Captive Insurance Company Tax Update

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Captive Insurance Company Tax Update
19 June 2008
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Agenda

• Panelists
• History of the Federal Taxation of Captives
• Recent Developments

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Panelists

• Mary Gillmarten, Director
• Deloitte Touche LLP, Washington, D.C.
• P. Bruce Wright, Partner
• Dewey LeBoeuff, LLP, New York
• Richard E. Irvine, Partner
• PricewaterhouseCoopers, Hamilton, Bermuda

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Captive Insurance Companies History of Federal
Taxation of Captives

• FAS 5 Standard for accruing liabilities
• Estimable and Probable Standard
• US Tax Standard for deducting accrued liabilities
  under IRC 461 Economic Performance Standard
• Liability must be fixed and determinable
• Economic performance occurs w/in 8 ½ months
  (i.e., payment) restrict deductibility to cash
  method
• US Insurance Company Taxation (Subchapter L)
• May establish (i.e., deduct) a reserve which is
  fair and reasonable
• May earn certain revenues over period of
  obligation (Extended Service Contracts)
• The contractual shifting of risks to a qualified
  captive establishes US GAAP/Tax parity
• Result Balance Sheet Monetization

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Captive Insurance Companies History of Federal
Taxation of Captives

• 1941 No statutory or regulatory definition of
  insurance, but U.S. Supreme Court said, for tax
  purposes, insurance must include
• Insurance Risk
• Risk Shifting
• Risk Distribution
• Common notions of insurance
• Helvering v. LeGierse, 312 U.S. 531 (1941)
• 1977 IRS issues Revenue Ruling 77-316, which
  establishes economic family doctrine, e.g., no
  insurance between related parties
• 1978-1990 Series of court cases denying captive
  benefits
• Carnation v. Commissioner, 71 T.C. 400 (1978),
  640 F .2d 1010 1981
• Parental Guaranty
• Clougherty Packing v. Commissioner, 84 T.C. No.
  61 (1985), 811 F.2d 1297 1987
• First application of the Balance Sheet Theory

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Captive Insurance Companies History of Federal
Taxation of Captives

• 1978-1990 Series of court cases denying captive
  benefits (Continued)
• Gulf Oil Corporation v. Commissioner, 89 T.C.
  1010 (1987), 914 F.2d 396 1990
• 2 unrelated risk insufficient
• Mobil Oil, Stearns-Rogers, Beech Aircraft
• 1989 Revenue Ruling 89-72
• No amount of unrelated risks will enable risk
  shifting

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Captive Insurance Companies History of Federal
Taxation of Captives

• 1989 Taxpayer wins in Humana in the 6th Circuit
  Court of Appeals
• Balance Sheet Theory applied (Brother/Sister
  distinguished from Parent/Subsidiary)
• 1991-1993 Taxpayer wins in AMERCO, Harper,
  Sears and ODECO based upon significant levels of
  unrelated risk
• Technical risk shifting
• Risk shifting in substance
• 1993 IRS issues Revenue Rulings 92-93 and
  Ruling 92-94 which conclude that employee benefit
  risks are unrelated risks
• 1997 Taxpayer wins in HCA and Kidde open
  brother/sister captive to all Circuits
• 1999 Tax Analyst files FOIA request to have
  access to Field Service Advices. Review of FSAs
  indicate IRS has been conceding captive cases
  since 1993

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Captive Insurance Companies History of Federal
Taxation of Captives

• 2001 IRS issues Revenue Ruling 2001-31 and
  obsoletes all prior captive rulings dealing
  with economic family
• will still pursue captive issue on facts and
  circumstances
• will look for thinly capitalized captives and
  presence of parental guarantees and hold
  harmless agreements
• 2002 Revenue Procedure 2002-75 IRS will now
  rule on captive insurance transactions (formerly
  a no rule area) and IRS Issues Revenue Rulings
  affirming insurance tax treatment

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Captive Insurance Companies History of Federal
Taxation of Captives

• 2002 Revenue Ruling 2002-89 Premium payments
  from parent and from subsidiaries are deductible
  provided
• Third party premium constitutes 50 or more of
  total premium,
• Risks are homogeneous
• Common notions of insurance are satisfied
• No loanbacks
• Premium payments from parent are not deductible
  when
• Third party premium constitutes 10 or less of
  the total premium
• Revenue Ruling 2002-90 brother/sister
  subsidiaries insure professional liability risks
  with captive
• 12 or more insured subsidiaries
• No insured accounts for less than 5 or more than
  15 of total risk insured by captive
• Homogeneous risks
• Captive licensed in each state it does business
• No loanbacks

