and operational differences

between them. This will make it difficult if not impossible for PEs to satisfy many of

the conditions for exemption.

Irrevocable election

8.2 Once the election to opt-in to the branch exemption is made, it is irrevocable if the

accounting period to which it relates has begun. Currently, PEs are subject to

temporary anti-avoidance rules contained in Finance Act 2011. The Government‟s

intention is that those PEs that elect under Finance Act 2011, will in future be

subject to the new CFC regime. As the outcome of the CFC reform is far from

clear, it would be unfair to hold PEs that have opted in, during the interim, to the

irrevocable election, if in the end they will be worse off under the new CFC rules. It

is therefore important to ensure that where a company has made an election under

the Finance Act 2011, its PEs are subject to UK tax treatment at least as

favourable as that to which they are subject currently.

Local management test and profits commensurate with activities

8.3 As outlined above in paragraphs 7.1 and 7.2 of this response, we do not believe

that a local management test is necessary under a territorial CFC regime.

27

8.4 The local management test is not a relevant test for the purposes of this

legislation. The reality is that a PE may consist exclusively of a front office

function, with no local ability to exercise day to day management and control over

the activities of that PE. However a PE will exist. Moreover, in the case of a

dependent agent PE, the agent‟s principal will, by definition, have no local

management presence within the agent. Therefore the only requirement for

eligibility for exemption should be that a PE exists.

8.5 OECD principles ensure that all profits attributable to the PE are commensurate

with the PE‟s activities. We struggle to see why an extra level of complexity needs

to be introduced through the introduction of a rather nebulous “profits

commensurate with economic activities test” which is to be considered after all

transfer pricing adjustments have already been made. In meetings with officials it

was suggested that it has been proposed to deal with quite a specific concern

relating to manipulation of intellectual property. Though it was suggested that the

test would only need to be applied in limited circumstances, if the point has to be

considered by all entities with PEs, the concept would need to be very well defined

in legislation (including drawing a clear distinction with transfer pricing

adjustments), and even then it would impose a considerable compliance burden on

all such entities. This approach is clearly at odds with the objective of minimising

complexity and is an over-reaction to the mischief it is seeking to counteract. A

simpler, more proportionate approach would be to simply apply a targeted anti-

avoidance rule which would trigger this additional test in response to the specific

situation of concern. This would also meet the objective of aligning with modern

business practice.

Operation of the rules to service PEs of UK insurance companies

8.6 Not all PEs of UK insurance companies necessarily perform underwriting activities.

Some may provide back office services for other parts of the entity (e.g. claims

handling, investment management activities, accounting services, etc.) We

consider that such service PEs should still be able to qualify for the insurance

exemption, on the footing that they support the insurance activities of the entity.

This is needed as UK insurance companies are not permitted to perform non-

insurance activities. Whilst in principle we understand that it may not be sensible

to apply gross trading receipt tests to a pure service PE, we do not believe that it

makes sense to deny the insurance exemption, particularly when a “mixed” branch

performing both front and back office services would be entitled to exemption.

Operation of the rules to PEs of a CFC

8.7 When considering the application of the ECE to a company, one should consider

the foreign PEs and the Home State operations of the CFC separately. This

approach has the benefit of protecting the tax base, reducing complexity and

levelling the playing field between using a branch structure over a company

structure.

28

8.8 For example if one was simply to look to the company, this could provide a

significant risk to the Exchequer, as a holding company in a white list country could

be set up with only business that relates to PEs in low tax jurisdictions. On the flip

side, if say a Hong Kong company had PEs throughout the Asia-Pacific region,

including countries such as Australia and Japan, it would be contrary to the

principle of avoiding complexity not to simply treat those PEs as qualifying for the

ECE. If they were not treated as qualifying from the outset, then one would have

to go through the complexity of working through another exemption to exclude

income that has already been subject to a relatively high level of tax.

8.9 This approach should also be adopted for the insurance exemption, provided that

the local management condition is dropped.

Capitalisation test

8.10 Irrespective of our position on a capital test for the insurance exemption, for PEs

specifically, no capital test is required. The OECD allocation of capital already

provides enough protection to the UK tax base to ensure that capital is allocated

correctly. To add another test on top of this would cause immense complexity and

would negate the benefit of opting into the branch exemption in the first place.

