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Tax Issues… Now and Later
Southampton Princess
June 24, 2009
Tax Issues… Now and Later
Thomas M. Jones, Partner
McDermott Will & Emery LLP
312 984 7536
[email protected]
Catherine Sheridan Moore, Partner
KPMG
441 294 2606
[email protected]
Overview
• Recap
– Why “insurance” matters
– Tax definition of “insurance”
• Recent IRS Pronouncements
• Emerging Issues for 2009 and Beyond
Taxation of Captives
• The key tax question:
• Will it be treated as
“insurance” for tax purposes?
Why “Insurance” Matters ?
• Tax deduction for premiums paid to captive by
policyholder
• Favorable insurance tax treatment of captive
(deduction for discounted insurance reserves,
unearned premiums)
• Offshore captives
– CFC – Subpart F
– Possible IRC § 953(d) tax election
Tax Definition of “Insurance”
• To find insurance, the IRS and the courts have
historically required the presence of both risk
shifting and risk distribution
• The first criterion connotes the transfer of the
risk to separate party
• The second mandates that enough
independent risks are being pooled to invoke
the “actuarial law of large numbers”
Tax Definition of “Insurance”
• Case law has liberalized the tax definition of
insurance by espousing two alternative
approaches to achieving insurance tax
treatment
– Unrelated Risk
– Brother-Sister Theory
Revenue Ruling 2002-89:
Unrelated Risk
• Single parent captive otherwise properly formed
and operated (adequate capital, no parent
guarantees, loan backs, etc.)
• Not “insurance” if 90% of risks/premiums come
from the parent
• “Insurance” if less than 50% come from the
parent and the remainder are from unrelated
parties
Revenue Ruling 2002-89:
Unrelated Risk
Scenario 1
*
Scenario 2
*
P
90% premium
<50% premium
90% of risks
<50% of risks
Captive
P
S
Risks of P pooled with risks of
unrelated insureds
* Not insurance – lacks requisite risk
shifting/risk distribution
* Is insurance – premiums paid by P
are deductible
Revenue Ruling 2002-90:
Sibling Ruling
• Single parent captive otherwise properly formed
and operated (adequate capital, no parent
guarantees, loan backs, etc.)
• Insures 12 domestic subs - parent a holding
company; no sub accounts for less than 5% or
over 15% of total risk/premium
• “Insurance” under brother/sister doctrine
• Note - captive had an insurance license in all
states in which it provided subsidiary coverage!
Revenue Ruling 2002-90:
Sibling Ruling
Ruling: Arrangement between Captive and 12 subsidiaries of
Captive’s parent constitutes insurance
P
12 subsidiaries
Insurance
Solely insures professional liability
risk of each of the 12 subsidiaries
The Brother/Sister Approach
Humana, Inc. v. Comm’r.
• Established a 3 Part Test:
– “Insurance risk” / Not a sham corporation
– Commonly accepted notion of insurance
– Risk shifting & risk distribution present
• Parent guaranty caused denial of premium
deduction for period it was in existence
• Brother-sister approach applies to subsidiaries,
but not to either parent or divisions
Revenue Ruling 2002-91:
Group Captives
• Captive constitutes an “insurance company” and
premiums paid by participants are deductible
– Industry group liability captive; exact number of
participants not specified
– No member owns over 15%; has over 15% of vote;
or accounts for over 15% of risk/premium;
implies 7 equal owners OK
– No assessments or refunds
– Valid non-tax business purpose was a key factor
– IRS reinforces prior rulings on group captive
insurance arrangements
Revenue Ruling 2002-91:
Group Captives
Ruling: Arrangement, based on facts, held as insurance
UNRELATED
MEMBERS
no Member owns
>15% of Captive
Premiums
Group
Captive
Post Rulings Caveats
• The captive must still establish:
