captive tax update 2 - 4, 2014

CAPTIVE TAX UPDATE

www.bermudacaptive.bm JUN 2 - 4, 2014

Moderator:

• Catherine Sheridan-Moore, KPMG Bermuda LLP

Speakers:

• Tom Jones, McDermott Will & Emery LLP

• P. Bruce Wright, Sutherland Asbill & Brennan LLP

2

• Divided opinion issued 1/14/14 in favor of taxpayer– Reviewed by full court – 16 judges (one recused himself)– 4 opinions: majority, concurring and 2 dissenting

• Majority found all major tax requirements were present:– Risk shifting (dissent disagreed)– Risk distribution (dissent position unclear)– Common notions of insurance (dissent disagreed)

• Applying facts & circumstances test, premium deduction of $43 million by sister subs was upheld (no premium was allocated to RAC itself, a pure holding company)

Rent-A-Center Tax Court Decision

3

• RAC a public company in “rent-to-own” business

• Formed Legacy in Bermuda in 2002; made 953(d) election

• Risks of approximately15 subs were covered; largest sub accounted for about 2/3 of total risk (latter percentage not stated in opinion)

• RAC paid premiums to Legacy on behalf of subs and used its cost accounting formula to allocate premium expense based on each sub’s exposure units

• Standard coverages – w/c, auto and general liability

• Structured as a deductible buy-back program

• Independent actuary and third party administrator

Rent-A-Center Case Key Facts

4

• IRS sham argument rejected; Legacy formed for valid non-tax business purposes

• Risk clearly shifted to Legacy from subs (but not parent)

• Majority of judges now accept brother/sister theory (rejected by Tax Court in Humana in 1987) based on either facts/circumstances or IRS concession of the economic family doctrine in Rev. Rul. 2001-31

• The 6th Circuit in Humana appeal held in 1989 that the Tax Court had erred on this point, so now 15 Tax Court judges voted on whether to overrule or keep its past brother/sister position (given that this case’s appeal goes to a different (the 5th) Circuit)

• As stated, a majority of judges now agree that the brother-sister theory works to create risk shifting/distribution, making application of the “balance sheet” test the official Tax Court position

Rent-A-Center Case Majority Opinion

5

Refining impact of a parent guaranty

•Majority opinion found RAC’s limited guaranty of Legacy did not prevent risk shifting

•Facts & circumstances test: “we must look to the substance of that guaranty”

– Legacy more than adequately capitalized (dissent disagreed)– Guaranty provided by parent, not by insured subs owning no Legacy

shares– Guaranty in favor of captive not fronting carrier (as in prior cases)– Regulatory purpose for guaranty – so BMA would recognize Legacy’s

deferred tax asset for statutory ratios– $25M amount relatively small compared with $264M premiums– Guaranty never used & removed when no longer needed for BMA

•Dissent says existence of RAC guaranty should negate “risk shifting”

RAC: Risk Shifting Take-Away

6

• Refining meaning of “risk distribution”

• Majority opinion primarily focused on risks, not on entities: “RAC’s subs had a sufficient number of statistically independent risks.”

• Judge Foley looked at number of stores, employees and vehicles

• If likely appeal of RAC and pending risk distribution cases reach similar result, then expansion of Humana doctrine will provide a much easier path to achieving insurance status (except for parent risk)

• Could reduce need for risk pools and other means of finding unrelated risk to place in a captive

• Rev. Rul. 2002-90 cited by majority only for IRS recognition of validity of Humana concept – IRS requirement of 12 subs each between 5%-15% of total risk (premiums) implicitly rejected by majority

RAC: Risk Distribution Take-Away

7

Legacy’s purchase of $108 million of RAC treasury shares

•Treasury shares bought and held by Legacy during years in issue

•Judge Foley said no circular cash flow because shares not sold

•Dissent said treasury shares were a factor in characterizing Legacy as “a mere holding tank for cash”