29

PART 3 RESPONSE ON LATEST OFFICIALS THINKING

9. INSURANCE EXEMPTION DEVELOPMENTS

9.1 At a meeting at the ABI during the consultation period, officials outlined their

emerging thinking in terms of the application of the rules to insurance companies.

9.2 As we understand it officials do not view insurance as a high risk activity, but the

approach to insurance needs to be broadly consistent with the approach to other

sectors/activities. As one of the key concerns of the new regime (as it is of the

current regime) is investment income, officials are looking to ensure that it is

recognised in one way or another across the spectrum of CFCs, for example by

looking at capitalisation levels or investment income receipts as appropriate.

Outside of financial services it is possible to look at the actual investment income

received and consider that. Clearly this does not work for insurance so to tackle

the potential for misallocation it is necessary to look at the capitalisation of

insurance companies.

9.3 What this means for the insurance exemption is that it could be constructed so that

the only test needed is one that sets out capitalisation safe harbours. These would

likely be mechanical tests, e.g. a multiple of regulatory capital required.

9.4 There is a possibility that there could a specific financial services sector GPE,

which would just ask whether the company is appropriately capitalised in line with

the needs of the business. This would ideally be agreed through a discussion with

CRMs.

ABI response

9.5 We very much welcome this clarification from officials. We consider that such a

test as outlined above is more in line with the Government objectives than the

proposals in the consultation document. We believe that this could be the basis of

a very positive, simplified CFC regime for insurance companies that would meet

our concerns and objectives, as well as Government‟s. However, we are

concerned that there could be an added compliance burden if we are expected to

look at the capital levels of all of our insurance subsidiaries. While we hope that

this will somewhat be mitigated by the ECE and the profits rate safe harbour, a

local company test which excludes a subsidiary/PE if its gross trading receipts are

mainly with third persons would help mitigate the compliance burden.

9.6 Likewise, a separate test that deals upfront with the global risk point would

recognise that this is effectively foreign to foreign business. Such a test would be

consistent with continuing to make London a centre for global insurance business

9.7 Below in Figure 5, we outline how we could see this test working.

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Fig 5 – Insurance exemption latest thinking

EXEMPT

Step 4: Is the CFC appropriately capitalised, according to safe harbours?

Step 1 – Qualifying conditions met?

Look for other exemption

Step 2 – Is the majority of GTR with third parties ?*

STEP 5 : FINANCIAL SERVICES GPE

Is the CFCs capital appropriate to the business

need?

APPORTIONMENTAmount over

capitalised

No

No

No

Yes

Yes

YesYes

Step 3 – Does the majority of the GTR of the CFC relate to (re)insurance of non-UK situsrisk or property?*

No

Yes

No

9.8 As outlined previously in this response, there is no simple capital test that would

work for the entire industry. Therefore the legislation would need to offer both the

option to satisfy the capital test through the company being within safe harbour

levels of capital and by the company being able to demonstrate that they are

appropriately capitalised as a matter of fact.

9.9 In terms of an appropriate safe harbour for this test, an option to either look at

regulatory capital or rating agency capital will be needed in order to accompany all

types of insurance business. It will also need to be an average figure, that looks at

the level of capital over the accounting period. We would therefore propose a test

based on:

300% of local or UK regulatory capital;

A margin over the rating agency capital required for the rating targeted

by the company or group;

A margin above the level of capital required by the counterparty for its

own security purposes;

The capital is no higher than the average held in the worldwide group; or

9.10 A company should not be considered to be in breach of the safe harbour test

where within 12 months of the end of the accounting period in question, it pays a

dividend at least equal to the amount by which the level of capital exceeds the safe

harbour amount.

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9.11 The margin we have proposed for regulatory capital is based on experience. We

consider at this level the majority of insurance companies applying the test would

be within the safe harbour. We will do further work over the next few weeks to

provide evidence to support or modify this margin, in addition to providing figures

for the other safe harbours.