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Captive Insurance Companies History of Federal
Taxation of Captives

• Revenue Ruling 2002-91 - group captive insures
  professional liability risks of its shareholders
• Number of insureds is not disclosed however, no
  insured accounts for less than 5 or more than
  15 of total risk insured by captive (implies 7
  or more owners)
• Homogeneous risks
• Captive licensed in each state it does business
• No loanbacks

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Captive Insurance Companies History of Federal
Taxation of Captives

• 2004 Pension Funding Equity Act of 2004
• Clarifies definition of insurance company for
  non-life insurance company purposes
• More than half of the business during the year is
  the issuance of insurance, reinsurance or annuity
  contracts
• Changes qualification standard for tax exempt
  status under IRC Section 501(c)(15)
• 600,000 gross receipts limitation
• 50 or more must be (re)insurance premiums
• Changes the qualification standard for small
  insurance companies under IRC Section 831(b)
• 0 - 1,200,000 premium limitation

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Captive Insurance Companies History of Federal
Taxation of Captives

• 2005 Revenue Ruling 2005-40
• IRS sets forth its position on risk
  distribution
• Examined 4 Situations
• Single Unrelated Insured not sufficient risk
  distribution
• Two Unrelated Insureds (90/10 concentration)
  not sufficient risk distribution
• 12 LLCs (disregarded entities) SMLLCs are not
  viewed as separate entities so a single insured,
  no risk distribution
• 12 LLCs elect to be treated as associations
  (check the box) multiple insureds, adequate
  risk distribution

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Captive Insurance Companies History of Federal
Taxation of Captives

• 2005 IRS Notice 2005-49
• IRS requested comments to develop additional
  guidance in the captive taxation area
• Specifically, the Service requested input
  regarding
• What factors should be taken into account in
  determining whether a cell captive arrangement
  constitutes insurance and if so, the mechanics of
  federal elections (i.e., IRC Sections 953(d) and
  953(c)(3)(C))
• Affect of loanbacks of premiums on a related
  party insurance arrangement
• Relevance of homogeneity on whether risks are
  adequately distributed
• Issues raised by finite risk transactions

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Captive Insurance Companies Recent Activity

• PLR 200644047
• The IRS ruled that an organization did not
  qualify for tax-exempt status under section
  501(c)(15) because its insurance arrangement had
  no risk distribution.
• Taxpayer's sole shareholder is X, a corporation
  that contracts with physicians and other medical
  service providers, as independent contractors.
• Taxpayer has no employees and issued one
  purported insurance contract each in 2002 and
  2003, identifying X as the "Name Insured" and
  several other parties as "Insureds."
• The other Insureds included approximately 30
  physicians.
• For each relevant policy year, the premium was
  paid by X on behalf of all the insureds.
• The IRS reasoned that even though there were
  purportedly multiple insureds under the policy,
  the only risks insured were those that arose in
  connection with providing medical services to
  Named Insureds' own clients. As such, it appeared
  likely that a claim against any Insured would
  necessarily entail a claim against the Named
  Insured as well.

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Captive Insurance Companies Recent Activity

• 2006 Proposed Regulations under 1.1502-13(e)(2)
• Involved the treatment of insurance transactions
  involving obligations between members of a
  consolidated group
• Under current regulations (1.1502-13(e)(2)(ii)(A))
  , if a member provides insurance to another
  member in an intercompany transaction, the
  transaction is taken into account on a separate
  entity basis
• Under the proposed regulations, where a
  significant portion (5 or more) of the business
  of the insuring member arises from insuring other
  members, the Service deemed it appropriate to
  take the items in the transaction into account on
  a single entity basis
• The proposed regulations had the effect of
  eliminating the tax benefits associated with
  captive insurance transactions in a consolidated
  group, which have been provided for by the courts
  in a number of captive insurance cases arguing
  against the Services economic family theory.
• On February 20, 2008, the IRS withdrew the
  portion of the proposed regulations relating to
  the treatment of transactions involving the
  provision of insurance between members of a
  consolidated group, in response to the comments
  received
• According to the IRS, it will continue to study
  whether revisions to the rules of intercompany
  transactions are necessary to clearly reflect the
  taxable income of consolidated groups.

