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BRIDGETOWN, Barbados-A year ago, it looked as though the Barbados government had navigated around new Canadian restrictions on tax breaks for Canadian-owned captives, one of the domicile's biggest sources of business.

Apparently not.

A 2-year-old tax struggle between Barbados and Canada is going a few extra rounds, leaving the tax status of some Canadian captives in limbo and slowing the formation of new companies, captive managers report.

Canadian legislation that went into effect in 1995 denied tax benefits to companies that were not "residents" of Barbados. To qualify as a resident, a captive had to be subject to local tax.

The Barbados government responded by amending its insurance law in December 1995 to impose taxes on captive earnings for the first time. The tax rate, though, was 0%, creating no new costs for captives.

While tax experts believed the change would meet the "residency" requirement, the Canadian government is apparently not impressed. Both Canada and Barbados are now mulling additional changes in their laws, tax experts say.

The result has been a drop-off in new Canadian-owned captives.

"There is a slowdown," said Denis C. Brown, a partner with Ernst & Young L.L.P. in Toronto. "It's the uncertainty that is the problem."

"We are still in a bit of a limbo situation right now," confirmed Stephen B. White, vp and general manager of Marsh & McLennan Management Services (Barbados) Ltd.

Several M&M clients are looking to form captives in Barbados, but "they would just like to see the tax situation resolved."

The impact is clear in the Barbados government's 1996 licensing statistics: Five new Canadian-owned insurers were formed last year, only half the 10 Canadian formations in 1995.

Overall, Canadian-owned insurers represented 101, or nearly a third, of the 323 Barbados insurers licensed as of year-end 1996. U.S.-owned companies accounted for 199, or roughly two-thirds, and other countries brought in the remaining 23, according to figures compiled by Towner Risk Management Ltd., a Barbados captive manager.

Despite the tax upheaval, though, Barbados' captive business is keeping pace.

The domicile saw a total of 23 new insurers formed last year-the same number as in 1995-with formations from the United States and other countries making up for the loss of Canadian business.

Excluding companies that have stopped underwriting, Barbados had 196 active insurers at the end of last year, unchanged from year-end 1995, according to government figures.

Of these, Business Insurance estimates that 15% are commercial insurers or reinsurers set up primarily to write third-party business, leaving 167 licensed captive insurers at the end of 1996.

In the first few months of 1997, Barbados licensed two new insurers, both owned by U.S. companies, according to government figures. Eight new insurers were licensed in the same period last year.

Barbados should maintain a steady pace of growth, drawing more new business from the United States and even some from Canada, some managers say.

"I think we will see a fairly consistent pattern-maybe 25 new formations for the year," predicted Christopher Towner, president of Towner Risk Management.

"While the tax situation is very significant, we are still an attractive domicile," Mr. Towner said. "The fact that the U.S. market has come back to Barbados to the extent that it has is an indication of that."

Apart from captives, Barbados is targeting other types of financial services businesses, including commercial reinsurance companies. For example, a new finite risk underwriter, Underwriters Reinsurance Co. (Barbados) Ltd., was formed last December with $111 million in capital, confirmed Dan McKay, president and chief executive officer.

Underwriters Reinsurance Group of Woodland Hills, Calif., contributed $11 million of the capital, and $100 million was raised from U.S. institutional investors in a private placement of preferred stock, Mr. McKay said.

The new reinsurer, which is self-managed, will retrocede some of its finite risk business to Underwriters Re in the United States, he said.

Most captive managers agree, however, that captive growth will be hampered in coming months by the Canadian tax question.

The problem stems from a set of 1994 Canadian tax reforms that took effect in 1995.

Under previous Canadian law, a Canada-Barbados tax treaty allowed companies to generate captive earnings tax-free if the earnings were related to third-party Canadian risks or the risks of the owner's non-Canadian operations. After the 1994 reforms, though, the tax breaks for third-party Canadian business were eliminated, and income on all Canadian business became taxable unless non-Canadian risks account for more than 90% of a captive's volume.

Hardest hit by this change were credit life and warranty captives set up by Canadian banks and auto dealers to insure customers. While these captives previously generated tax-free earnings on third-party Canadian risks, owners have seen this benefit evaporate.

The new rules preserved a tax break for earnings on related non-Canadian risks, maintaining a benefit for Canadian multinational companies that insure their non-Canadian operations with their captives.

To qualify for this break, though, the captive must be a "resident" of Barbados under the tax treaty, meaning that it must be subject to local taxation.

Responding to this, the Barbados government amended its Exempt Insurance Act of 1993 to make captives liable for local taxes. The change amounted only to "virtual taxation," though, because it imposed a tax of 0% on exempt insurers' earnings for the first 15 years after the company is licensed. For the next 15 years, the tax rate is 2% of the first $125,000 of profits-or $2,500-which will be offset by a waiver of the government's $2,500 annual license fee.

Though tax experts believed that the Barbados amendments would pass muster with Canadian tax authorities, Revenue Canada apparently feels otherwise.

