ILS have been issued since the mid-90s. The structures utilise the risk appetite available in capital markets for reinsurance purposes. By issuing ILS, an insurer can utilise investment capacity otherwise not accessible through the ordinary reinsurance channels. When capital markets were still booming, the issuance of ILS as an alternative investment grew. A part of the sales pitch was that, if structured correctly, the performance of ILS was not linked to the market in general. As with other structured finance instruments, the demand came to a halt following the financial crisis. The losses suffered on instruments backed by subprime mortgages made investors wary of complex financial instruments. As capital markets now gradually return to normal, investors' risk appetite is growing. At the same time, insurers recognise the need to adjust their risk profile. Hence, the market seems ready for the comeback of ILS as an alternative investment form.
The instruments referred to as ILS can take many forms and there is little point trying to describe all varieties. An insurer (sponsor) intending to transfer risk into capital markets normally establishes a special purpose insurance/risk acceptance vehicle (SPV) in a jurisdiction allowing this type of SPV. The sponsor enters into agreements with the SPV to transfer certain specified risks out of its portfolio to the SPV. The investors are offered the opportunity to participate in the risks assumed by the SPV. This participation is structured through bonds, shares, derivatives or other financial instruments. The investor invests the nominal sum upfront or provides collateral for the risk assumed under the instrument. Assets corresponding to the nominal sum are often held in trust and investment income generated is returned to the investor. Triggering events are specified for the instruments. The triggering event may either entail reference to the losses suffered by the sponsor or to an index of the industry-wide losses suffered by an event. If a triggering event occurs, investors risk losing whole or part of the nominal amount. The triggering event may relate to longevity, mortality and catastrophe risks.
Swedish tax implications for the sponsor
For a Swedish sponsor, the introduction of an ILS structure entails establishing a foreign SPV. Several of the jurisdictions having the relevant legislation in place also have favourable tax regimes. This adds to the complexity described below. As the purpose of the structures is to manage and reduce risk, tax risks should also be considered when choosing jurisdiction. These factors naturally also impact the overall financial outcome of the ILS structure. In the following I describe what I perceive to be the main Swedish tax issues for a Swedish sponsor. These are:
- The tax-deductibility of the premiums paid to SPV;
- Risk of controlled foreign company (CFC) taxation at sponsor level for profits of SPV; and
- Risk of Swedish permanent establishment for SPV.
To ensure the premiums are tax-deductible, a Swedish sponsor should primarily aim to ensure that the SPV chosen is considered a proper insurance company in its jurisdiction. It should be regulated and supervised by the relevant local authority. It is also important that the premiums payable be calculated in accordance with actuarial principles. Since the SPV normally would be considered a related company pricing must be arm's-length.
If the SPV is not a regulated insurance company, the question arises as to how the payments should be treated under Swedish tax law. It may of course still be possible to argue that the payments to the SPV for the risk assumed should still be tax-deductible. However, tax- deductibility will not be as clear as where actual insurance premiums are paid to an ordinary regulated insurance company. As may be seen from the outline above, an SPV is established only for the purpose of assuming risks under a certain specified structure and situation and normally reinsures only one insurer. In a worst-case scenario, the payments could be construed as a mere pooling of assets to cover future unforeseen risks. Such payments for pooling of assets are normally non-deductible for Swedish tax purposes. Depending on the structure, it should also be considered whether the payments could be characterised as interest payments for Swedish tax purposes. If the payments are viewed as interest payments their tax-deductibility must also be tested under the Swedish rules restricting the tax-deductibility of interest expenses.
If the payments are not disqualified from tax-deductibility because of their character per se, the next obstacle is whether the expenditure is a cost related to the sponsors' business operations. In the case of an insurer transferring risks to the SPV this should be a quite straightforward analysis. Reducing the risks kept for own account and freeing up capital should normally be seen as a part of the ordinary business of an insurance company. However, even though a simple analysis, it is vital to have proper documentation of the purpose of the transactions and the risks that are being transferred to the SPV.
When it has been established whether the payments are tax-deductible for the sponsor, the Swedish CFC regime must be considered. An application of the CFC regulations may render the chosen alternative unfavourable. Under the Swedish CFC regime, direct and/or indirect control of more than 25% of a foreign legal entity may result in a taxation of the SPV's profits in the hands of the Swedish sponsor. For an SPV's income to be subject to Swedish CFC taxation at sponsor level, two criteria must be fulfilled:
- The SPV must be considered low taxed (the low taxed test); and
- The low-taxed foreign legal entity should have a positive income as calculated under Swedish tax rules (the CFC income calculation).
Under the main rule, a foreign legal entity taxed at less than 12.1% (55% of the Swedish statutory tax rate) of its earnings calculated under Swedish rules is considered low-taxed. For the income calculation, please see the description below, which includes some of the relevant considerations. The main rule is subject to several exceptions. For example, there are white listed jurisdictions. Hence, even where the foreign legal entity fails the low taxed test, it will be deemed not low taxed if it is established in a jurisdiction included on the white list. To complicate matters further, there are exceptions to this white list in certain cases. For some jurisdictions, a foreign legal entity conducting intra-group financial business operations will still be regarded as low taxed under the CFC rules even though the jurisdiction concerned is white listed. Then again, there are exceptions to this exception to the exception. In addition, the relevant double tax treaty may have to be considered as part of the analysis. As seen above, it may often prove complicated to establish whether a foreign legal entity should be considered a CFC.
