captive insurance: surviving heightened irs...

Captive Insurance: Surviving Heightened IRS Scrutiny Implementing Key IRS Rules; Navigating Reinsurance Safe Harbors, Premium Deductibility, IRC 831(b), FATCA and State Taxes

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

WEDNESDAY, JULY 9, 2014

Presenting a live 90-minute teleconference with interactive Q&A

Jerry Jonckheere, International Tax Partner, Plante & Moran, Grand Rapids, Mich.

P. Bruce Wright, Partner, Sutherland Asbill & Brennan, New York

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STRAFFORD PUBLICATIONS WEBINAR

CAPTIVE INSURANCE: SURVIVING HEIGHTENED IRS SCRUTINY©

JULY 9, 2014 1:00 – 2:30 P.M. (EASTERN)

JERRY JONCKHEERE P. BRUCE WRIGHT [email protected] [email protected]

PLANTE & MORAN PLLC SUTHERLAND ASBILL & BRENNAN LLP GRAND RAPIDS, MI NEW YORK, NY

mailto:[email protected]

mailto:[email protected]

Today’s Presentation

• What is a Captive? • What is Insurance? • Foreign Domiciles – Tax Issues • IRC § 831(b) “Micro-Captives” • Protected Cell Companies • Employee Benefits In Captives • State and Local Tax Issues

5

WHAT IS A CAPTIVE?

• When you see one captive you’ve seen… one captive

• Captives come in many shapes and sizes depending on the goals of the parent or group

6

BRIEF HISTORY • 1950s – Captives introduced • 1960s – Captive industry develops in Bermuda • 1950s-1980s – Captives generally viewed with

suspicion by the IRS • 1989 – Humana – favorable Supreme Court case

(economic family doctrine) • 1991 – Harper Group – favorable Tax Court case

(unrelated risk) • 1990s – Growth in Captives • 2002 – IRS issues three key Revenue Rulings • 2009 – Proposed Regulations – Protected Cells

7

WHAT IS A CAPTIVE?

• A Captive is a legal entity that is licensed to insure the risks of its parent company and companies related to the parent company.

• TYPES OF CAPTIVES: – SINGLE PARENT – GROUP CAPTIVES – RISK RETENTION GROUPS

• DOMESTIC or FOREIGN DOMICILED

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WHAT IS A CAPTIVE?

• Writing Related Business • Writing Controlled Business • Why Form a Captive?

– Business Reasons: • Manage insurance costs – “keep” the profits • Coverages not available in the market

– Accelerate Deductions – Defer Revenue – Small Insurance Company Election

9

WHAT IS A CAPTIVE?

• Who are the professionals involved with forming/maintaining a Captive? – Captive Manager – Insurance Broker – Actuary – Legal Counsel – Tax Advisor – Accountant

10

WHAT IS INSURANCE?

• Risk Shifting and Risk Distribution – The tax definition of insurance is based on judicial

principals first discussed in Helvering v. LeGierse, 312 U.S. 531 (1941)

• Economic Family Doctrine – SEE HUMANA, HCA, MALONE & HYDE – REV. RUL. 2002-90 – 12 entity safe harbor – LIMITATIONS ON Economic Family Doctrine

– REV. RUL. 2005-40, 2005-27 IRB 4 (LOOK THROUGH SINGLE MEMBER LLC, BUT NOT MULTI-OWNER LLC)

– PLR 200952061, TAM 200816029 (RISK ATTRIBUTED TO GENERAL PARTNER)

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WHAT IS INSURANCE?

• Risk Shifting and Risk Distribution – Third-party business

• See HARPER GROUP, ODECO • 50% Safe Harbor - REV. RUL. 2002-89, 2002-2 IRB 984 • Sources of Unrelated Business

– CUSTOMERS, e.g., EXTENDED WARRANTY (SEE PLR 201419007)

– EMPLOYEE COVERAGES (e.g., H.O., AUTO, UMBRELLA) – EMPLOYEE BENEFITS, SEE REV. RUL. 92-93, 1992-2 C.B. 45 – MEDICAL STOP LOSS (?), REV. RUL. 2014-15, 2014-22 IRB 1

12

WHAT IS INSURANCE?

• Risk Shifting and Risk Distribution – Unrelated Business

• Pooling Arrangements • Concentration of Risks

– REV. RUL. 2005-40, 2005-27 IRB 4 – REV. RUL. 2009-26, 2009-38 IRB 366

13

WHAT IS INSURANCE?

