Budget 2017: Reinsurance– Catalyst for growth vexed with tax uncertainties

Deloitte Haskins & Sells LLPPrivatization of reinsurance has become the latest buzz word in the insurance world. Major foreign players such as Reinsurance Group of America, Munich Re, Hannover Re, Swiss Re etc. have recently received R3 approval from IRDA. R3 is the final approval from IRDA to begin reinsurance business through a branch in India. Some other major players such as GenRe and XL Catlin also have their applications pending at the initial stages. Till December 2016, the state owned General Insurance Corporation was the sole reinsurer in the country. The much needed reforms in this sector were initiated with the passing of the Insurance Laws (Amendment) Act, 2015 which amended the Insurance Act, 1938. The amendment inter-alia paved way for foreign reinsurance companies to set-up a branch in India. The reforms also enabled domestic players to enter the reinsurance industry with ITI Reinsurance getting approval from Insurance Regulatory and Development Authority of India (‘IRDA’) in December 2016 for commencing reinsurance operations.Reinsurance is essentially an insurance for insurance companies. Reinsurance companies help primary insurers insure a variety of risk which has in turn ensured that insurance companies write more business. By freeing up capital requirements of the primary insurers, reinsurance companies have facilitated economic growth and helped in creating stability. Since this is a new sector for private corporations, there are no tax laws specifically applicable to reinsurance companies. There is accordingly an urgent need to provide clarifications which will facilitate and smoothen the set-up of this important segment of the insurance business. This article highlights some of the direct tax considerations that would be faced by the new players in reinsurance industry. Absence of specific regime for taxation of reinsurance industryCurrently, there is a specific regime for taxation of insurance companies under the provisions of the Income-tax Act, 1961 (‘Act’). As per the provisions of section 44 of the Act, profits and gains from insurance business is to be computed in accordance with the rules outlined in the First Schedule. Although reinsurance companies are engaged in insuring the insurance companies, there is no specific provision under the Act relating to taxation of profits from reinsurance business. Applicability of withholding tax on payments made by Indian branch to head officeThere may be situations where the Indian branch of a foreign reinsurance company would cede risk to its head office located outside India. In which case, the Indian branch would be required to pay premium to its foreign head office.Currently, there are challenges in claiming deduction for payments made by branch to head office under the provisions of the Act (except under section 44C of the Act) as well as on deduction of tax on payments made by branch to head office.The Finance Act, 2015 had clarified on the taxability of interest paid by branch of a foreign company in India to the head office located outside India. However, this clarification was specifically for interest payments by Indian banking branch to their head office. In the absence of clarity, payments made by Indian branch of a reinsurance company to its foreign head office is likely to attract litigation. A clarification on deduction for payments made to foreign head office as well as on deduction of tax on such payments will help mitigate litigation to a large extent.Withholding tax on income of reinsurance branchPayments to reinsurance branches of a foreign company will attract withholding tax at 40% since the branch will be construed as a permanent establishment of the foreign company. There is an urgent need to introduce a provision which allows the Indian branch to receive income without any withholding tax to avoid a significant cash flow issue for the branch. This can be in the form of a similar benefit given to bank branches.   Presuming that First Schedule were to apply to reinsurance companies, some of the other direct tax considerations are as follows:Applicability of First Schedule in case of life reinsuranceCurrently taxation of life insurance business is covered by Part A of First Schedule whereas Part B of the First Schedule deals with ‘other insurance business’. If the reinsurance companies are also subject to provisions of First Schedule, a question arises whether a reinsurance company which is engaged in life reinsurance, would be governed by provisions of Part A of First Schedule or provisions of Part B of the First Schedule.Life insurance refers to business of effecting contracts of insurance upon human life including any contract whereby the payment of money is assured on death (except death by accident only) or the happening of any. Similarly, under a life reinsurance contract, the liability of a reinsurance company would arise on death. Accordingly, it should be clarified that a reinsurance company which is engaged in life reinsurance business should be taxed in a similar manner as a company which is engaged in life insurance. Adjustments to profits under First ScheduleSection 44 of the Act is a special provision governing computation of taxable income earned from insurance business. It opens with a non obstante clause and, thus, has an overriding effect over the other provisions contained in the Act. As per the existing provisions of the First Schedule, an expenditure is not allowed as a deduction if it falls within the purview of section 30 to 43B of the Act. For example, provision for leave encashment debited in year 1 but paid in year 3 will not be eligible for deduction whereas in a normal scenario such amounts paid in year 3 would be allowed as a deduction in year 3. The current scheme of First Schedule has resulted in a permanent disallowance for expenditure which would otherwise have been a timing difference.Allowability of other reservesAs per Rule 5(c) of the First Schedule, only transfer to reserve for unexpired risk is allowed as a deduction. The Act does not specifically deal with other reserves such as claim reserve. Accordingly, as per the current provisions, in year 1 where an amount is provided towards claim reserve, its admissibility would be tested in terms of provisions of section 30 to 43B of the Act and the same may be be disallowed under Rule 5(a) of the First Schedule on the premise that is such reserves represent contingent liability. It is interesting to note that Rule 5 of the First Schedule does not provide for an adjustment for the amounts provided earlier but subsequently written back. Accordingly, where a portion of the claim reserve provided earlier is written back and if that portion is considered as income and again subjected to tax, there may be potential double taxation on the same amount of claim reserve.Transition issuesThe reinsurance branch will also have to grapple with important tax issues relating to setting up the branch. These include the need for and tax and transfer pricing issues raising out of transfer of existing book of business from the parent to the Indian branch, migration of existing back office operations in India into the branch, deductibility of pre-incorporation expenses etc.End noteConsidering that the reinsurance sector will act as a catalyst to the India growth story, it is essential that some of the uncertainties surrounding this sector which are outlined above are addressed which would not only provide clarity but also boost investor sentiments in general.