Cell captives

Short-term insurance cell captives are as common in practice. The Western Cape division of the High Court of South Africa recently handed down a judgement that has sent shivers down the spine of the cell captive industry.

Introduction

Cell captives in the short-term insurance industry is widely used as a mechanism for self-insurance in large entities. The captive serves as a ring-fenced insurance policy whereby claims are paid from the cell captive limited to the capital in the cell captive.

The deductibility for income tax purposes of the short-term insurance premiums paid into the cell captive has recently been challenged successfully by SARS in a judgement handed down by the Western Cape division of the High Court of South Africa.

While the judgement is likely to be appealed, the view taken by the court cannot be ignored.

This article deals with the principles applied in the case. In the next article, we shall deal with the potential VAT implications of the judgement.

The legal framework

Section 11(a) of the Income Tax Act allows deductions of expenses actually incurred during a year of assessment. Expenses are regarded as being actually incurred when it has been paid, or where an unconditional liability to pay for the expenses has been incurred during a year of assessment.

Section 23H of the Income Tax Act only allows a deduction of expenditure paid during a year of assessment, if the benefits of the expenses do not continue beyond six months into a subsequent year of assessment (pre-paid expenses).

Where do cell captives fit in?

The purpose of a cell captive is to provide insurance against uncertain future events that may be to the detriment of the insured entity. To mediate the risk of incurring large insurance premiums without any claims against the premiums, a ring-fenced insurance product (referred to as a cell captive) is created whereby the insured enters into a contract of insurance with the cell captive, as the insurer.

A premium is determined for the insured risk and is paid to the cell captive, being the insurer. If no claim is made under the policy, the insured is refunded an amount equal to the capital left in the cell captive on expiry of the contract of insurance (kind of a 100% six-monthly out-bonus!).

The amount refunded is normally paid back to the cell captive as premiums for a new insurance policy for the next six months.

In practice, the capital in the insurance policy is treated as effectively belonging to the insured and any investment income generated from the investment of the capital is credited to the capital account of the cell captive.

What did the court say?

The court held that the essence of the arrangement was an investment product whereby amounts were invested on behalf of the insured and on which the insured earned investment income.

It therefore concluded that the contract was not a contract of insurance from a legal perspective (after the court has examined the essentials of a contract of insurance). One of the critical essentials noted by the court as not being present in the contract was the assuming of risk by the cell captive.

The court did not hold that the arrangement was a sham transaction; it concluded that the contract that established the cell captive was not a contract of insurance and that the premiums paid were therefore not short-term insurance premiums, but amount invested in an instrument.

The court therefore concluded that the amounts were not actually incurred as envisaged in section 11(a) of the Income Tax Act,  but were invested for the benefit of the insured. As such it denied the deduction claimed by the taxpayer in respect of the premiums paid.

Conclusion

The use of short-term insurance cell captives is widely used in practice in South Africa. SARS is likely to challenge taxpayers involved in cell captives, based on the outcome of the judgement.

While the judgement will probably go on appeal, taxpayers involved in cell captives must considered their position and whether they can distinguish their facts from the facts on which the judgement was based. If the facts cannot be distinguished, the taxpayers are at risk of having the historic deductions claimed disallowed, with the further risk of penalties, interest and understatement penalties being imposed.

Proactive attention to this matter would be prudent.