• Other Issues – Premiums were not for “insurance”

• Retroactive Insurance, e.g., REV. RUL. 89-96 • Imbedded Warranty • Residual Value Insurance

– TAM 201149021, RVI GUARANTY COMPANY LTD. – ENTERPRISE RISK

• Fortuitous Events

14

WHAT IS INSURANCE?

• Recent Case Law – Rent-A-Center v. Commissioner, 142 T.C. 1 (January

14, 2014) • Dividend opinion in favor of taxpayer • Deduction for premium was allowed for all amounts

paid by subsidiaries – deduction for premium paid by parent was disallowed

• Big Three Coverages: Workers Compensation, Auto Liability, General Liability

• 15 Affiliates were covered with largest accounting for 65% of premiums paid

15

WHAT IS INSURANCE?

Rent-A-Center v. Commissioner • IRS focuses on the business practices of the Captive

– Guaranty of Deferred Tax Asset – Guaranty/Keepwell by Parent – Purchase of Treasury Stock of Parent – subject to a Put

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WHAT IS INSURANCE?

Rent-A-Center v. Commissioner • Majority opinion agreed with 6th Circuit in Humana • Guaranty was by parent, not by insureds • Guaranty was not in favor of a third party • Guaranty amount was small • Majority opinion focused on exposure units that were

“statistically independent risks”

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WHAT IS INSURANCE?

Rent-A-Center v. Commissioner • Dissent

– Ownership of parent’s treasury shares by the Captive were an issues – if the parent was insolvent the put would not have been enforceable

– There was no shifting of risk because of the parent’s guaranty and low capitalization

– Assets did not create income

• Will the IRS Appeal?

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Slide Intentionally Left Blank

DOMESTIC TAX ISSUES

Insurance Companies generally benefit from book-to-tax differences that non-insurance companies are not entitled to: -- Deduction for Loss reserves -- Modified Premium Recognition Rules -- Small Company Elections – 831(b), 501(c)(15)

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FOREIGN TAX ISSUES

• Basis for U.S. Taxation of Foreign Operations – Nexus in U.S. – Statutory Provisions – Trade or Business – IRC § 953(d) Election – Taxation as CFC or NCFC

• Taxation as a U.S. Trade or Business – Statutory rules for non-treaty country entities – Treaty rules for permanent establishment apply

for treaty country entities

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FOREIGN TAX ISSUES

• Controlled vs Non-Controlled Foreign Corporations – Special rules for foreign insurance companies that

have “RPII” (related party insurance income) – CFC if 25% or more owned by “U.S. Shareholders” – 10% de minimis does not apply for RPII entities – RPII and Investment Income is taxed currently to U.S.

parent of CFC • IRC 953(d) Election • IRC 953(c)(3)(C) Election • Branch Profits Tax

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FOREIGN TAX ISSUES

• Passive Foreign Investment Company – Definition – Issues

• No risk risking or risk distribution • Excess Capitalization

– CFC “Kick-Out”

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FOREIGN TAX ISSUES • Passive Foreign Investment Company

– U.S. Individual invests $1,000 in year x1 and sells investment in year x5 for $2,000.

– Taxpayer is taxed at highest individual rates in each year on 1/5 of the gain plus underpayment interest rate:

• Year x1 = $200 * 39.6% * 1.25 = $99.00 • Year x2 = $200 * 39.6% * 1.20 = $95.04 • Year x3 = $200 * 39.6% * 1.15 = $91.08 • Year x4 = $200 * 39.6% * 1.10 = $87.12 • Year x5 = $200 * 39.6% * 1.05 = $83.16

– Total Tax assessed = $455.40 on $1,000 gain

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FOREIGN TAX ISSUES

• IRC § 953(d) Election – Election to treat foreign domiciled insurance

company as a domestic entity (Form 1120-PC) – Losses will still be Dual Consolidated Losses – FAA 20092101F applies IRC § 845 to reinsurance

designed to utilize NOLs in electing foreign insurance companies

25

FOREIGN TAX ISSUES

• IRC § 953(c)(3)(C) Election – Treated “as if” engaged in a trade or business with

respect to U.S. risks only – No actual engaged in a trade or business with or

branch profits tax unless facts and circumstances support that treatment

– Utilized most commonly with offshore group captives with both U.S. and non-U.S. insureds