– Because the shares were non-income producing and illiquid, dissent said they were poorly suited for an insurance company’s investments

– Plus dissent found a negative correlation such that if RAC experienced large losses, the value of the shares would decline when most needed by Legacy

– Coupled with the guaranty and low capitalization, dissent said no risk was shifted to Legacy

RAC: Loan Back Issue

8

Validus Reinsurance Ltd.: Cascading FET Case

• As a result of imposition of “cascading” federal excise tax, a refund suit was filed by Validus in U.S. District Court for the District of Columbia– Validus is a Bermuda reinsurance company which has no

place of business in the U.S.– As part of its reinsurance business, Validus sometimes

buys re-reinsurance for a portion of its potential liabilities– Issue is whether 1% FET is due when a foreign reinsurer

covering U.S. risk cedes the risk to another foreign reinsurer (i.e., in a retrocession transaction)

9

Cascading Tax

• Validus– Validus’ arguments:

• Plain language of statute does not apply to retrocessions• No clear evidence that Congress intended to tax wholly extra-

territorial transactions. (When a statute is not specific as to extra-territorial application, it has none. Kiobel v. Royal Dutch Petroleum Co., 133 S. Ct. 1659 (2013))

• Stamp tax imposed on reinsurance premiums in 1942 indicates legislative intent to apply only to U.S. location

• Regulations issued almost 30 years after excise tax first enacted refer to transfers of premium paid to a foreign insurer or reinsurer

• Anti-conduit provision in treaties indicates intent to tax transaction only once

10

Cascading Tax

• Validus– IRS’ arguments

• Plain language of the statute allows cascading tax to be imposed on premium if issued “to or for” an insured defined in IRC §4372(d)

• Congress intended to impose the tax extra-territorially to implement its purpose to eliminate a tax advantage to foreign reinsurers

• Stamp tax argument is not valid as anyone could affix stamps anywhere

• Thus, FET applies to retrocessions

1111

Cascading Tax

• Validus– Court holding

• IRC§4371 limits application to contracts of reinsurance covering contracts taxable under IRC§ 4371(1) or (2), i.e., property or life contracts

• Premiums at issue were paid for re-reinsurance, i.e., retrocession of reinsurance assumed not policies described in IRC§4371(1) or (2)

• Rejected IRS arguments that (1) if Congress had intended to have an exception for retrocession, it would have provided it, and (2) that taxing retrocessions was consistent with underlying statute

12

Cascading Tax

• Validus court holding– Observations

• Decision relieving all retrocessions from FET appears overly broad

• For example, US risk covered by US insurer who reinsures with US reinsurer that then retrocedes to Bermuda reinsurers escapes FET

• Inconsistent with Congressional intent to level the playing field between US and foreign reinsurance transactions

• IRS filed an appeal to the US Court of Appeals for the District of Columbia Circuit on April 10, 2014

13

Residual Value Lease Insurance Case

• In RVI Guaranty Co., Ltd., filed in Tax Court on 11/8/12, Bermuda commercial RVI insurer challenges holdings of TAM 201149021

• Over $55 million at stake – IRS denied insurance accounting (unearned premium and loss reserve deductions)

• IRS revoked IRC §953(d) domestic election

• Also imputed interest issue on intercompany loan

• Key issue – business vs. insurance risk

14

TAM 201149021 – Released 12/9/11

• Concluded policy providing residual lease value coverage to a “protected party” (i.e., policyholder) is not an “insurance” contract for federal tax purposes based on a 3-pronged IRS rationale:

• Absence of insurance risk - loss is measured by market forces (i.e., law of supply & demand) rather than by consequences of a “accident” or “casualty event” so no fortuity; therefore must be an investment risk

• Not insurance in the commonly accepted sense - coverage excluded physical damage to the leased property; IRS ignored fact that residual value insurance is readily available commercially

15

TAM 201149021 (cont’d)