– Presence of risk distribution
– That the captive should be respected as a separate
and distinct taxable entity, i.e., it is not a sham
– IRS refers to its new approach as a “facts and
circumstances” test
Non-Sham Status
• Insurance status continues to require respect for
the captive as an entity separate and distinct
from its economic family:
– Valid non-tax business purpose
– Adequate capitalization (maximum 5:1 premium/surplus ratio
recommended)
– No parental support agreements
– Limited loan backs of captive assets to parent or affiliates
(“circularity of cash flow”)
– Formation of captive in other than a weakly or non-regulated
offshore domicile
– Captive operates on an arm’s length basis in a manner similar
to that of commercial insurers
Tax Classification of Insurance
Companies
• All entities eligible for “insurance company”
federal tax treatment are per se corporations
under § 7701(a)(3)
• Thus, there is no such thing as pass-through tax
treatment for an “insurance company” even if it’s
formed as a LLC, LLP or trust under state/local
law
17
U.S. Taxation of Offshore
Captives
• Offshore captive tax issues include:
– Imputed federal income tax on U.S. share-holders of
controlled foreign corporations (Subpart F income)
– Related party insurance income (“RPII”)
– Direct “mainstream” income tax plus potential branch
profits tax if engaged in a U.S. trade or business
– Federal 30% withholding tax (discourages loan
backs)
– Federal excise tax on premiums of 4% or 1%
U.S. Taxation of Offshore
Captives
• IRC 953(d) election:
– Taxed as if a domestic (“U.S.”) insurance company
– Direct taxation
– No Federal withholding tax
– No FET
Emerging Issues for 2009 and
Beyond
• Notice 2005-49, IRS requested taxpayer
comments on 4 captive related subjects:
– Finite risk policies as “insurance” (in captive
arrangements)
– Proper characterization of cell captive structures as
“insurance” and mechanics of making elections
– Tax consequences of loan-backs from a captive to
its owner(s)
– Homogeneity of risk as a key element of risk
distribution
Future Tax Challenges for Captives
 In short term, cash stress = more loan backs
 Mid-term, more captive IRS audits
 Longer term, parent’s tax losses will mean
insurance tax status of captive less important
 In long term, likely future tax rate reversal
with corporate rates < individual rates means
fewer S corp, LLC, etc. pass-thru structures
and more “C corp” families eligible for tax
benefits based on brother/sister risk
21
Recent IRS Cell Captive
Guidance
22
IRS 2009-10 Priority Guidance
Plan
• Released 9/10/08 – Captive related matters
listed:
• “Guidance on the classification of certain cell
captive insurance arrangements. Previous
guidance was published in Notice 2008-19.”
• “Revenue ruling providing guidance on
reinsurance arrangements entered into with a
single ceding company.”
• “Guidance concerning the classification of series
LLCs and cell companies under §7701.”
Key Tax Considerations of the
Cell Captive
• Who is the taxpayer?
– Entire company
– Each cell viewed separately
– The sponsor organization or the participant
• At what level is the determination of “insurance”
status made?
– Entire company level
– Cell level
– The sponsor organization or the participant level
24
Cell Companies: Rev. Rul.
2008-8
Y
General Account
X





Preferred Shares
Insurance Policy
Cell X
No Insured except for X
No guarantee of Cell X obligations
Adequate capital
No loans
Annual policy
Cell Y







25
Insurance
Policy Covering
Brother/Sister
Group
1
12
Adequate capital
No subsidiary < 5% nor >15%
No loans
No guarantees by Y or Y1 → Y12 of Cell Y
obligations
No other insurance contracts
Homogeneous risk
Annual policy
Cell Companies: Rev. Rul.