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Captive Insurance Companies Recent Activity

• Revenue Ruling 2007-47
• X, a domestic accrual method corporation, was
  engaged in a business process that was inherently
  harmful to people and property. As a result,
  government regulations required X to remediate
  the harm, requiring X to incur future costs in
  order to restore Xs business location to its
  condition before Xs business began.
• The exact amount and timing of the future costs
  were a function of many unknown factors however,
  there was no uncertainty that the future costs
  would be incurred.
• X estimated the present value of the future costs
  (150x) and entered into an arrangement with an
  unrelated insurance company (IC) to reimburse X
  for its future costs, up to a limit of 300x.
• The IRS concluded that the arrangement lacked the
  requisite insurance risk to constitute insurance.
  There was certainty that IC would have to
  perform under the arrangement, so the arrangement
  was pre-funding by X of its future obligations.
• The central theme is that an arrangement that
  lacks fortuity fails to qualify as insurance for
  tax purposes.

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Captive Insurance Companies Recent Activity

• PLR 200746003
• Group captive ruling where an undisclosed number
  of companies in a group captive insure
  homogeneous risks.
• The Taxpayer requests a ruling not to be taxed as
  an insurance company under IRC Section 831(c)
• Service applies Revenue Ruling 2002-91
• IRS notes that each participating entity is in
  significant part paying for its own risks
• Notes that several members constitute gt 15 of
  the risks insured by the captive
• There is not adequate risk distribution because
  there are too few members (less than the number
  implied in Revenue Ruling 2002-91) because
  several members constitute gt 15 of the risks.
• Service concludes a lack of risk distribution and
  no insurance.

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Captive Insurance Companies Recent Activity

• Final Regulations under 1.6012-2
• 1.6012-2(c)(2)--Domestic nonlife insurance
  companies.
• Every domestic insurance company other than a
  life insurance company shall make a return on
  Form 1120-PC, "U.S. Property and Casualty
  Insurance Company Income Tax Return." This
  includes organizations described in section
  501(m)(1) that provide commercial-type insurance
  and organizations described in section 833.
  Except as provided in paragraph (c)(4) of this
  section, such company shall file with its return
  a copy of its annual statement (or a pro forma
  annual statement), including the underwriting and
  investment exhibit (or any successor thereto) for
  the year covered by such return.
• 1.6012-2(c)(4)--Exception for insurance companies
  filing their Federal income tax returns
  electronically.
• If an insurance company described in paragraph
  (c)(1), (c)(2), or (c)(3) of this section files
  its Federal income tax return electronically, it
  should not include on or with such return its
  annual statement (or pro forma annual statement),
  or any portion thereof. Such statement must be
  available at all times for inspection by
  authorized Internal Revenue Service officers or
  employees and retained for so long as such
  statements may be material in the administration
  of any internal revenue law. See 1.6001-1(e).

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Captive Insurance Companies Recent Activity

• Final Regulations under 1.6012-2
• 1.6012-2(c)(5) -- Definition.
• For purposes of this section, the term annual
  statement means the annual statement, the form of
  which is approved by the National Association of
  Insurance Commissioners (NAIC), which is filed by
  an insurance company for the year with the
  insurance departments of States, Territories, and
  the District of Columbia. The term annual
  statement also includes a pro forma annual
  statement if the insurance company is not
  required to file the NAIC annual statement.
• 1.6012-2(k) Effective/applicability date.
• Paragraph (c) of this section applies to any
  taxable year beginning on or after May 30, 2006.
  However, taxpayers may apply paragraph (c) of
  this section to any original Federal income tax
  return (including any amended return filed on or
  before the due date (including extensions) of
  such original return) timely filed on or after
  May 30, 2006. For taxable years beginning before
  May 30, 2006, see 1.6012-2 as contained in 26 CFR
  part 1 in effect on April 1, 2006.
• IRS acknowledges that "pro forma" is not defined,
  and advises to prepare financial statements that
  provide sufficient information for the Service to
  understand a company's activities. For example
• Vintaging of loss reserves
• Schedule F type reinsurance detail

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Captive Insurance Companies Recent Activity

• FAA 20072502F
• Example of the IRS applying FAS 113 criteria
• IRS Counsel gave advice to revenue agent that
  transaction did not meet tax criteria for
  insurance risk where A (the ceding company) and
  B (the assuming company) entered into a
  retroactive insurance contract in Year 1.
• The contract ceded 90 of A's losses to multiple
  assuming companies.
• B assumed 30,
• A retained 10,
• Remaining 60 was assumed by other insurers.
• Losses subject to the contract included loss and
  loss adjustment expenses paid by A on or after
  Year 1 for accident years prior to Year 1.
• Transaction met risk transfer criteria for both
  GAAP (FAS 113) and Stat (SSAP 62)
• IRS counsel ultimately found that no insurance
  risk had transferred when the tax savings were
  included in the analysis, and therefore
  sufficient insurance risk was not present.