• IRS quote: “The tax treatment of a product at issue should be decided by legal relationships and not by the number of product sellers or the amount of product sales”

• Lack of Risk Distribution - IRS alleged contracts in issue were interdependent in that a general economic recession, increase in unemployment, jump in fuel prices, etc. would adversely impact the residual value of all leased property (motor vehicles, etc.)– IRS invoked the “flood plain” no uncorrelated risk ruling– Hard to accept with potentially thousands of leased items scattered

across the globe

16

• Background– Often captives with elections under IRC 831(b) have entered into

“pooling arrangements” to generate adequate risk distribution, i.e., the net retention is risk from all pool participants

– In December 2013, the IRS issued nine similar private letter rulings (CCAs): 201350008, 201350009, 201350010, 201350026-31

831(b) Captives

17

• PLR Facts– Captive formed in foreign jurisdiction & made a§ 953(d) election– Policies were issued to two or more affiliates– Captive joined a pool with unrelated parties and (a) ceded a

substantial portion of direct written premium, and (b) assumed a roughly equal amount of premium and risk

– Pool arrangement provided for experience refunds and experience loss carryforwards

– Facts do not discuss specifics of business ceded, provisions of pooling arrangement, etc.

831(b) Captives

18

• Rulings sought:– Treatment as an insurance company– Deduction for premiums

• PLR Holdings– Based on review of submitted materials

• Questions whether pooling arrangement provided risk shifting & risk distribution and whether contractual provisions negated it

• Questions whether some or all of the purported insurance contracts were “insurance risks” for federal income tax purposes – i.e., were they contracts that covered investment or business risks?

• Questions whether policy terms reflected an arm’s-length transaction

– IRS noted that had they been able to rule, because 831(c) imposes an annual test and contracts were for one year – any PLR would have been controlling for only the year specified (i.e., it would have no future value)

831(b) Captives

19

• Observations– Different group at IRS looking at this issue with different approaches– Scrutiny regarding the nature of risks being ceded– Scrutiny of provisions in pooling agreements with experience debits

and credits– Scrutiny of arm’s-length consideration/how premiums/limits are

determined– Unlike prior groups of PLRs on pooling arrangements, possibly limits

the effect to one year as most pooling arrangements operate one year at a time

831(b) Captives

20

• An employer (a U.S. domestic corporation) provides health benefits to a large group of retired employees and their dependents.

• The employer maintains a single-employer voluntary employees’ beneficiary association (VEBA) and makes a contribution to the VEBA to provide the health benefits. In turn, the VEBA enters into Contract A with an unrelated commercial insurance company (IC).

• Contract A provides non-cancellable accident and health coverage.

• Under Contract A, IC will issue quarterly reimbursements to the VEBA for medical claims that are incurred by the covered retirees and their dependents and paid by the VEBA.

• Contract A is regulated by the relevant state insurance commissioner as an accident and health insurance contract.

Rev. Rul. 2014-15: Background

21

• To keep the premium payment under Contract A affordable, IC then enters into Contract B with the employer’s wholly owned subsidiary (S1).

• S1 receives a premium and reinsures 100% of IC’s liabilities under Contract A.

• Contract B constitutes S1’s sole business; S1 is regulated as an insurance company under state law; and Contract B is regulated as insurance.

• The amount of premium under Contract B is determined to be at arm’s length under applicable insurance industry standards.

• S1 has adequate capital to fulfill its obligations to IC under Contract B.• There are no guarantees that the VEBA or the employer will reimburse

S1 with respect to its obligations under Contract B, nor is any of the premium received by S1 for Contract B loaned back to the VEBA or to the employer.

• In all respects, the parties conduct themselves consistent with the standards applicable to an insurance arrangement between unrelated parties, except that S1 does not reinsure any other insurance contracts.

Rev. Rul. 2014-15: Background

22

Rev. Rul. 2014-15

23

VEBA

Parent(US Co.)

