This case concerns the sale of extended warranties to third-party customers of Dixons, a large retail chain in the UK selling white goods and home electrical products.
The DSG group captive (re)insurer in the Isle of Man (DISL) insured these extended warranties for DSG’s UK customers. Until 1997 this was structured via a third-party insurer (Cornhill) that reinsured 95% on to DISL. From 1997 onwards the warranties were offered as service contracts that were 100% insured by DISL. The dispute concerned the level of sales commissions and profit commissions received by DSG.
The Tax Tribunal rejected the taxpayer’s contentions that the transfer pricing legislation did not apply to the particular series of transactions (under ICTA 88 Section 770 and Schedule 28AA) – essentially the phrases ‘facility’ (Section 770) and ‘provision’ (Schedule 28AA) were interpreted broadly so that there was something to price between DSG and DISL, despite the insertion of a third party and the absence of a recognised transaction between DSG and the other parties involved.
The Tax Tribunal also rejected potentially comparable contracts that the taxpayer had used to benchmark sales commissions on similar contracts on the basis that the commission rate depended on profitability, which itself depended on the different level of loss ratios expected in relation to the products covered. A much more robust looking comparable provider of extended warranty cover offered as a benchmark for the market return on capital of DISL was also rejected owing to its differing relative bargaining power compared to DISL. This third-party re-insurer was considered to be a powerful brand providing extended ‘off-the-shelf’ warranty cover through disparate distributors – the tribunal noted that DSG had a strong brand, powerful point of sales advantage through access to customers in their shops and could easily have sourced the basic insurance provided by DISL elsewhere.
The overall finding of the Tax Tribunal was that, to the extent that ‘super profits’ were available, these should be distributed between the parties according to the ability of each party to protect itself from normal competitive forces and each party’s bargaining power.
The Tax Tribunal noted in this context that DISL was entirely reliant on DSG for its business. According to the facts of this case, the super profits were deemed to arise because of DSG’s point-of-sale advantage as the largest retailer of domestic electrical goods in the UK and also DSG’s past claims data. DISL was considered to possess only routine actuarial know-how and adequate capital, both of which DSG could find for itself.
As a result, the tribunal thought that a profit-split approach was the most appropriate, whereby DISL was entitled to a market return on capital, with residual profit over and above this amount being returned to DSG via a profit commission.
This decision offers valuable insights into consideration of the level of comparability demanded to support the use of comparable uncontrolled prices; Selection of the appropriate ‘tested party’ in seeking to benchmark a transaction; The importance of bargaining power; Approval of profit split as the most appropriate methodology; That a captive insurer that is underwriting ‘simple’ risks, particularly where the loss ratios are relatively stable and predictable, and that does not possess significant intangibles or other negotiating power, should not expect to earn more than a market return to its economic capital.