2008-8
• Look to existing rules; apply on cellular basis
– Risk shifting
– Risk distribution
• Arrangement between X and Cell X akin to a parent
and wholly-owned subsidiary under Rev. Ruls. 2002-89
& 2005-40
• Arrangement between Y and Cell Y characterized as
brother/sister insurance under Rev. Rul. 2002-90
• Should have been a 3rd situation in which Cell Z owned
by Z wrote over 50% unrelated risk with holding of
insurance under Rev. Rul. 2002-89
26
Cell Companies: IRS Notice
2008-19
• Proposed Guidance
• Cell of a PCC would be treated as an insurance company separate
from any other entity if:
– Assets and liabilities are legally segregated
– Based on facts and circumstances cell would be classified as an insurance
company taxable under IRC § 816(a) or § 831(c)
• Tax Effect
– Elections at cell level
– Cell must apply for FEIN if subject to U.S. tax jurisdiction
– Cell activities not taken into account in characterizing PCC’s “general
account” (core)
– Cell (or parent, if consolidated) responsible for filing returns and paying tax
– PCC does not include income items with respect to cell
27
Cell Companies: IRS Notice
2008-19
• To implement this guidance, taxpayer comment requested by
5/5/08 regarding:
– Transitional rules
– Reporting, if any, necessary to ensure PCC has needed
information
– Special rules regarding foreign entities (including CFCs)
– Treatment of PCCs and cells under consolidated return rules
– How to handle segregated arrangements not involving insurance
• Note explicitly states no inference should be inferred as to tax
status of PCC core or its non-insurance cells
• Effective date would be for tax years beginning more than 12
months after this guidance is finalized
28
Chief Counsel Advice
200849013
• Offshore cell captive that made an onshore tax election
• Wholly owned by a mutual with numerous unrelated
policyholder/member-owners
• IRS assumed each cell is a separate taxpayer
• Each cell was tied to a specific mutual member via a
participation agreement
• Held Cell 1 qualifies under the brother-sister test – IRS
agent was wrong to aggregate 1st & 2nd tier subs
• No IRS conclusion on aggregate analysis versus by lines
of business because IRS position on homogeneity issue
remains unclear as of the CCA release date (12/5/08)
Recent IRS Federal Excise
Tax Guidance
30
U.S. Federal Excise Tax
• “Insurance Premiums” received by a non-U.S.
Captive from a U.S. (re)insurer are subject
to a U.S. excise tax
– Exceptions for
• 953(d) electing companies
• Those engaged in a U.S. trade or business
• Treaty provisions
• Tax Rates – on gross premiums
– Direct P&C insurance – 4%
– Reinsurance & Life – 1%
Cascading of Federal Excise
Tax
• In Rev. Rul. 2008-15, the IRS announced that
it will impose a 1% excise tax on every
subsequent reinsurance transaction
associated with U.S. risks.
• Rev. Rul. 2008-15 sets forth four situations to
demonstrate this principle with and without
applicable tax treaties.
Example – U.S. Federal
Excise Tax (“FET”)
US
Front
Premium $
Will FET apply?
If so, at what rate?
Bermuda
Captive
Will FET apply
to this cession?
Premium $
Bermuda
Reinsurer
Cascading of Federal Excise
Tax
Voluntary Compliance Initiative
• IRS Announcement 2008-18 states that the
IRS will not seek to collect the cascading
taxes for periods prior to October 1, 2008,
from insurance companies that agree to
collect such taxes at all times on or after
October 1, 2008
• If an insurance company does not agree to
do so, then the IRS can collect those taxes
for all prior and future periods
Recent IRS Tax Rulings
PLR 200910066 - Released
3/06/09
• Insurer in run-off qualified as an insurance company
since >50% of its business during the year involved
(re)insurance
• Did not qualify for tax exempt status since it did not
meet the 50% gross receipts test (as it had no
premiums)
PLR 200907006 - Released
2/13/09
• Offshore captive owned by Individual A with onshore tax election
• Direct writes numerous barely related domestic poIicyholders
• Also participates (as cedant and reinsurer) in same foreign jurisdiction
risk pool with >12 unrelated participants no one of which accounts for
>15% of total pooled risk
• Mostly in extraction industry so risks mostly are homogeneous
• No guarantees by any related party and captive is well capitalized
• PLR concludes captive is a bona fide insurance company applying the
group captive standards of Rev. Rul. 2002-91
• But seems like the unrelated risk standards of Rev. Rul. 2002-89 would
be a more appropriate basis for reaching this taxpayer favorable result
FAA 20092101F - Released
2/4/09
• Field Attorney Advice invokes long dormant IRC §845