CT

Subsidiary (“S1”)

3rd partyInsurance

Co. (“IC”)

CONTRIBUTION to provide health benefits to retired

employees Contract AInsurance

Contract BReinsurance

The questions presented in Rev. Rul. 2014-15 are:

• Does this arrangement constitute insurance within the meaning of subchapter L of the Code?

• If so, does SI qualify as an insurance company?

Rev. Rul. 2014-15 concludes:

• S1 is regulated as an insurance company under state law.

• Contract B constitutes insurance.

• Because Contract B is more than half of the business done by S1 during this year, S1 qualifies as an insurance company under subchapter L for the tax year.

Rev. Rul. 2014-15

24

• Background– Premium taxes imposed by captive jurisdiction– Direct placement taxes– Taxation of captive income

State and Local Taxes

25

• Pre-Dodd Frank– Direct Placement Statutes and Industrial Insured Statutes

allow placement with non-admitted carriers, but require (a) compliance with statutory requirements and (b) payment of a tax generally at a rate equal to surplus lines tax and filing of applicable returns based on allocation of risk

State and Local Taxes – Direct Placement

26

• Pre-Dodd Frank– Direct procurement/case law

• State Board of Insurance v. Todd Shipyards Corp., 370 U.S. 451 (1962)

• Dow Chemical Co. v. Rylander, 38 S.W.3d 741 (Ct. App. Tex 2001)

• Ministers Life & Cas. Union v. Haase, 30 Wis.2d 339 (1966)• Howell v. Rosecliff Realty Co., 52 N.J. 313 (1968)• Associated Electric & Gas Insurance Services, Ltd. v.

Clark, 676 A 2d 1357 (R.I. 1996)


27

• Dodd Frank– Non-Admited and Reinsurance Reform Act of 2010

("NRRA")• Effective date July 21, 2011• Only applies to direct insurance, i.e., not reinsurance• No state other than home state of an insured may require

any premium tax payment for non-admitted insurance. § 521

– Non-admitted insurance means any property and casualty insurance permitted to be placed directly or though a surplus lines broker with a non-admitted insurer eligible to accept such insurance. § 527(9)


28

• Dodd Frank– NRRA – Definitions– Premium tax means, with respect to surplus lines or

independently procured insurance coverage, any tax, fee, assessment, or other charge imposed by a government entity directly or indirectly based on any payment made as consideration for an insurance contract for such insurance, including premium deposits, assessments, registration fees, and any other compensation given in consideration for a contract of insurance. § 527(12)


29

• Dodd Frank– NRRA – Definitions

• Independently procured insurance means insurance procured directly by an insured from a non-admitted insurer. § 527(7)


30

• Dodd Frank– NRRA – Definition of home state– Home state means with respect to an insured:

• The state in which an insured maintains its principal place of business or, in the case of an individual, the individual's primary residence; or

• If 100 percent of the insured risk is located out of the state referred to in clause (i), the state to which the greatest percentage of the insured's taxable premium for that insurance contract is allocated, provided, however, if more than 1 insured from an affiliated group are named insureds on a single non-admitted insurance contract, the term "home state" means the home states, as determined pursuant to subparagraph (a), of the member of the affiliated group that has the largest percentage of premium attributed to it under such insurance contract. § 527(6)


31

• Dodd Frank– Allocation

• A state compact may be entered into, or states may otherwise establish procedures to allocate among the states the premium taxes paid to an insured's home state. § 521(b)(1)

• To facilitate the payment of premium taxes among the states, an insured's home state may require surplus lines brokers and insureds who have independently procured insurance to annually file tax allocation reports with the insured's home state detailing the portion of the non-admitted insurance policy premium or premiums attributable to properties, risks or exposures located in each state. The filing of a non-admitted insurance tax allocation report and the payment of tax may be made by a person authorized by the insured to act as its agent. § 521(c)


32

• Dodd Frank– Out of state captive policies all cover home state

– Policy covers H.S. risk, P pays H.S. tax on 100% of premium


(SUBSIDIARIES) (DIVISIONS)

1 2 3 4 A B C D CaptiveNon-H.S.