9.12 Companies above these levels are likely to be based in particularly politically

unsettled areas or intragroup reinsurance pooling vehicles. Furthermore,

companies holding additional capital for a temporary period, (e.g. before

acquisition or during a start-up) would also be likely to fail this test although the risk

is likely to be reduced if an average is used. In addition companies based in

countries where there are dividend restrictions are also likely to fail. Such

companies can then look to the financial services GPE for exemption.

9.13 We would expect in the circumstances outlined above, HMRC will look favourably

on them. Furthermore, in circumstances where a company can prove that the

capitalisation is in line with the overall group policy then clearance should be given.

Exchequer impact of proposal

9.14 We do not consider that this approach will result in an increased cost to the

Exchequer. Many general insurers, for example, are no longer headquartered in

the UK and therefore not within the current CFC regime. Therefore, by introducing

this proposal the UK could make itself an attractive Head Office location for

insurers thereby attracting economic activity to the UK, and thus making the

proposal revenue positive

9.15 For those headquartered here, the majority of protection insurance is already

currently reinsured to third parties. Therefore, allowing this to be done intra-group

will have little, if any, effect on costings. Furthermore, as we have outlined

previously, functional analysis, ceding commissions and profits commissions all

result in a substantial proportion of the profits being attributed to the UK regardless

of the amount of reinsurance.

9.16 The current CFC rules do not have a capitalisation test and there is no evidence to

suggest that insurance companies are typically over-capitalised to a level that

reflects artificial diversion of profits from the UK. Therefore, there will be no

Exchequer impact from introducing a capital test, provided the levels are robust

enough to exclude harmful captive insurance practices.

10. GPE DEVELOPMENTS

10.1 Officials have very recently indicated to us, their developing thinking on how they

see the GPE operating and how they could affect insurance companies. While we

would need to see the detail of this before being able to formally respond, as

described to us, the GPE will be a two part test which first looks at the passive

income (in our case capital levels) and then applies a selection of subjective tests

32

to the “active” part of the business. There was also a suggestion that this could be

used as a gateway test to the regime.

10.2 As a gateway test this will definitely not meet the Government‟s aims of certainty or

attracting companies to the UK. Our members who are not domiciled in the UK

have said that such an approach would not entice them to consider moving to the

UK.

10.3 Regardless of whether this is used as a gateway test, or not, we consider this

latest thinking is wholly inappropriate for the insurance sector as we do not seek to

enter into abusive or artificial transactions with CFCs. The fact that officials‟ accept

that intragroup reinsurance vehicles are likely from the outset to fail two out of the

three tests, also means that these tests are not targeted correctly. Furthermore,

the suggestion that the final rules may not have an insurance exemption and

instead insurance will be dealt with in the financial services GPE, would result in

insurers having the additional burden of proving the active GPE test, while others

could easily get out under the territorial business exemption. This would put the

insurance sector on an uneven playing field with other sectors and is completely at

odds with officials‟ recent statement to us, that insurance is not viewed as a high

risk activity

10.4 Finally, this would introduce untried and untested concepts into UK law, thus

generating new compliance burdens for no good purpose, and creating

uncertainty. This uncertainty would deter rather than attract insurance groups

which might otherwise have wanted to invest in the UK. Furthermore, due to this

late development, this brings the target date of Finance Bill 2012, into serious

doubt.

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Annex Movement of insurance group domiciles Groups that have redomiciled from the UK in the last five years

Company Headquarters location Date

Hiscox plc Bermuda September 2006

Omega Insurance Holdings Ltd

Bermuda September 2006

Kiln Ltd Bermuda March 2007

Hardy Underwriting Bermuda Ltd

Bermuda Feb 2008

Beazley plc Ireland Feb 2009

BRIT Insurance Holdings plc

Netherlands December 2009

Groups that have redomiciled from other locations but chose not to come to the UK

Company From To Date

ACE Cayman Switzerland

XL Cayman Ireland

Flagstone Reinsurance Holdings

Bermuda Luxembourg May 2010

Allied World Assurance Company

Bermuda Switzerland Dec 2010

For further information and/or clarification please contact: Megan McInally Policy Adviser Taxation, ABI Direct Line: 020 7216 7692 megan.mcinally@abi.org.uk