The proposed regulation would defer the tax deductibility of incurred losses,
i.e., a captive's loss reserves and the parent's premium, obtained from related
party business (the captive's parent), until the loss is actually paid. This
means that for tax purposes, the once-acceptable insurance transaction between
parent and captive would be disallowed.
The proposed regulation would extend to the furthest reaches of the IRS's
grasp. This includes primarily two groups:
- All domestically domiciled single-parent captives, and
- All foreign domiciled captives that elected, under Section 953(d) of
the IRS Code, to be taxed as if they were domestic companies.
Those of you unfamiliar with the 953(d) election may wonder why in the world
would any offshore captive actually volunteer to be taxed by the U.S. Internal
Revenue Service. The main reason is that the U.S. shareholders of a foreign
captive are subject to U.S. taxation anyway. Since 1986, owners of what are
known as controlled foreign corporations (CFCs) must declare such ownership
and pay taxes commensurate with their respective earnings. The captive itself,
as a CFC, is not taxed, but the shareholders are, which washes out the pre-1986
tax advantage of forming a CFC. The 953(d) election is, of course, irrevocable.
Proposed New Regulation
The proposed regulation applies to captives that are consolidated in its
parent's tax return wherein the parent owns 80 percent or more of the captive's
voting stock—the definition of almost every garden-variety single-parent captive.
The net effect of the proposed change would be that the IRS would become entitled
to the tax revenues generated on the captive's earnings sooner than it would
have been under the current system. It is nothing more than a timing issue,
but given the fact that the majority of the affected captives rely on the accelerated
deductions to enhance profitability and offset frictional costs, its impact
would be significant.
It is obvious to me that either the IRS does not fully understand the impact
of such a change, or, it is certifiably insane. While the latter possibility
serves to explain quite a bit of the Service's behavior, I have a suspicion
that the first guess is probably correct.
Unfortunately for the IRS and the roughly 26 U.S. captive domiciles, this
proposed regulation would have the polar opposite effect of that which its creators
intend—it would cause a loss of tax revenues at both the federal and state levels
resulting from a not insignificant exodus of U.S. domiciled captives to offshore
locales, and the certain reduction in the numbers of newly formed domestic captives.
While the proposed regulation would disallow a captive to restructure itself
specifically to avoid applicability, there is no law that forbids a captive's
parent from forming an offshore company into which the domestic captive would
move 100 percent of its business, thus winding down the domestic captive, or,
engaging in any number of other legal strategies that would protect its insurance
The Economic Family Theory
The proposed IRS regulation perhaps wouldn't cause as much heartache if it
weren't for the tortured history of how related-party insurance transactions
evolved. It all began back in 1977, when the IRS issued Revenue Ruling 77-316
which disallowed insurance status to any captive whose only business was derived
from its parent. The ruling codified the Economic Family Theory, which reasoned
that since the captive was a wholly owned subsidiary of the parent, and it wrote
no unrelated third-party insurance business, it did not meet the two-prong tests
for an insurance company: risk transfer and risk distribution. Both the parent
and the captive were members of the same "economic family," therefore, the risks
in the captive had not been actually transferred off the balance sheet and certainly
not distributed over a pool of unrelated entities.
Over many years and many shareholder challenges, the Service finally relented
and in 2001 issued Revenue Ruling 2001-31, which acknowledges that the Economic
Family Theory was insufficient unto itself to judge a captive's status as an
insurance company, as evidenced by the succession of shareholder victories in
the tax and circuit courts. Now, as if none of the hard-won caselaw existed,
including its own 2001 revenue ruling, the IRS is attempting to turn back the
clock to 1977—to its ultimate detriment.
Earlier I mentioned that offshore captives that have made the election to
be taxed domestically are equally subject to the proposed regulation. The proposed
regulation does not, however, apply to captives that retain their controlled
foreign corporation (CFC) status. (Making the 953(d) election voids CFC status).
While a CFC's earnings are taxed at the shareholder level, it is free to employ
insurance accounting as long as it satisfies the various insurance company tests.
Now, the decision to retain CFC status, post the 1986 tax changes, never made
much sense for a captive owned in the majority by U.S. taxpayers. The main benefit
derived from making the 953(d) election is that the captive obtains its own
tax rate, which is generally lower, at least in the early years, than its parent's
tax rate. Controlled foreign corporations have no such individual tax rate;
their earnings are taxed at their shareholders' rate.
Another significant drawback to remaining a CFC is that it is prohibited
from conducting any business whatsoever in the United States. While this might
require the captive's shareholders to travel to Bermuda or Cayman to do captive
business, it also means that they cannot conduct even the most rudimentary captive
transaction within the boundaries of the United States. A CFC captive doing
business in the United States has a special name: Engaged in Trade or Business
CFCs found to be running afoul of the ETB prohibition are subject to what
the Service calls a "branch profits tax," because if a foreign company conducts
business in the United States it must, by definition, have a U.S. "branch."
And since this fictitious branch doesn't pay income taxes, the Service can collect
as much as 30 percent of the foreign company's earnings. Controlled foreign
corporation captives also must pay federal excise tax (FET) on their U.S. premiums;
4 percent for direct-writing captives and 1 percent for fronted captives. Making
the 953(d) election eliminates the FET.
As you can see, forming your captive onshore or making the domestic election
if it's offshore makes perfect business sense—unless the IRS succeeds in turning
this onerous and ill-conceived proposal into law. If this happens, the question
for existing domestic captives will be whether the costs and risks associated
with moving to an offshore domicile and assuming CFC status would be worth it
given the fact that they would lose their ability to use insurance accounting
if they did nothing. Thankfully, the captive industry is mounting a formidable
lobbying effort to help the Service see the error of its ways. The Captive Insurance
Companies Association (CICA) has partnered with the Vermont Captive Insurance
Association (VCIA) to defeat this proposed regulation.
Note: Nothing in this
article should be construed to be tax or legal advice and cannot be used to
avoid tax penalties. Readers should consult their own tax counsel relative to
the application and consequences of the proposed regulation to their own unique