• Super-§482 transfer pricing adjustment provision applies to reinsurance
• Insurer used quota share reinsurance to transfer profitable business into
subsidiary reinsurer (offshore with §953(d) election)
• Motive: Sub had net operating tax losses isolated under DCL rules
• IRS conceded transaction was not a sham and reinsurance was real
• IRS viewed surplus relief of ceding company generated by transaction to
be unnecessary and wouldn’t have occurred but for tax benefit
• IRS applied §845(b) stating business reason for reinsurance transaction
is irrelevant if “significant tax avoidance effect” occurs
• Note §845 applies to both related party and unrelated party reinsurance
• A “wild card” that the IRS can play in many factual situations
CCA 200844011 - Released
10/31/08
• Involves an offshore contractual risk pooling arrangement
among wholly owned domestic captives of numerous
unrelated U.S. parents
• The pool operates through committees meeting offshore
and is managed by an offshore captive manager
• Holds that notwithstanding non-entity legal status, for tax
purposes the pool functions and is taxable as a reinsurance
company under § 7701(a)(3)
• Thus, the pool is classified as a foreign reinsurer covering
U.S. risks of the captives’ policyholders
• As a result, federal excise tax is imposed (presumably at a
1% rate) on premiums paid to the pool
PLR 200837041 - Released
9/12/08
• Offshore mutual group captive lost (c)(15) status and 953(d) election
revoked due to lack of risk distribution; insufficient insurance activity
• Concedes “no court has squarely held that there can be no risk
distribution if there is only one, or a few, insureds.”
• But indicates “risk distribution in terms of exposure units is computed
by line of business” citing FSA 1998-578 for a homogeneity
requirement (but compare CCA 200849013, already discussed)
• PLR states that too much income derived from investments rather
than premiums and that the taxpayer was over-capitalized
• PLR says taxpayer “had no employees, no sales staff or clerical staff”
and there was “no promoting or selling of insurance services”
• Taxpayer apparently failed to conduct level of insurance activity
indicated in its tax exemption application
TAM 200827006 - Released
7/4/08
• Embedded warranty, similar to PLR 200628018, but latter deals with
manufacturer itself while this ruling deals with retailer assuming and
covering manufacturers’ warranty obligations
• Non-insurance status of embedded warranty applies to both
manufacturer branded products and taxpayer branded products
• IRS rationale is lack of fortuity because “insurance does not
guarantee the integrity of an item” but rather covers “outside perils”
• Here the product likely was defective when shipped and sold, so the
problem was under the manufacturer’s control, was not accidental
and therefore is a business rather than an insurance risk
• IRS asserts shifting the risk to the retailer’s captive does not change
the nature of the underlying risk
TAM 200824028 - Released
6/13/08
• Captive allegedly in run-off lost (c)(15) status and 953(d)
election revoked
• Taxpayer’s argument that more extensive insurance
activities in prior years should count in year under audit
rejected: “the test is applied on a year to year basis”
• IRS concedes insurers in run-off can retain insurance
company tax status, but notes taxpayer’s activities not
consistent with a run-off company as it “did not undertake
any efforts to either expedite closing the run-off business or
develop additional [insurance] business”
• Also held taxpayer was a member of a controlled group
causing it to exceed the then applicable statutory $350,000
premium limitation
TAM 200816029 – Released
4/18/08
Where a partnership is the named insured in a
captive insurance arrangement, is the partnership
or the partners the insureds for determining
adequacy of risk distribution?
The IRS determined that the:
– The partners are the insureds if it is a general partnership
– The partnership is the insured if there are no general
partners and no liability could attach to anyone other than
the partnership (i.e., a multi-member LLC choosing
partnership taxation)
A Few Problems with TAM
200816029
• Fails to discuss the aggregate vs. entity theory
surrounding proper tax treatment of partnership
items
• Disregards the partnership as the named insured
• Does not consider the existence of multiple,
independent risks in determining risk distribution
• Fails to comport with business realities – e.g., most
limited partnerships have a single general
corporate partner with nominal capital, yet all risks
are attributed to it
Questions
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