Economic substance regulation could spell trouble for offshore captives
Updated: Mar 10, 2020
Economic substance regulation enacted to appease the EU is undermining the business case for offshore captives, according to Mark Chudleigh, a partner at Kennedys in Bermuda.
Writing in a blog post on the Kennedys website, Chudleigh said: “Whether or not the EU had captives in mind when they devised their economic substance requirements, captives, like almost all offshore insurers, are unavoidably subject to the new substance requirements.”
The result is that, despite the hardening market, offshore jurisdictions such as Bermuda, Cayman and Guernsey are not seeing the kind of increased activity around captive formations that might be expected, he said.
“A mild chill has spread over the sector as a result of uncertainty over the impact of the European Union’s so-called economic substance requirements,” explained Chudleigh. “These requirements are designed to eradicate harmful tax practices in certain low or no tax jurisdictions, principally through the use of so-called shell companies, whereby structures may attract profits but do not reflect real economic activity.”
Chudleigh stressed the significant differences between captives and shell companies that justify a different treatment for captives. “Captive insurers are regulated and subject to solvency and other requirements in their domicile, which typically apply a risk-based approach to regulation,” he said.
Chudleigh noted that some offshore jurisdictions, including Bermuda, already had economic substance requirements for captives. Bermuda requires captives be licensed by the Bermuda Monetary Authority, which satisfies the economic substance requirement.
But with Bermuda’s Registrar of Companies suggesting it will independently monitor the economic presence of captives, captives may be required to file a second, detailed declaration with the Registrar under the separate, EU-driven substance rules, he warned.
“Captives will now be reviewing, and possibly reforming, the nature and extent of core activities conducted offshore,” said Chudleigh.
Most captives have limited need for dedicated staff or premises, making it harder to demonstrate substance, noted Chudleigh. He called for “a more nuanced and considered approach to demonstrating compliance with the substance requirements” for captives.
But Chudleigh clarified that the “mild chill” that had descended on offshore captives did not represent a complete freeze of the industry.
“It would be alarmist to view the EU’s substance requirements as an existential threat to the offshore captive industry,” he said. “It is to be hoped that the EU will recognise that captives do not engage in harmful tax practices. Indeed, forcing offshore captives to close may only lead to them relocating to Vermont and other jurisdictions not subject to the EU requirements.”
In fact, in the case of Bermuda “the increased focus on on-island activities may not be especially burdensome and, indeed, may enhance Bermuda’s attractiveness over jurisdictions that do not have a developed insurance market,” said Chudleigh.
The recent focus on the substance requirements may also increase the attractiveness of group captives, where economies of scale justify dedicated employees and premises, noted Chudleigh. Other alternative insurance arrangements such as mutual insurance, and rent-a-captive, may also benefit, he added.
Mark Chudleigh, Kennedys, Economic substance regulation, Bermuda Monetary Authority