In a letter to a Canadian corporation last year, Revenue Canada said the Barbados amendments are not in accordance with the "spirit" of the Canada-Barbados tax treaty and that Barbados captives still may not be considered "residents" of the domicile.

The Canadian tax authorities have since reaffirmed this view, according to Ernst & Young's Mr. Brown.

Revenue Canada was especially unhappy with moves made by some bank-owned credit life insurers to blunt the impact of the reforms, captive observers say. One strategy, for example, was for a credit life insurer to trade Canadian risks for non-Canadian business in reinsurance "swaps" that would cut Canadian business to less than 10% of the total and preserve the tax break.

Canadian authorities were not impressed with the steps that were taken to avoid the new taxes, Mr. Brown observed.

Summed up one management official who asked not to be named, "It seems we've pissed off Revenue Canada."

Barbados officials and the Barbados Exempt Insurance Management Assn. are now working on ways to resolve the problems.

One possibility, captive experts say, would be for Barbados to impose full taxation on Canadian-owned companies and then largely offset the taxes with credits generated by the foreign currency a captive brings to the island. Such foreign currency tax credits, for example, might reduce a tax rate of 40% to under 3%, experts say.

For its part, the Canadian government is considering a more radical change: eliminating altogether the concept of "exempt surplus," or the tax-free buildup of earnings in a foreign affiliate, according to Mr. Brown.

With such a reform, Canada would do away with all tax breaks for captives and impose full Canadian taxation on captive earnings, offset by foreign tax credits reflecting local taxes paid in Barbados, he explained.

If Canada pursues it, this change could take years to become effective, he noted.

In a statement, Phillip Goddard, Barbados Minister of International Business & Trade, acknowledged that "some uncertainties have arisen recently affecting Canadian investors in the international insurance sector.

"The government of Barbados is working with the Canadian government to clarify these matters and to provide certainty of tax treatment to all Canadian investors in Barbados," Mr. Goddard said. "Constructive dialogue between officials of both countries is progressing. We are confident that the outcome of these discussions will be positive and mutually acceptable to our two governments, which have always had and continue to have strong fraternal ties as members of the commonwealth."

Amid the confusion, Barbados has seen the growth of its Canadian business fall off, and several managers say they expect it to remain slow.

Mr. Brown said he has advised clients to wait on forming Barbados captives until the tax questions are answered.

"If you've waited this long, why not wait just a bit longer?" he asked.

There is interest in forming new

captives, "but it is tempered by a wait-and-see attitude," agreed Anderson Marshall, deputy branch manager of Johnson & Higgins (Barbados) Ltd.

"In terms of existing clients, there has been no impact," said Chris Evans, general manager of Watson Wyatt Management (Barbados) Ltd. "None of my clients has expressed a desire to cease underwriting or move."

But "the issue has created uncertainty and has hindered our marketing efforts," he added.

Mr. Evans and other managers stressed the importance of resolving the questions.

"If we start messing up the way we resolve these things, we are just not sending a good message to the world," he said.

Solutions may be several months in coming, though.

"I'm certainly not telling my clients to expect a resolution in a month or two," Mr. Evans said.

Barbados' largest managers have very different groups of clients and reported widely varying experience last year. They include:

International Insurance Management Ltd., an independent manager with 17 active clients and $600.5 million in premium volume at the end of last year. IIM manages reinsurance units of Lincoln National Corp., which generate a large part of its total volume, confirmed Christine M. O'Connor, manager.

Watson Wyatt, which had 15 clients at the end of the year, including 11 active insurers that generated $115 million in premiums. Watson Wyatt's business includes clients of Sedgwick Group P.L.C. that it manages under contract.

Alexander Insurance Managers (Barbados) Ltd., which saw its client base increase to 27 captives from 20 in 1995 and its premium volume rise to $89 million from $75 million.

Aon Group Inc., which acquired Alexander & Alexander Services Inc. in December, also has a small Barbados management unit, with two captives under management. It is unclear when and how the two operations will be combined.

J&H (Barbados), which saw a slight drop in clients to 25 from 28 in 1995 and in premium volume to $76.1 million from $79 million.

A few of J&H's clients shut down last year, including one whose parent also had a Bermuda captive and decided to consolidate and one owned by a Canadian company that lost tax benefits, Mr. Marshall said.

J&H has also added two new Canadian-owned captives and a U.S.-owned company, he said.

Mr. Marshall said he expects continued new business, including from Canada, though "obviously given the state of the Canadian market, it will not be as buoyant as in previous years."

M&M (Barbados), which saw its client list shrink to six insurers from nine in 1995 and its premium volume fall to $40 million from $124 million.

A couple of M&M's large Canadian clients substantially cut back their Barbados operations because of the loss of tax benefits, and another client became self-managed last year, Mr. White said of the drop in volume.

Marsh & McLennan Cos. Inc. recently completed its acquisition of Johnson & Higgins, though Mr. White and Mr. Marshall both said there has been no decision on how the companies' Barbados operations will be combined.