PH.S.

15 15 15 40

15 15 15 40

CT NJ PA CA

CT NJ PA CA

33

• Dodd Frank– Out of state captive policy covers subsidiaries only

– Policy covers subsidiaries only, home state is subsidiary with largest premium allocation. Home state is California.




PH.S.

15 15 15 40

15 15 15 40

CT NJ PA CA

CT NJ PA CA

34

• Dodd Frank– Out of state captive policy covers divisions only

– Policy covers divisions only, home state is state with greatest premium allocation. Home state is California.




PH.S.

15 15 15 40

15 15 15 40

CT NJ PA CA

CT NJ PA CA

35

• Dodd Frank– In state captive policy covers home state

– No tax due



1 2 3 4 A B C D CaptiveH.S.

PH.S.

15 15 15 40

15 15 15 40

CT NJ PA CA

CT NJ PA CA

36

• Dodd Frank– Existing non-home state captive insures home state and

non-home state risks• Create home state captive and merge existing non-home

state captive• No future tax


PH.S.

OPERATINGSUB 1 (NON-

H.S.) MERGE

NEW HSCAPTIVE

EXISTING NON-

H.S.CAPTIVE

37

• Dodd Frank– Existing non-home state captive, home state captive law

prohibits some desired activity

• Federal income tax issues• State tax issues


PH.S.

OPERATING

ENTITY REINSURE

HOME STATE

CAPTIVE

NON- HOME STATE

CAPTIVE

INSURE

INSURE

38

• Dodd Frank– Texas Rule 38 TEX 2609

• Provides for tax on unauthorized insurer if tax not otherwise paid on transaction

– Premium tax on authorized insurer– Surplus lines tax– Independently procured tax

• Rate 4.85%– Applies generally to portion of risk allocable to Texas– If indemnity policy issued all risk deemed to be allocated to

home state» Texas» Other


39


A) Home state tax is “0”B) Texas?


HOME STATE

10% RISK TEXAS

100% PREMIUM

INDEMNITY POLICY

HOME STATE

CAPTIVE

40


A) Home State claims tax on 100% of premiumB) Texas?


NON-HOME STATE

CAPTIVE

HOME STATE

10% RISKIN TEXAS

100%PREMIUM PAY

ON BEHALF OF

POLICY

41


A) Home state tax is “0”B) Texas would tax 10% of premium


HOME STATE

CAPTIVE

HOME STATE

10% RISKTEXAS

100%PREMIUM PAY

ON BEHALF OF POLICY

42

State and Local Taxes – Income Tax

A

ApportionmentFactor(s)

CombinedIncome

Rate

B C

x x

43

• The domicile of neither the parent nor the captive is necessarily relevant – only that the parent does business in the state


44

• United Parcel Service, Inc. v. Indiana Dept. of State Revenue, 995 N.E.2d 20 (2013)

• Costco Wholesale Corp. v. Department of Revenue, 2012 WL 2992959, 20 Or. 537 (2012)

• Wendy’s International, Inc. v. Brian Hamer, et al., 375 Ill Dec 194, 996 NE2d 1250 (2013)

• Scioto Insurance Company v. Oklahoma Tax Commission, 2012 OK 41, 279 P.3d 782


45

• New York – Provision re: Overstuffed Captive– Includes income attributable to captive if premium does

not exceed investment income– Thus, Wendy’s would likely be captured– Governor’s Budget introduced in January 2014 would

have amended the law to require income attributable to any captive 50% owned to be combined regardless of relationship of premium income to investment income; all entities “doing business in New York” which owned a captive (except some aliens) would have been affected

– Ultimate modification of law was only to define “premium” as calculated under federal law


46

captive tax update 2 - 4, 2014

Documents