Where it is established that the SPV is deemed low taxed following the low taxed test and no exemptions apply, the CFC income to be taxed at sponsor level must be calculated. As noted above, the income is calculated in accordance with Swedish rules and under the fiction that the foreign legal entity is performing business in Sweden. Here, the actual financial instruments issued must be considered. If the payments made from the SPV under these instruments could be regarded as interest and the investor is a member of the same unity of interests as the SPV, the interest payable may not be tax-deductible under the Swedish restrictions on the tax-deductibility of interest expenses. An application of these rules on the payments under the instrument could thus have the following overall result (provided that the premiums are deductible):
- Deduction for premiums paid by the sponsor to SPV; and
- CFC taxation of the premium income of the SPV without corresponding tax deduction for interest paid under the financial instruments.
The same principle would apply where the SPV issues preferential shares, since such distributions/dividends would not be deductible under Swedish tax rules and would thus not reduce the income in the CFC's income calculation. If the CFC's income is very limited, for example if the premium income is offset by interest expenses on the ILS, the ILS structure may still be viable even where SPV is a CFC.
The Swedish rules on permanent establishments (PE) largely adhere to the OECD principles. Hence, there is a risk of the sponsor attracting PE status for the SPV in Sweden should it be deemed controlled by the sponsor from Sweden. To avoid the risk of a PE, it is advisable that any decisions on the SPV be taken outside of Swedish territory. The SPV should also have true substance, for example adequate resources for performing its business. Sweden could otherwise claim the power to tax the profits of the SPV even though the CFC regime does not apply. Any impact of such taxation must be carefully considered.
As a final comment, it may be noted that Sweden does not levy withholding taxes on interest payments or on insurance premiums in general.
Swedish tax implications for the investor
There are several tax-related issues for an investor to consider before deciding to invest in an ILS. For example, the following items may be of importance:
- The relationship between the sponsor, the SPV and the investor. Should these be related parties or otherwise considered to be members of the same unity of interests, this could limit the tax-deductibility of a loss on the ILS;
- The classification of the ILS as a financial instrument, reinsurance contract or merely a contract. The differences between these classifications are mainly about timing;
- If it qualifies as a financial instrument, classification of the ILS for tax purposes. If it is classified as a share-based instrument and not held as a current asset, losses may only be offset against gains on other similar instruments.
- If classified as a share-based instrument it should be analysed whether the holding qualifies under the participation exemption regime and thus if gains are tax exempt and losses non-deductible;
- Whether periodical income should be taxed as interest or dividend or whether it forms part of capital gains taxation and if so at when;
- Tax treatment of a loss if an insured event occurs, a question of tax-deductibility and the timing of tax-deductibility; and
- Whether investors risk recognising the SPV as a CFC and potential recognition of CFC income. If structured as a shareholding or if the investor exercises control over the SPV, the investment could be deemed a CFC for a Swedish investor (see the above discussion concerning the sponsor).
In general, the answers to these questions all depend on the facts and circumstances of the specific ILS structure. There are thus no generic answers to these questions. An investor should carefully analyse the structure and the tax implications before any investment decision. The analysis should include both taxation on a going concern basis and taxation if a loss-triggering event occurs.
A valuable and versatile tool
An ILS structure could prove a valuable and versatile tool for the risk management of an insurer. Where reinsurance capacity proves limited, the structures offer additional capacity. On the flip-side of the coin, ILS provide insurers with an investment opportunity for diversifying the risks assumed and geographical risk regions covered. Depending on the chosen structure, the ILS could be considered either to be an investment or a reinsurance contract. For investors other than insurers, ILS could represent an interesting alternative investment and the opportunity to participate in the risks and rewards of the insurance market without being a regulated entity.
Any successful implementation of an ILS structure or investment in ILS presupposes that all regulatory, financial and tax aspects have been analysed properly prior to the decision. Hence, before any business decision is taken, the full financial impact (including tax) of the alternatives must be properly assessed.
Kristofer Brodin is a senior tax manager in the KPMG financial services (FS) tax practice and is based in Stockholm. He is specialised on Swedish and international corporate taxation. He also advises on taxes and duties specific to the financial sector such as the EU FTT proposals and the Swedish bank levy (stabilitetsavgift). Brodin is knowledge manager for KPMG's FS tax practice in Sweden.
Brodin has experience in a vast variety of tax issues arising within the financial services industry, including issues specific to banking, non-life and life insurance. He advises domestic and international clients on restructurings, M&A, cross-border investments, outsourcing projects, asset finance, and structured finance transactions.
Before joining KPMG, Brodin served as head of corporate income tax and products at one of the major Nordic banking groups.
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