For better or for worse, in the United States, the decision to form or participate in a captive is informed by external factors, the most prevalent of which is the US Internal Revenue Service (IRS).
If the prospective captive owner cannot meet minimum financial requirements, the question is moot; however, in most cases, if the stars align to suggest that a captive makes economic sense, those stars almost always include tax-deductible premiums and the captive's use of insurance accounting.
The most contentious tax-related issue today is the definition and interpretation of risk distribution. Also called risk sharing, a bona fide insurance company per the IRS requires that the captive insure a sufficient number of unrelated risks. Over the past few years, this has been the primary focus of IRS auditors. As the IRS has never provided a "bright line" test of whether or not risk distribution is present, captive owners and their advisers have relied on various interpretations of the relevant IRS "safe harbor" revenue rulings and court cases.
Onshore captives are under a very bright IRS spotlight. One of the obvious reasons for this is that onshore captives are relatively high-profile entities and are becoming very sophisticated operations, adding staff, and insuring a wide variety of risks heretofore considered uninsurable business risks. While single-parent captives, regardless of domicile, are not insurance companies per the IRS unless they satisfy one of the risk distribution tests, many captive owners treat their captives as though they were insurers, deducting their premiums from their income taxes.
To the uninitiated, one of the assumed benefits of onshore captives is the fact that they are onshore and not domiciled in some tropical island paradise with little or no effective financial regulation. This state of affairs was, to a large extent, true decades ago, but in those days, there were no onshore captive domiciles. (Vermont was the first, established in 1981.) Clearly, we have come a very long way since the days of renegade offshore tax havens, but there are some very good reasons why onshore captive owners should seriously consider moving to an offshore domicile and into a cell captive.
The cell captive was first legislated in Guernsey in 1997 and has provided a relatively less expensive, and some argue more efficient, alternative to single-parent equity captives. A cell captive provides the domicile, the license, a small amount of capital, and the legal structure in which to create a group or single-parent captive. The major difference between a cell captive and a single-parent captive is that someone else owns the cell captive. The captive "parent" might own the cell's assets, but it does not own the captive.
So, what are we talking about? We're talking about significantly reducing an onshore single-parent captive's visibility to US tax and regulatory authorities by moving offshore, into someone else's cell captive. Gone are the concerns about the efficacy of offshore regulatory regimes. Domiciles such as the Cayman Islands and Bermuda offer highly sophisticated environments, as evidenced by the hundreds of captives in each domicile.
One of the strongest arguments for the establishment of wholly owned single-parent captives is the notion of control. The parent has effective control over the captive's governance, financial decisions, and utilization. Cell captives, on the other hand, allow the cell residents no control over these important areas but, if structured properly, provide a relatively low profile from a tax and regulatory perspective. Either a "properly structured" cell captive provides a mechanism for risk distribution, or its ownership structure places the cell company outside of the IRS's jurisdiction.
Is moving to a cell captive worth relinquishing control? Not only does a cell captive reduce the captive's profile today, but it also maintains the low profile regarding any future tax or regulatory changes that may imperil the economic viability of onshore captives.
A Hypothetical Example
Let's look at one captive owner, ABC Contracting. ABC's captive, Digby Insurance Company, is domiciled onshore. ABC is an aggressive, risk-taking company. This philosophy extends to every facet of the company, including its tax positions.
Even though Digby insures no third-party risks, and ABC does not have enough qualifying subsidiaries to satisfy risk distribution, the company deducts its captive premiums from its US income taxes each year. ABC's CEO understands the issues, but because the captive is fronted, he simply shows the auditor a copy of the insurance policies, and that's as far as it goes. The company's financial statements consolidate the captive's results, and the notes accompanying the statements do not include any information about the captive. Digby is a typical on-balance-sheet captive.
ABC's captive consultant warns the CEO that he's on thin ice regarding the tax deductions, as the penalties imposed by the IRS could be significant if Digby is discovered. "Okay," asks the CEO, "is there anything I can do to insulate the company from IRS penalty hell?" "Well, no," the consultant replies, "the years in which you deducted captive premiums remain exposed to penalties if discovered, but we can do something to possibly reduce the exposure to IRS scrutiny and penalties in the future." (Please remember that this is just a hypothetical example.)
The consultant continues, "If you are amenable to closing Digby and transferring its assets into Far Rockaway Insurance SPC (Segregated Portfolio Company), a cell captive domiciled in the Cayman Islands, you could possibly continue to deduct its premiums from ABC's income taxes—this time arguably within the IRS's parameters for doing so."
Far Rockaway SPC, the Cayman cell captive, is a typical cell captive in that it exhibits many characteristics of a bona fide commercial insurance company. It controls many facets of the captive—the risks you may (and may not) place, investment decisions, the raft of service providers (attorney, auditor, captive manager, etc.), and the composition of the board.
In light of this control, coupled with third-party ownership, and a way to satisfy risk distribution, many captive owners are comfortable that a cell captive is a separate and distinct insurance company. Likewise, many captive promoters cite the fact that cell captives are off-balance-sheet entities, identical to any commercial insurer. However, this is where it gets complicated. The cell structure provides legal firewalls between the assets of each cell resident; albeit many cell captives provide a reinsurance mechanism whereby each cell shares a small portion of its risk with all of the other cells.
Far Rockaway SPC has not elected to be taxed as a US domestic entity. If it is a controlled foreign corporation, its US shareholders are subject to US income tax, but the captive itself is not taxed. Cell residents are not shareholders of the captive, but IRS Revenue Ruling 2008–08 says that each cell should be considered tantamount to a single-parent captive for tax purposes and not consolidated with the cell captive. This means that if there were no risk distribution, the cell would not be considered an insurance company for tax purposes. Conversely, if Far Rockaway SPC is a non-controlled foreign corporation (NCFC), the IRS cannot tax the shareholders or the entity (or the cell residents) until the captive's earnings are repatriated into the United States.
Now we return to the initial question—does moving an onshore, single-parent captive to an offshore cell captive owned by a third party reduce the likelihood that the IRS will disallow the tax deductibility of the parent's premiums? If the cell captive provides for some risk distribution, the answer is probably, depending on how robust the risk distribution is. If the cell captive is an NCFC, the answer is yes, as the IRS has no jurisdiction over NCFC captive insurers, as long as earnings (and business activities) remain offshore.
Caution: This article is not intended to provide any form of advice relative to US taxation of captives or the deductibility of captive premiums. The reader assumes full responsibility for any and all actions taken in this regard.
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