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Captive Insurance Companies Recent Activity

• Revenue Ruling 2008-08
• The IRS provided guidance through examples of
  when a cell of a protected cell company can enter
  into a transaction which is treated as insurance
  for federal income tax purposes, and when amounts
  paid to these cells is deductible as insurance
  premiums under Section 162.
• Example 1 X, a corporation that owns Cell X,
  enters into a contract whereby Cell X insures
  professional liability risks of X. Cell X does
  not enter into any arrangements with entities
  other than X.
• IRS finds the arrangement between X and Cell X is
  akin to a parent and its wholly owned subsidiary,
  and in the absence of unrelated risk, lacks the
  requisite risk shifting and risk distribution to
  constitute insurance.
• Example 2 Y, a corporation, owns all stock of
  Cell Y, as well as all the stock of 12
  subsidiaries. (Mirrors facts of Rev. Rul.
  2002-90). The 12 subs have a significant volume
  of independent, homogenous risks, insured into
  Cell Y. No sub has coverage for less than 5 nor
  more than 15 of the total risk insured by Cell
  Y.
• IRS finds the subsidiaries have shifted the
  liability risks to Cell Y. The premiums are
  pooled such that a loss by one sub is not in
  substantial part paid from its own premiums. Had
  the subs of Y entered into identical arrangements
  with a sibling corporation that was regulated as
  an insurance company, the arrangements would
  constitute insurance and the premiums would be
  deductible under Section 162.

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Captive Insurance Companies Recent Activity

• IRS Notice 2008-19
• In conjunction with Revenue Ruling 2008-8, the
  IRS issued the Notice to request comments on
  further guidance to address issues that arise if
  those arrangements do constitute insurance,
  specifically, the status of such a cell as an
  insurance company within the meaning of 816(a)
  and 831(c), and some of the consequences of a
  cells status as an insurance company.
• The Notice puts forth proposed guidance that
  would address (a) when a cell of a Protected Cell
  Company is treated as an insurance company for
  federal income tax purposes, and (b) some of the
  consequences of the treatment of a cell as an
  insurance company.
• The proposed guidance would include a rule to the
  effect that a cell of a Protected Cell Company
  would be treated as an insurance company separate
  from any other entity if
• the assets and liabilities of the cell are
  segregated from the assets and liabilities of any
  other cells and from the assets and liabilities
  of the Protected Cell Company
• based on all the facts and circumstances, the
  arrangements and other activities of the cell, if
  conducted by a corporation, would result in its
  being classified as an insurance company within
  the meaning of 816(a) or 831(c).

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Captive Insurance Companies Recent Activity

• IRS Notice 2008-19
• Effect of insurance company treatment at the cell
  level under the proposed rule
• Any tax elections that are available by reason of
  a cells status as an insurance company would be
  made by the cell
• The cell would be required to receive an employer
  identification number (EIN) if it is subject to
  U.S. tax jurisdiction
• The activities of the cell would be disregarded
  for purposes of determining the status of the
  Protected Cell Company as an insurance company
  for federal income tax purposes
• The cell would be required to file all applicable
  federal income tax returns and pay all required
  taxes with respect to its income and
• A Protected Cell Company would not take into
  account any items of income, deduction, reserve
  or credit with respect to any cell that is
  treated as an insurance company under the
  proposed rule making

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Captive Insurance Companies Recent Activity

• PLR 200803022
• IRS revoked the tax-exempt status of a Section
  501(c)(15) because it was overcapitalized and did
  not meet the operational requirements of an
  insurance company.
• Corporation was formed to write mortgage
  guarantee reinsurance and other classes of
  insurance and reinsurance to its parent and
  affiliates.
• When corporation was created, it generated
  minimal investment income however, as a result
  of reorganization, corporation was the recipient
  of additional paid in capital in the form of
  shares of stock.
• Stock had a significant FMV and generated
  dividend and interest income
• Corp received 88.6 of the gross income from
  interest and dividends and only earned 11.4 of
  its combined total revenue from insurance
  premiums.
• In revoking the entity's tax-exempt status the
  IRS raised the following questions about the
  organizations' status as an insurance company
• Whether the organization is an insurance company
  exempt from tax pursuant to Section 501(c)(15)
  for the relevant taxable years?,
• Whether the organization continues to qualify for
  exemption from federal income tax as an
  organization described in Section 501(c)(15)?,
• Can the organization Rely on the Determination
  Letter Granted by the IRS Pursuant to IRC Section
  501(c)(15)?, and
• Is the entity entitled to relief pursuant to IRC
  Section 7805(b)?

