captive insurance taxation 101 presenter: doug harrell november 2011

Captive Insurance Taxation 101

Presenter: Doug Harrell

November 2011

© [year] [legal member firm name], a [jurisdiction] [legal structure] and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

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Agenda

Insurance or Non-Insurance

Non-Insurance

Insurance

Elections 953(d) & 831(b)

Tax Provisions

FIN 48

Forms and Reporting Requirements

New Developments


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Insurance or Non-Insurance

No statutory or regulatory definition of “insurance” - only cases and rulings

To find insurance, the IRS and the courts have historically required the presence of both risk shifting and risk distribution


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Risk Shifting and Risk Distribution

Risk Shifting to include a passage of loss from an insured to an insurer; a payment of a premium that is less than the risk insured; and an insurer that is financially capable of accepting the risk

Risk Distribution exists when all of the following are present: the insurer has a sufficient number of exposures for the statistical law of averages to function; the exposures present approximately the same chance of loss; and the exposures are each separate and distinct


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Economic Family

The Tax Court commenced by rejecting the IRS proposition that a parent corporation can never obtain insurance from an insurance company related by ownership.

The court had repeatedly rejected the Service's economic family theory, then developed a test that it characterized as a facts-and-circumstances approach with three prongs, each of which must be satisfied:

- (1) the arrangement must involve the existence of an insurance risk; (2) there must be both risk shifting and risk distribution; and (3) the arrangement must be for insurance in its commonly accepted sense.


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Revenue Ruling 2002-89 Unrelated Risk Ruling

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


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P

Captive

Scenario 1 Scenario 2

P

S

* *90% premium

90% of risks<50% premium

<50% of risks

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 2002-89


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Taxpayer’s Theory – The “Balance Sheet” Approach

Risk shifting and risk distribution may exist within an economic family

Risk shifting exists where the risk of loss is transferred off the policyholder’s balance sheet

Risk distribution exists where the risk of loss is distributed among independent policyholders (even within a family)


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The Brother/Sister ApproachHumana, Inc. v. Comm’r.

In Humana, the parent of an affiliated group established a captive subsidiary after its coverage was cancelled by a commercial insurance carrier and it was unable to obtain other coverage. The parent paid premiums to the captive, which were calculated by using standard insurance industry practices for itself and its subsidiaries. The parent then charged back to the subsidiaries the payments that it made on their behalf


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The Brother/Sister ApproachHumana, Inc. v. Comm’r.

No tax deduction for payments from parent to subsidiary

Tax deductibility of subsidiaries’ premiums paid to captive (brother - sister premiums)

Humana

NYSE Shareholders

100+Subs100+Subs

Foreign Holding Co.Foreign Holding Co.

ColoradoCaptive

ColoradoCaptive


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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


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P

Insurance

12 subsidiaries

Solely insures professional liability risk of each of the 12 subsidiaries

Ruling: Arrangement between Captive and 12 subsidiaries of Captive’s parent constitutes insurance



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Revenue Ruling 2002-91 Group Captive Ruling

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


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GroupCaptive

Ruling: Arrangement, based on facts, held as insurance

UNRELATEDMEMBERS

Premiums

no Member owns>15% of Captive



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Offshore Federal Tax Considerations

Offshore captive tax issues include:

- Imputed federal income tax on controlled foreign corporations (“Subpart F” income)

- Related party insurance income (“RPII”)

- Branch profits tax

- Federal withholding tax

- Federal excise tax

- A qualifying “insurance company” can opt out of foregoing by electing taxation as a domestic entity


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Avoidance of U.S. Trade or Business

A factual determination

Determined each tax year

Main factors are continuity, regularity and substantiality of captive’s U.S. activities

Management situs test - where is captive’s “mind and management?”

Activity of employees and dependent agents attributed to captive; not independent agents


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Controlled Foreign Corporations

A foreign corporation is a CFC if, on any day during its tax year, U.S. shareholders own more than 50% of the combined voting power of all classes of stock, or more than 50% of the total value of the corporation

a U.S. shareholder is any person owning at least 10% of the total combined voting power of all classes of stock of the foreign corporation

A company is an insurance CFC if its 10% U.S. shareholders own more than 25% of the vote or value of the offshore captive.


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RPII – Related Person Insurance Income

Another rule applies for purposes of allocating insurance income derived from the insuring of related parties (“related person insurance income”); here, all U.S. shareholders, not just 10% or more, are included for purposes of the 25% test.

Thus, if a foreign captive is a CFC, the U.S. shareholders must include in taxable income their pro rata share of the CFC's Subpart F insurance income, thereby negating any deferral of such income, whether or not repatriated


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Subpart F

Subpart F requires every person (and entity) that is a U.S. shareholder of a CFC, and owns stock in the corporation on the last day of the CFC's tax year, to include in gross income a deemed dividend equal to the shareholder's pro rata share of the CFC's “tainted earnings,” which includes “insurance income.”

Subpart F applies only to a CFC.

The Subpart F income is reported on Form 5471 which is required to be filed on an annual basis.