26

FOREIGN TAX ISSUES

• FATCA (Foreign Account Tax Compliance Act) – General Background

• HIRE Act (2010) • FFI vs NFFE

– Filing Requirements for Captives • Insurance companies are generally not FFIs unless they

offer annuity contracts or make payments with respect to financial accounts

27

FEDERAL EXCISE TAX • Background

– Insurance – Reinsurance

• No Transfer of Risk

• Treaties – UK Format – Other Formats

• Cascading Tax – TAM 9621001 – Rev Rul 2008-15

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FEDERAL EXCISE TAX

• Treatment as insurer vs reinsurer – 4% (Property & Casualty Insurance) – 1% (Life insurance, reinsurance, sickness and

accident policies, annuity contracts)

• Validus Reinsurance Ltd v United States, 2014 U.S. Dist Lexis 13981(DDC 2013), on appeal – Retrocession – Nuances

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SECTION 831(b) COMPANIES

31

Operating Company

Captive Insurance Company

(831(b) Election)

Gen-1 or Gen-2

Up to $1,200,000 in Premiums

(Deductible at Ordinary Tax Rates) Losses & Fees Paid from Premiums

Dividends Paid (Taxed at Qualified

Dividend Rates)

SECTION 831(b) COMPANIES • What is an 831(b) election?

– Premiums must be less than $1,200,000 (greater of direct or net written) • Multiple “micro-captives” may be formed if there is no attribution between them

– Must qualify as an “insurance company” – Underwriting Income is not taxed – Election is irrevocable without IRS consent – NOL carryovers/carrybacks lost

• Income Tax Benefits – Tax free income – Tax rate arbitrage – ordinary rates for deductions, qualified dividend rates for

income • Possible Wealth Transfer Structure

– Nature of Risk must be addressed – Change in branch – Consider IRS positions in PLRs 201219009, 201219010, 201219011

32

PROTECTED CELL COMPANIES

• BACKGROUND – Preferred Status – Participation Agreement – Independently incorporated

• Cells are generally Bankruptcy Remote from other cells and from the General Account

33

GENERAL ACCOUNT

CELL 1 CELL 2 CELL 3 CELL 4 CELL 5 CELL 6


• Deduction for Premiums Paid – Rev Rul 2008-8 – in general, individual cells may

be treated as if it were a separate captive insurance company

• Brother/Sister • Unrelated Business test

34


• Taxation of Cell Companies – Proposed Regulations (REG-119921-09) issued in

2009 • Domestic cell companies (or series LLC companies) will

generally be treated as separate companies • Foreign cell companies (or series LLC companies) will

generally be treated as separate companies

35

EMPLOYEE BENEFITS IN CAPTIVES • REV. RUL. 92-93, 1992-2 C.B. 45

(UNRELATED BUSINESS

PREMIUM FOR EMPLOYEE BENEFITS

100%

I

P

36

EMPLOYEE BENEFITS IN CAPTIVES

• STATE REGULATORY ISSUES – DIRECT PLACEMENT/INDUSTRIAL INSURED – REINSURED PROGRAM

• LICENSED • EXISTING PROGRAM • EXISTING ADMINISTRATION

37


• ERISA – WELFARE BENEFIT PLAN – PROHIBITED TRANSACTION – PROVISION OF

SERVICES BETWEEN “PARTY IN INTEREST” AND A PLAN

– ADDRESSING PROHIBITED TRANSACTION • ADVISORY OPINION • CLASS EXEMPTION • PRIVATE EXEMPTION

38

EMPLOYEE BENEFITS IN CAPTIVES • PTE 79-41

– PARTY IN INTEREST – LICENSED TO SELL INSURANCE

IN ONE OF THE STATES* OR D.C.