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Captive Insurance Companies Recent Activity

• Revenue Ruling 2008-15
• Describes the insurance excise tax consequences
  (under section 4371) of insurance premiums paid
  by one foreign insurer (foreign insurer) to
  another (foreign reinsurer).
• The ruling describes 4 fact patterns
• Situation 1 --Foreign insurer, incorporated in X,
  insures U.S. risk. There is no tax treaty
  between U.S. and X. Foreign insurer reinsures
  with foreign reinsurer in country Y. There is a
  tax treaty between U.S. and Y that does not
  exempt insurance from excise tax.
• Premiums paid by U.S. corporation are subject to
  4 excise tax
• Premiums paid by foreign insurer to foreign
  reinsurer are subject to 1 excise tax.

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Captive Insurance Companies Recent Activity

• Revenue Ruling 2008-15
• Situation 2 --Foreign reinsurer, incorporated in
  country W, reinsures U.S. insurer. Foreign
  reinsurer enters into reinsurance agreement with
  foreign reinsurer, incorporated in country Y.
  Both W and Y have tax treaties with U.S. that do
  not exempt insurance from excise tax.
• Premiums paid by U.S. insurer to foreign
  reinsurer are subject to 1 excise tax.
• Premiums paid by Foreign reinsurer to other
  foreign reinsurer are subject to 1 excise tax.
• Situation 3 --Same facts as 1, except that there
  is a tax treaty between X and U.S that exempts
  insurance from excise tax as long as it is not
  reinsured with an entity not entitled to the
  benefits of the treaty.
• Premiums paid by U.S. corporation would be exempt
  from excise tax however are subject to 4 excise
  tax as of the date the reinsurance premiums are
  paid by foreign insurer to foreign reinsurer.
• Premiums paid by foreign insurer to foreign
  reinsurer are subject to 1 excise tax.

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Captive Insurance Companies Recent Activity

• Revenue Ruling 2008-15
• Situation 4 --Same facts as 1, except that
  foreign insurer is resident of country Z, and
  there is a tax treaty between Z and U.S. which
  exempts insurance from excise tax, as long as the
  policies are not part of a conduit arrangement.
• Premiums paid by U.S. corporation to foreign
  insurer are exempt from excise tax.
• Premiums paid by foreign insurer to foreign
  reinsurer are subject to 1 excise tax.

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Captive Insurance Companies Recent Activity

• Announcement 2008-18
• Voluntary compliance initiative
• Allows foreign insurance companies who have
  failed to pay excise tax due under section 4371,
  or failed to disclose that it had claimed a
  waiver from the taxes pursuant to an income tax
  treaty, to become compliant with its obligations.
  
• In general, if a taxpayer participates in this
  initiative in accordance with the terms laid out
  in this announcement, the IRS will not conduct
  examinations covering insurance excise tax
  liabilities arising under the four situations set
  forth in Rev. Rul. 2008-15, or any similar fact
  pattern, to the extent that premiums are paid or
  received by the participating taxpayer during any
  quarterly tax period prior to October 1, 2008.
• Does not cover foreign (re)insurers previously
  subject to a Closing Agreement with the IRS.

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Captive Insurance Companies Recent Activity

• TAM 200816029
• Addressed whether an entity classified as a
  partnership for federal income tax purposes
  should be considered the insured entity under a
  purported insurance arrangement for purposes of
  evaluating whether there is sufficient risk
  distribution to treat the arrangement as
  insurance for federal income tax purposes
• The Service concluded that a general
  partnership, where the general partner(s) are
  ultimately liable for the liabilities of the
  entity, it is the general partner whose risk of
  loss is shifted as such, it is the general
  partner who should be considered the insured
• The Service concluded that an entity treated as a
  partnership which is of the type that does not
  have a general partner(s) that is, under
  applicable law no liability of the entity can in
  the ordinary course attach to anyone other than
  the entity, it is the entity that should be
  considered the insured.

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Questions?