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Non-Insurance Captive Summary

Subpart F income

U.S. Withholding taxes of 30% of the fixed and determinable income. Portfolio debt exception generally eliminates withholding tax on interest and generally, no withholding tax on capital proceeds

No Excise Tax imposed on premiums


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Taxation of Offshore Captives with a Tax-Exempt Owner

Goal to avoid “insurance company” status for captive

If not insurance, then can avoid federal excise tax and state tax on premiums

If not insurance, then can avoid “unrelated business taxable income” to tax-exempt parent


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Insurance Company Taxation

How is the captive taxed?

If the captive qualifies as an insurance company for tax purposes, the taxable income will be calculated pursuant to the insurance company provisions of the U.S. tax code.

- Tax adjustments

- Loss reserves discounting

- 20% haircut for unearned premiums

- Deferred acquisition costs - when a company defers the sales costs that are associated with acquiring a new customer over the term of the insurance contract.


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Federal Excise Tax

Applies to premiums paid to foreign insurers/reinsurers covering U.S. risks

- 4% on “direct” property & casualty policies

- 1% on life policies and all reinsurance

Withheld and remitted (quarterly on IRS Form 720) by payer of premium

If not a deductible “insurance” premium, then FET N/A - Rev. Rul. 78-277

Also N/A if onshore tax election is made or tax treaty applies (e.g., Ireland, UK, Germany, Switzerland)


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953(d) Election

We elect

Elect to be treated as a U.S. taxpayer

- Section 953(d) election

- Taxed on all income, same as a U.S. company


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Section 953(d) Election

Election is irrevocable

Captive becomes a U.S. domestic corporation for all purposes of the U.S. tax code

LOC requirement if not sufficient U.S. assets

Captive files U.S. tax return and pays income tax (Form 5471 no longer required for shareholders)


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Section 953(d) Election

Eliminates U.S. trade or business concerns

State regulatory concerns still exist

There are two levels of U.S. tax on corporate earnings. However, the effect is mitigated by the dividends received deduction and the maximum tax rate for dividends of 15%.

No FET

No withholding tax

Dual Consolidated Losses – taxable losses of the captive cannot be used to offset taxable income of other members of the consolidated group


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Section 831(b) Election

Available to captives that have made the §953(d) election

Premiums must be no greater than $1,200,000

If election is made, it is effective for the year made and all subsequent years when the requirements are met.

Company will be taxed on net investment income only


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Tax Provision

Captives that have made the §953(d) election must have a tax provision as part of their audited financial statements.

Most times the Firm that is engaged to prepare the tax returns will prepare the tax provision .

It is imperative that you work closely with your tax advisors to obtain the tax provision to ensure that you are able to meet regulatory and client deadlines.


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FIN 48

U.S. taxpayers must report tax uncertainties per U.S. GAAP

A tax position meets the uncertainty definition if the taxpayer can not demonstrate that they have a greater than 50% likelihood of sustaining the position if it is challenged by the tax authorities.

Tax uncertainties must be disclosed in the foot notes of the financial statements.


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U.S. Tax Reporting Requirements

Common U.S. Tax Forms Summary

Form 5471 – non-insurance CFC, or non 953(d) electing insurance CFC

Form 926

Form 1120PC – for a 953(d) electing captive

Form 1120F - Protective tax return

Form 720 - Excise Tax Form – quarterly filing of forms.

Form TDF 90-22.1 - Treasury Forms


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Recent Developments

There should be limited additional reporting for captives under FATCA

A new tax form for US individuals will be required for the 2011 tax year and subsequent years (Form 8938) if they own an interest in a specified foreign financial asset and the value of such assets in the aggregate exceeds US$50,000 for any year

Form 8938 is not yet available and the filing requirement is suspended until the final version of the form in released

May impact US individual owners of Cayman captives

Questions


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ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

The information contained herein is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser.

This presentation is not an opinion of KPMG with respect to any matter discussed herein and may not be relied upon as such by any party. In various sections of this presentation, for ease of understanding and as a stylistic matter, we may use language (such as “will” or “should”) that might suggest that we have reached a conclusion on an issue at a specific level of opinion. Such language should not be so construed. We would be pleased to work with you further in finalizing the transaction, and developing an opinion on any aspect of the issues addressed herein should you so request.

Certain matters addressed in these slides relate to recent legislation and as such, our comments herein should be considered as preliminary and subject to change. We expect to receive more details of any possible changes over the next few weeks and months.

© 2011 KPMG, a Cayman Islands partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. The KPMG name, logo and “cutting through complexity” are registered trademarks or trademarks of KPMG International Cooperative (“KPMG International”).

Circular 230 Notice – This communication is not intended for a specific set of facts. Any tax advice in this communication is not intended or written to be used, and cannot be used, by a client or any other person or entity for the purpose of (i) avoiding penalties that may be imposed on any taxpayer or (ii) promoting, marketing or recommending to another party any matters addressed herein.

Any advice in this communication is limited. Tax law, regulations, and the judicial and administrative interpretations thereof are subject to change or modifications, retroactively and/or prospectively, and any such changes could affect the validity of this presentation.

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

Doug HarrellPartner+1 345 914 [email protected]

captive insurance taxation 101 presenter: doug harrell november 2011

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