Hospital Captive Legalities: Update on Regulatory, Tax

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Hospital Captive Legalities Update on
Regulatory, Tax Corporate Governance
Developments Affecting Health Care Provider
CaptivesJune 17, 2008
Thomas M. Jones McDermott Will Emery
LLPtjones_at_mwe.com 312-984-7536
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XYZ Bermuda Indemnity, Ltd.

• Sample Captive Board Presentation
• ABC Health Care System
• Operates Hospitals in Illinois and Iowa Elbow
  Beach ResortBermuda
• Educational Session March _, 2008
• Thomas M. Jones
• McDermott Will Emery LLP
• Chicago, Illinois

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Captive Structural/Regulatory Issues

• State insurance laws and regulations
• Federal and state tax considerations
• Securities registration exemption/antifraud
  disclosure (applicable to group captives)
• Other legal considerations (e.g., Medicare fraud
  and abuse)
• Management/governance (directors and committees)
• Coverage and policy questions
• Choice of form (stock/mutual/reciprocal) (onshore
  vs. offshore)

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The Bermuda Regulatory Environment

• Judicious discretion with limited statutory rules
• Bermudas Insurance Act provides the basic
  framework
• The Bermuda Monetary Authority sets financial
  parameters using a holistic approach and rules
  of thumb rather than rigid rules meritorious
  exceptions are granted by the BMA granting a
  Sec. 56 Directive
• The captives filed business plan, as amended
  from time to time, establishes its
  responsibilities and undertakings
• Local insurance managers play a contingent but
  important regulatory role

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Directors Duties Under Bermuda Law

• Duty of skill, care and diligence
• Oversight role - duty to adequately supervise
  competent service providers
• Fiduciary duties - directors must act in the best
  interests of the captive and must disclose to
  other directors any material conflict of interest
• Director indemnification - except for dishonesty,
  willful default or gross negligence

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Illinois Insurance Regulatory Issues

• Prohibition against conducting an unauthorized
  business of insurance in IL
• Two potential bases for the position that there
  is no unauthorized insurance in Illinois
• Industrial insured exception
• No insurance

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Illinois Insurance Regulatory Issues

• Exception for IL industrial insureds (each of
  these three requirements must be met)
• At least 100,000 in annual premiums
• Access to employed risk manager or contracted
  insurance consultant and
• Gross assets over 3 million or gross revenues
  over 5 million or at least 25 full-time
  employees

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Iowa Insurance Regulatory Issues

• Prohibition against conducting an unauthorized
  business of insurance in IA
• Two potential bases for the position that there
  is no unauthorized insurance in IA
• Policy solicited, written delivered outside IA
• No insurance
• IA has no industrial insured exception

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IL IA Insurance Regulatory Issues

• No insurance position
• The business of insurance requires risk
  spreading and risk shifting
• Arguably, there is no shifting or spreading of
  risk within an economically integrated group of
  entities
• Typically, entities within a corporate system
  that are under common ownership and control of
  the First Named Insured are covered under a
  single policy issued to the First Named Insured

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IL IA Insurance Regulatory Issues

• In order to cover affiliates under the same
  policy and take the position that the single
  policy does not represent insurance, the
  covered entities must be under common control,
  i.e., the policyholder must have more than 50
  control, through ownership or ability to elect
  the governing body
• Independent non-employee medical staff physicians
  constitute third party risk

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Taxation of Healthcare Captives

• The key tax question
• Is it treated as insurance?

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Tax Definition of Insurance

• No clear-cut definition in tax law
• Must analyze case law and IRS rulings
• Captives preference is to avoid insurance
  company tax status for itself and for its parent
• But voluntary physicians need premium
  deductibility

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Two Basic Requirements

• For insurance treatment, both risk shifting and
  risk distribution must be present
• Risk shifting must be to a separate legal entity
• Risk distribution connotes enough independent
  risks pooled to invoke the actuarial law of
  large numbers

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Advantages of Non-Insurance Status for Tax
Exempt Owner of Offshore Captive

• Premiums paid not subject to a federal excise tax
  (4 of the premium for direct insurance and 1
  for reinsurance or life)
• Can avoid attribution of any unrelated business
  taxable income to captives tax-exempt parent
• State premium tax (known as direct placement
  tax or self-procurement tax) would apply
  e.g., IA rate of 2 of premium none in IL