– CERTIFICATE OF COMPLIANCE OBTAINED FROM DOMICILIARY STATE AT EARLIER OF 18 MONTHS PRIOR TO TRANSACTION OR WHEN CERTIFICATES WERE LAST AVAILABLE

– NO MORE THAN ADEQUATE CONSIDERATION PAID BY PLAN

– NO SALES COMMISSIONS – HAS UNDERGONE A STATE

EXAM WITHIN 5 YEARS OF THE TRANSACTION OR EXAMINED BY A CPA IN ITS LAST YEAR

– PERCENTAGE OF PREMIUMS TEST

PTE = Prohibited Transaction Exemption

39


• PTE’S WHERE 50% OR LESS OF BUSINESS IS UNRELATED – AUGMENTATION OF BENEFITS – INDEPENDENT FIDUCIARY

• PTE’S WHERE GREATER THAN 50% OF BUSINESS IS UNRELATED

40


• COMMON REQUIREMENTS – INDEMNITY REINSURANCE – INSURER WITH BEST’S RATING OF “A” – NO COMMISSIONS

• DIRECT INSURANCE • REINSURANCE

41

EMPLOYEE BENEFITS IN CAPTIVES PTE 2000-48 (COLUMBIA ENERGY) 03-07 (ADM)

03-32E (IP) 04-12 (SCA) 04-17E (ALCON) W/DRAWN (WHIRLPOOL) 05-2E (ALCOA) 05-22E (SUN MICROSYSTEMS) 06-01E (ASTRA ZENECA) 06-11E (AGL) 06-4E (HEINZ) 07-01E (WELLS FARGO) 07-02E (WELLS FARGO) 07-04E (NISOURCE) 08-04E (CEPHALON)

08-05E (HEINZ) 09-148 (YKK) 08-22E (SLOAN KETT) 08-18E (UT) 08-16E (ASTRA ZENECA) 08-17E (DPWNHOLDING) 08-08E (CONAGRA) 09-1E (ADM) 09-10E (BANNER) 09-16E (MICROSOFT)

09-17E (DOW) 10-11 (COCA-COLA) 10-15 (SUBARU OF AMER)

11-12 (VERIZON) 13-06 (COKE)* 2013 (ADM)*

42


• OFFSHORE WITH U.S. BRANCH – IRC § 953(d)

• EXPEDITED EXEMPTION PROCEDURE – 50% OR LESS IS UNRELATED BUSINESS – GREATER THAN 50% UNRELATED BUSINESS

43


• MEDICAL STOP LOSS, SEE ADVISORY OPINION 92-02A

• MEDICAL STOP LOSS AS UNRELATED BUSINESS • REV. RUL. 2014-15, 2014-24 IRB 1095

44

STATE TAXATION • Most states tax corporations on income, but state

taxation of insurance and insurers is very different – State taxation of insurance is based on premiums received

or gross receipts • Surplus Lines Tax – paid by in-state broker placing

insurance with a non-admitted carrier • Premium Tax – paid by an admitted insurer on

premiums collected – Retaliatory Taxes

• Self-Procurement Tax – paid by the insured on non-admitted insurance

46

STATE TAXATION • Direct Placement

– Prior to Dodd-Frank • Most states have either a direct procurement or industrial

insured statute that allows some access for regulatory purposes to non-admitted insurers

• Most states have a tax associated with these statutes similar to surplus lines rate

• The law generally requires apportionment of premium based on risks associated with that state

47

STATE TAXATION

• Direct Placement – After Dodd-Frank

• Direct procurement and industrial insured statutes have not changed from a regulatory perspective

• Tax is required to be paid to an insurance company’s “home state”

– An insurance company’s “home state” is its principal place of busines if risk in that state is covered by (i) if no premium is allocated to that state, the state with the greates allocation of premium or (ii) if an affiliated group covering more than one member, the home state is the state in which the member with the greatest premium is located

48

STATE TAXATION

• After Dodd-Frank – Location of Captive

• “Home State” • Other than “Home State” • Texas – seeks to tax premium attribute to Texas-based

risks paid to an unauthorized insurer if (a) premium tax, (b) independently procured tax, and (c) surplus lines tax is not paid

– But see: “INDEMNITY POLICY” (34 TAC § 3.835(C)(2))

49

STATE TAXATION • Income tax computation

50

Apportionment Factors

Combined Income Rate

X X

STATE TAXATION

• State income tax issues: – UPS v Indiana Dept of State Revenue, 995 NE2D 20

(2013) – Costco Wholesale Corp. v Dept of Revenue, 2012

WL 2992959, 20 OR. TAX 537 (2012) – Wendy’s International, Inc. v Brian Hamer, et. al.,

375 ILL DEC 194, 996 NE2D 1250 (2013) – Rent-A-Center, Inc. & Subsidiaries vs Dept of

Revenue (2014)

51

STATE TAXATION

• Income Tax Issues – New York State – New York State Budget Proposal – Indiana Retroactive Provision

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