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FAPI And Offshore Captive Insurance Arrangements


July 28, 2015


Angelo Discepola

Pre-2014 Regime

Paragraph 95(2)(a.2) of the Income Tax Act (Canada)[1] was introduced as a measure to restrict the tax benefit associated with transferring income from the insurance of a risk in respect of a person resident in Canada, property situated in Canada or a business carried on in Canada (each a Canadian Risk) to an offshore captive insurance entity. In short, paragraph 95(2)(a.2) includes in income from a business other than an active business (which is included in foreign accrual property income, or FAPI) a foreign affiliate’s income from the insurance of Canadian Risks (and any income that pertains or is incidental to that income). Paragraph 95(2)(a.2), however, contains a de minimis exception that allows a controlled foreign affiliate (CFA) to earn up to 10% of its income from Canadian Risks without that income being subject to FAPI.

Budget 2014 Amendments

Paragraphs 95(2)(a.21) and (a.22) were introduced as part of the 2014 Federal Budget to curtail the use of certain arrangements (known as “insurance swaps”) designed to circumvent paragraph 95(2)(a.2). An insurance swap is essentially an arrangement whereby a CFA insures foreign risks, but maintains economic exposure to Canadian Risks (i.e., its return on the foreign risks “tracks” the return on the Canadian Risks). Prior to the 2014 Federal Budget, paragraph 95(2)(a.2) did not apply to insurance swaps because the CFA would not own the Canadian Risks; therefore, the income generated by the CFA from the insurance of the foreign risks, while economically tied to the Canadian Risks, would be included in its income from an active business, which is not included in FAPI.

Paragraph 95(2)(a.21) deems foreign risks to be Canadian Risks of a CFA (and therefore subject to FAPI by virtue of paragraph 95(2)(a.2)) in the context of insurance swap transactions. Paragraph 95(2)(a.21) applies when (i) the CFA’s risk of loss or opportunity for gain or profit from the foreign risks could reasonably be considered to be determined, in whole or in part, by reference to the fair market value, revenue, income, loss, cash flow or any other similar criterion in respect of one or more risks that were insured by another person or partnership (a Tracked Policy Pool); and (ii) 10% or more of the Tracked Policy Pool comprises Canadian Risks. Further, by virtue of paragraph 95(2)(a.22), activities of a CFA performed in connection with an insurance swap transaction are deemed to be a separate business and any income of the CFA from such activities would be subject to FAPI.

Budget 2015 Amendments

According to the Department of Finance, certain taxpayers were quick to identify deficiencies in paragraphs 95(2)(a.21) and (a.22). Although no example is provided in the 2015 Federal Budget, the transactions apparently achieve exactly the same results paragraphs 95(2)(a.21) and (a.22) were intended to prevent and involve a CFA’s “ceding” of Canadian Risks. In broad terms, the ceding of insurance risks involves the transfer by one insurer (the cedant) of all or part of an insurance risk to another insurer (the accepting insurer). In this type of arrangement, the cedant typically receives a commission in respect of the claims ceded and must pay a premium to the accepting insurer.

The 2015 Federal Budget introduced new paragraphs 95(2)(a.2)(iii) and (iv) to include in income from a business other than an active business, income of a CFA in respect of the ceding of Canadian Risks.[2] More specifically, under clause 95(2)(a.2)(iii)(A), income from services in respect of the ceding of Canadian Risks will be included in FAPI (e.g., income from claims processing). Further, clause 95(2)(a.2)(iii)(B) provides a formulaic inclusion for income arising from the ceding of Canadian Risks. The amount included in income is the difference between (i) the fair market value of the consideration provided in respect of the ceding of the Canadian Risks and (ii) the CFA’s cost in respect of Canadian Risks.

For example, assume that a CFA of a taxpayer insures a basket of Canadian Risks and cedes those risks to another foreign insurer (that is not a CFA of the taxpayer) in consideration for a $1-million commission. In the absence of clause 95(2)(a.2)(iii)(B), if the CFA were to cede the Canadian Risks and receive property with an embedded profit of $1 million in satisfaction of its commission, it could take the position that paragraph 95(2)(a.21) does not apply because it does not have economic exposure to the Canadian Risks. In this instance, however, clause 95(2)(a.2)(iii)(B) would now apply to include in the CFA’s income from a business other than an active business the difference between $1 million (i.e., the fair market value of the consideration provided in respect of the ceding of the Canadian Risks) and the CFA’s cost in respect of Canadian Risks.

Questions arise, however, regarding the interpretation of the terms “fair market value of the consideration provided” and “cost” in clause 95(2)(a.2)(iii)(B). More specifically, it is unclear whether “consideration provided” refers to the commission payable to the CFA in exchange for the ceding of the Canadian Risks (as illustrated in the example above) or whether that phrase refers to the expected gross premiums payable in respect of the Canadian Risks. In the same way, uncertainty also exists as to what amounts form part of the CFA’s “cost” for the purposes of clause 95(2)(a.2)(iii)(B). Needless to say, these variations in interpretation can have a material impact on a CFA’s FAPI (or FAPL) computations.

Moreover, it is interesting to note that contrary to paragraph 95(2)(a.21), clause 95(2)(a.2)(iii)(B) does not contain a de minimis exception. Accordingly, the ceding of any Canadian Risks by a CFA may give rise to a FAPI inclusion even if its gross premium revenue from the insurance (or reinsurance) of such risks is less than 10% of its total gross premium revenue.

Finally, under paragraph 95(2)(a.2)(iv), if paragraph 95(2)(a.2)(iii) applies to include any income in respect of the ceding of Canadian Risks in the CFA’s income from a business other than an active business, income that pertains to or is incidental to that income will be deemed to have been earned as part of a separate business and included in its FAPI as well.

[1] All statutory references herein are to the Income Tax Act (Canada), as amended.

[2] For the purposes of this section, references to Canadian Risks shall include references to “specified Canadian risks” (as defined in paragraph 95(2)(a.23).

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