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Onshore Hospital Captives Tax Status

• If captive funds risk of only its tax exempt
  parent and employees, then captive can obtain an
  IRS determination letter granting IRC Sec.
  501(c)(3) tax exempt status
• Must file IRS Form 1023 with a description of
  intended activities can cover non-employed
  physicians or other third parties only if
  insubstantial in amount (lt5 of premiums)
• Thus limited scope of captive activities if
  onshore covering any substantial ineligible
  party causes all income of the domestic captive
  to become fully taxable

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Offshore Hospital Captives - Tax Issues

• No corporate income taxes in Bermuda
• Offshore captives are not tax-exempt so they
  can accommodate addition of non-employed
  physicians, but there may be tax ramifications
• Federal excise tax on premiums
• Unrelated business taxable income to captives
  U.S. shareholder on net income from covering
  VAPs or non-controlled entities
• But unlike onshore captives, covering third
  parties may generate some tax but it does not
  taint the entire captive this is the principal
  reason most captives owned by tax exempt
  hospitals are domiciled offshore

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Hospital Captive with Independent Physician
Coverage
501(c)(3)Parent
Insurance
HospitalOwned Medical Practice
Non-Employed Medical Staff Physicians
501(c)(3)Hospital
Insurance
Insurance
Captive Insurance Company
Insurance
(Regulatory Issues)
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Avoiding a U.S. Trade or Business

• Why? If offshore captive is found to be engaging
  in a U.S. business, it will become subject to
  U.S. corporate income tax on its income
  effectively connected with the U.S.
• How to avoid
• Conduct day-to-day activities outside of U.S.
• Do not qualify to do business in any state
• Utilize offshore management company
• Never sign contracts in U.S.
• Never hold meetings or make official decisions in
  U.S.

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Avoiding a U.S. Trade or Business

• Critical for offshore captives not electing
  onshore tax treatment, but also relevant for
  compliance with state insurance unauthorized
  business of insurance laws
• Potential double taxation - mainstream 35
  corporate income tax plus additional 30 branch
  profits tax on profit repatriations from the
  U.S.
• Goal - make captive a passive reimburser of
  already paid claims

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Avoiding a U.S. Trade or Business

• A factual determination
• Determined anew each tax year
• Main factors are continuity, regularity and
  substantiality of captives U.S. activities
• Management situs test - where is captives mind
  and management?
• Activity of employees and dependent agents
  attributed to captive not independent agents

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Avoiding a U.S. Trade or Business

• Suggested actions to avoid a U.S. business
• Prohibit U.S. meetings and contract signing in
  offshore captives corporate bylaws (called
  bye-laws in Bermuda)
• Policy language should allow indemnitee to adjust
  claims with optional participation by captive
• Parents risk manager should not be an officer or
  director of the captive he/she should present
  claims report, etc. in capacity of consultant to
  the board

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Bermuda Captive Investments

• A 30 non-recoverable federal withholding tax
  is imposed on certain U.S. investments
• All dividends paid on equities (common and
  preferred shares, ETFs) of U.S. issuers (except
  American Depository Receipts)
• U.S. bond funds (3 year exception enacted in 2004
  expired 1/1/08) (but no tax on portfolios
  comprised of individual bonds)
• Clone bond funds formed in Ireland (UCITS) or
  Luxembourg (SICAVs) avoid this tax under
  applicable U.S. tax treaties
• Avoid funds formed in the U.S. as trusts or
  partnerships

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U.S. Tax Compliance

• The captives U.S. shareholder must file annually
  the following forms
• IRS Form 5471 show captive as an investment
  company
• IRS Form 926 report all transfers to captive as
  capital contributions
• Treasury Form TD F 90-22.1 all U.S. persons must
  disclose signatory authority over foreign bank
  accounts

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U.S. Tax Compliance (Continued)

• Making a Protective IRS Form 1120-F Filing
• A foreign corporation that is engaged in a U.S.
  trade or business is subject to U.S. tax on its
  net income, not its gross income, but ONLY if it
  files a U.S. return in that year
• If a foreign corporation is found to be engaged
  in a trade or business on audit and has not filed
  a U.S. return for the year in question, it will
  generally be taxed in the U.S. on its gross
  income (i.e., no deductions or credits allowed)
• A foreign corporation can make a protective
  filing in any year even if it does not believe it
  has a U.S. trade or business by filing a Form
  1120-F and indicating that the form is being
  filed for protective purposes
• No need to show numbers just name, address
  FEIN

