Captivating Canadians with Tax Agreements

Mark Allitt, Senior Manager, KPMG Advisory Limited (Bermuda)

Jason Carne, Partner, Insurance, KPMG Bermuda

Nunzio Tedesco, Partner, Tax, KPMG Toronto

The subject of Tax Information Exchange Agreements (TIEAs) is a hot topic within the captive insurance industry, and for good reason. To date, Canada has ratified three TIEAs with captive jurisdictions, including Bermuda and The Cayman Islands. These new TIEAs open the choice of captive domicile available to Canadian organizations. They also provide an opportunity for Canadian firms, many of which have located captives in countries sharing a double-taxation treaty with Canada, to re-domicile their operations to alternative jurisdictions that may provide many commercial benefits while enjoying a comparable or potentially more efficient tax position.

What is a TIEA?

TIEAs outline a framework for exchanging information between countries to help administer and enforce tax laws. These agreements are typically based on Organization for Economic Cooperation and Development (OECD) standards. They are seen as an important tool to prevent tax evasion in circumstances in which no comprehensive tax treaty is in place between the countries concerned. While this is their primary purpose, a number of TIEAs, such as the one between Bermuda and Canada, provide additional benefits for Canadian companies.

Under Canada’s tax regulations, a “designated treaty country” includes a jurisdiction with which Canada has a TIEA in effect. This enables Canadian foreign affiliates resident and carrying on active business in a TIEA jurisdiction to be eligible for “exempt surplus” treatment on their earnings, enabling them to repatriate profits to Canada without incurring Canadian tax. Previously, active business income earned by foreign affiliates in non-treaty countries was subject to Canadian tax when repatriated to Canada as “taxable surplus.”

Additionally, other forms of income earned in the TIEA jurisdiction – such as interest received from another foreign affiliate resident and carrying on an active business in a third jurisdiction (also being a TIEA or treaty jurisdiction) – may be repatriated on a tax-free basis to the Canadian parent, so long as the amount is deductible in computing active business income of the first affiliate.

Such benefits have previously been conferred only to affiliates carrying on business in countries with a double-tax treaty with Canada – Barbados, for example. The new TIEAs therefore establish more of a level playing field in comparison to treaty jurisdictions.

By extending such tax benefits to countries that enter into TIEAs with Canada, the Canadian federal government is offering an incentive to attract more jurisdictions to join its TIEA network. At the same time, it discourages investment in countries that do not come to the table. If Canada does not enter a TIEA with a country within five years following the initiation of negotiations or a written invitation to enter into negotiations, active business income earned by a foreign affiliate in that country is taxed in Canada on an accrual basis (i.e., the income is taxed as it is earned as “foreign accrual property income”).

When do TIEAs take effect?

Generally, a signed TIEA comes into force once both countries have ratified it. In the example of the Bermuda TIEA, the ratification process was completed in June 2011 and the agreement formally entered into force on July 1, 2011. Although the TIEA entered into force only midway through 2011, its benefits can be enjoyed by foreign affiliates of Canadian organizations for their entire tax year that includes this date. Similarly for the Cayman Islands TIEA, both countries ratified the agreement in June 2011 and came into force on June 1, 2011.

TIEA v. Double-Tax Treaties

Traditionally Barbados has been the jurisdiction of choice for many Canadian organizations operating a captive because of its double-tax treaty with Canada. But we expect to see an increase in Canadian captives in TIEA jurisdictions going forward.Due to differences in residency requirements to qualify for exempt surplus treatment under Canada’s tax treaties and TIEAs, under current policy, it may be easier to qualify for residency (and thus exempt surplus treatment) under TIEAs than treaties.For example, to qualify under a treaty, a foreign affiliate must meet two tests. A test under common law based on mind and management, and a residency test under the treaty, which is based on liability for tax in the country due to domicile, residence or place of management or incorporation. Any special provisions that deem certain entities not to be treaty-resident also need to be considered. In contrast, to qualify under a TIEA, the foreign affiliate only needs to meet the common law mind and management test.

Furthermore, unlike Barbados, where captives can be taxed on profits at rates ranging from 1.75% to 2.5%, many TIEA jurisdictions have a zero corporate income tax rate and do not impose capital gains tax or withholding tax. Therefore, by establishing a captive in a TIEA jurisdiction, a Canadian corporation may benefit from the additional tax savings available to it. This could represent a substantial benefit for companies generating a sizeable active business income.

TIEA jurisdictions may also provide other commercial benefits such as specialized and advanced business infrastructure, convenient locale to the Canadian parent and, in the case of Bermuda, the presence of commercial insurance and reinsurance companies that allow captive owners and operators to access open-market underwriting capacity not found in other captive domiciles.

Why Establish a Captive Now?

As a result of the fallout from the recent financial crisis, cost control and effective risk management is now higher on the agenda for most organizations than it has been for some time. Captives can help reduce the cost of insurance programs by mitigating or avoiding commercial insurers’ administrative overheads, as well as by recapturing underwriting profits and investment income that would have otherwise gone to the commercial marketplace. Other potential savings can be made by using a captive to access the reinsurance markets, which operate on a lower cost structure than direct insurers.

In addition to tax planning advantages, additional financial benefits of using captives include allowing the parent company to earn investment income on unpaid loss reserves, and enabling a captive owner to benefit from its own individual loss experience rather than pay higher premiums based on industry-wide losses. A well-run captive can also create a focal point for enhanced risk management and claims control and thus make significant further contributions to the bottom line.

Captives help provide a greater degree of flexibility and control over the risk management function by allowing programs to be designed in response to specific coverage, premium and retention requirements. These programs can be designed to offer individual operating units of a company the coverage and deductibles they require, while at the same time the overall control and design of the insurance program is maintained at the corporate level. Thus captives can help centralize the financial and administrative operation of a corporate insurance program.