Cell captives – More pain!

In the previous article we dealt with the income tax consequences of the recent judgement on the deductibility of short-term insurance payments made to cell captives that are essentially investment instruments. Unfortunately the potential pain does not stop there. This article deals with the potential VAT implications.

Introduction

Cell captives are commonly used mechanisms in industry to act as a ring-fenced insurance product whereby insurance premiums are paid into a cell captive for the exclusive benefit of a single insured.

Certain of these arrangements do not comply with the essentials of a contract of insurance. The court therefore held that these contracts were not contracts of insurance, but essentially investment vehicles.

The judgement dealt with the deductibility of premiums paid into the cell captives for income tax purposes. The potential of VAT implications may also be challenging.

VAT and short-term insurance

The premiums

Cell captives are generally registered as VAT vendors. The cell captive will issue tax invoices to the insured for premiums levied and account for output tax to SARS. The insured will claim the corresponding input tax deduction.

If it subsequently transpires that no taxable supply was made, the contract not being a contract of insurance, the agreement can be cancelled and a credit note issued for the premiums previously invoiced.

The cell captive can recover the output tax previously paid to SARS and the insured will be required to reverse any input tax previously claimed. Based on the rules governing credit notes, the adjustments must be made in the tax period that it becomes apparent that a credit note should be issued. This is normally the tax period in which the credit note is actually issued.

There will accordingly be no need to make any retrospective adjustment with regard to disclosure made in historic VAT returns. It can (and must) be done in the tax period that the credit note is issued.

Do I hear a sigh of relief?

Unfortunately the good news ends here!

Payments of claims

The treatment of claims, specifically deductions allowed when claims are made by an insurance company, are not dealt with under the normal VAT rules, but under specific deeming provisions. This means that the tax period in which credit note adjustment may be made does not apply to the deeming  provisions.

So what is the impact?

An insurer is entitled, when making an insurance claim payment, to make a deduction computed by multiplying the tax fraction (15/115) to the amount paid. If it subsequently transpires that the deduction was not allowable as the contract was not a contract of insurance, a correction will have to be made in the tax period in which the deduction was originally made. It would appear that the only manner of avoiding penalties being imposed on the underpayment of VAT, would be to apply for voluntary disclosure prior to SARS challenging the position.

The recipient of the claim must account for output tax by applying the tax fraction to the amount received in the tax period that it has actually been received. As the debit and credit note correction mechanism cannot be used under these circumstances, the taxpayer will have to apply to SARS for a refund under the Tax Administration Act, which could be a challenging process.

Summary

We may be accused of making a mountain out of a mole hill, but the red flags are out there. Anybody involved in cell captives would be well advised to obtain advice as soon as possible as to their potential exposure following the judgement.