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Summary of Hospital Captive Status

• Not an insurance company for tax purposes
• No federal excise tax imposed on premiums
• No unrelated business taxable income to sole
  S/H
• Premiums are not deductible for taxable
  affiliates
• No violation of Illinois or Iowa insurance law
• No captive activity in Illinois or Iowa
• Self-funding, not true insurance
• Policyholders representing most of the premium
  also qualify as industrial insureds
• Foregoing not changed with coverage of controlled
  affiliates
• But some major changes if non-employed physician
  practices are covered in the future

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Goals of Corporate Governance Presentation

• To provide an overview of ten key 2007-2008
  corporate governance developments
• To list underlying factors causing the subtle and
  ongoing shift in board focus from guidance to
  compliance
• To alert attendees of important corporate
  governance developments so they can position
  themselves to anticipate upcoming changes

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Development One Environment of Skepticism

• Healthcare providers are operating within an
  increasingly skeptical environment
• Governmental (federal, state and local)
• Media (biased?)
• Patients, residents, families and service
  recipients
• Standard setting associations, consumer advocacy
  groups, corporate payer alliances, etc.

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Development Two Best Practices 2.0

• Governance best practices continued to evolve
  in 2007-08, both through actions taken by leading
  nonprofit organizations and by report released by
  the Panel on the Nonprofit Sectors Principles
  for Good Governance and Ethical Practice

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Development Three Conflict Avoidance

• Closer emphasis on proper board and key committee
  (compensation, audit, compliance) composition
  generated by legislatures, regulators, media and
  public interest groups
• Elimination of incestuous financial relationships
  created difficult decisions in the nominating
  process and narrowed the field of eligible
  independent candidates knowledgeable about the
  industry

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Development Four Conflicts Management

• Issues associated with proper handling of
  existing director conflicts of interest and lack
  of independence continued to surface in 2008,
  placing boards under increasing pressure to
  address legislative/regulatory concerns with the
  integrity of the boards decision-making process

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Development Five Executive Compensation

• Matters relating to executive compensation paid
  by nonprofit, tax-exempt organizations, and the
  boards role in approving such compensation,
  continued to be the source of close regulatory
  attention in 2008

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Development Six IRS and Governance

• The IRS has dramatically increased its level of
  attention to the corporate governance practices
  of tax-exempt organizations, as manifested in
  multiple different ways
• 2007-08 witnessed several important developments
  relating to the ability of nonprofit hospitals
  and health systems to qualify for both local
  (property tax) and federal (income) tax exemptions

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Development Seven Legal Controls

• 2007 was particularly notable for a series of
  events which emphasize the importance of legal
  controls, and of a strong internal/general
  counsel function, within the organization

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Development Eight Quality of Care Oversight

• A growing expectation of the board to exercise an
  increasing degree of oversight regarding quality
  as it relates to service performance, measurement
  tools and reporting requirements emerged during
  2007

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Development Nine Financial Irregularities

• An important 2007 development which flew under
  the radar is the dramatic increase in reported
  cases/allegations of financial impropriety
  involving corporate management of nonprofits

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Development Ten Proper Role of Board

• The foregoing developments collectively
  contribute to a particularly significant shift in
  the role of the board from guidance to
  compliance

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The Guidance Board

• Traditional approach
• Focused principally on providing management with
  strategic guidance
• Advice and support versus direct oversight
• Supportive of entrepreneurial spirit

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The Compliance Board

• Focused principally on organizational compliance
  with laws and regulations
• Responsive to increasing legal/public opinions
  scrutiny
• Mentality of constructive skepticism
• Appreciation of enhanced oversight obligation
• Vigorous oversight of corporate affairs

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Emerging Governance Concerns

• How far should corporate accountability extend?
  Cost/benefit analysis?
• Do executives suffer from less direct expression
  of vision from the board?
• Decline in informed risk taking?
• Are boards becoming too reactive too focused on
  regulation, compliance, whistle-blowing risks?

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Questions
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Thank You