101 Tax Update The Good, Bad, and Ugly

Transcription

1 101 Tax Update The Good, Bad, and Ugly Michael Serricchio, Senior VP, Marsh Captive Solutions Fred Krull, Principal, EY Ernie Achtien, CFO, Captive Resources

2 Agenda Captives trends, value drivers and benchmarking Taxation of captives Micro-captives in today s environment Questions

3 Captive trends, value drivers and benchmarking Tax Update and IRC 831(b) March 14, 2017

4 The Growth of Captives Globally Total Captives Worldwide by Year with Corresponding World Events Business Insurance Special Report, February 2016

5 What is a Captive? A captive is a closely held insurance company whose insurance business is primarily supplied and controlled by its owners. Generally, the risk that is insured through the captive organization is also a captive risk (i.e., a risk of the owners or of affiliated organizations), although in the recent years industry is seeing an increase in 3 rd party risk being included into captive structures Generally, the original insureds are the principal beneficiaries. Given the six-decade history of captive insurance arrangements, multiple variations have surfaced, significantly broadening the definition of captives and variety of the risks insured.

6 Why Do Companies Form Captives? The 6 Cs Companies establish captive insurance vehicles for at least one of the following reasons: Cost: Reduce reliance on third parties and capture costs and profits leaked to insurers. In addition, there may be corporate tax benefit in earning profit in a captive insurance vehicle located in a lower tax jurisdiction. Capacity: A captive insurance vehicle can access international reinsurers and specialty insurers directly, which can introduce new capacity, greater competition and better pricing for insured risks. Control: As the primary insurer a captive insurance vehicle can tailor its cover (policy language), manage claims and direct subsequent reinsurance to ensure that the group enjoys the widest possible coverage, at the best price, in a fully transparent manner. Compliance: A captive insurance vehicle provides a legal basis for subsidiaries to pool retained risk across borders and different tax systems. The accounting, tax and legal treatment is well known and understood. Conversely, transactions with less formalised RRV s may be subject to greater scrutiny by various regulators and tax authorities around the world. Cover: A captive insurance company can issue proof of insurance (cover note or an insurance policy) to comply with contractual obligations. The group may prefer to retain certain risks that it is contractually obliged to insure. For example, professional liability insurance for customers or leased property insurance to a Landlord. A captive insurance vehicle can evidence insurance and capture premium that would be otherwise leaked to third parties. Commercial: A captive insurance vehicle can participate in third party insurances offered to customers, vendors or other related parties, such as customer warranty insurance or sub-contractors under an Owner Controlled Insurance Programme, etc.

7 Captive Value Drivers Funding Corporate Retained Risk

8 Captive Value Drivers Accessing Reinsurance

9 Type of Risk-Financing Vehicle

10 Captives by Net Premium Volume

11 Risk Transfer Versus Risk Retention EXPOSURES RISKS TRANSFER RISK ASSETS TECHNOLOGY/ CYBER CAT RISK (EQ, WIND, FLOOD) TIME ELEMENT PRODUCT EMPLOYEES WAGE & HOUR EPL CRIME WC BENEFITS RETAIN RISK CUSTOMERS WARRANTY GENERAL LIABILITY RECALL E&O

12 Older versus Newer Lines of Coverage to be Considered Workers Comp General liability Casualty/Liability Auto/Truckers liability Business Interruption/Contingent Business Interruption Contractual Liability Excess Product liability Product Recall Malicious Tampering Cyber risk Crime Excess liability Wage & Hour Directors & Officers Supply Chain Intellectual Property Property Property Terrorism insurance: U.S. TRIA policy with NBCR All Risk Property Cyber Terrorism Shipping, cargo, and transit insurance Third Party Insurance Employee benefits: Global Voluntary U.S. ERISA benefits Equipment Maintenance Customer related insurance Customer, vendor, and jointventure business

13 US For-Profit Captive Owners That Treat Their Captive As An Insurance Company For Tax Purposes

14 Captives That Write Some Amount of Unrelated Risk

15 Approach to Achieve Insurance Tax Status for All Small Captives

16 Captive Utilization By Parent Company Industry

17 Taxation of Captives Tax Update and IRC 831(b) March 14, 2017

18 Qualification as an Insurance Company General Insurance companies other than life insurance companies (property and casualty (P&C) insurance companies) are taxed under IRC 831. Prior to 2004, IRC 831 did not specifically define what constitutes an insurance company. However, the Pension Funding Equity Act of 2004 amended IRC 831 to define insurance company as follows: The term insurance company identifies a company, more than half of the business of which during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies Implicit in the definition of insurance company is the issue of what constitutes an insurance or a reinsurance contract. Unfortunately, while insurance company is now a defined term there is no statutory authority defining the term insurance contract for federal income tax purposes* * IRC 7702(a) defines a life insurance contract, but not an insurance contract

19 Qualification as an Insurance Company As industry turned to the U.S. Courts for guidance on qualification as an Insurance company the courts have provided a set of principles in order for an arrangement to constitute insurance for U.S. Federal income tax purposes. The arrangement must contain: Presence of insurance or insurable risk; Risk shifting; Risk distribution; and Commonly accepted notions of insurance General The Seventh Circuit and the Ninth Circuit Court of Appeals have also expressed views regarding qualification by taking an alternative route via not asking what is insurance but rather Is there adequate reason to recharacterize this transaction?, given the norm that tax law respects both the form of the transaction and the form of the corporate structure.

20 Qualification as an Insurance Company Insurance Risk Basic to any insurance transaction must be risk. An insured faces some hazard; an insurer accepts a premium and agrees to perform some act if or when the loss event occurs. If no risk exists, then insurance cannot be present. If parties structure an apparent insurance transaction to effectively eliminate the effect of insurance risk therein, insurance cannot be present. The risk transferred must be risk of economic loss. The risk must contemplate the fortuitous occurrence of a stated contingency and must not merely be an investment or business risk*. If the only risks borne by an insurer are (1) that it will be required to make payments with respect to a known loss earlier than expected and (2) that the available investment yield between the time of payment of the premiums and the time of the payment of the claims will be lower than expected, then such risks are investment and not insurance risks (also subject to expanded views based on RVI court case decision). *The RVI court case decision expanded this to note that an insurance arrangement can include significant investment and/or business risk and fortuity needs to be looked at in a broader terms

21 Qualification as an Insurance Company Risk Shifting Risk shifting is viewed from the presence of the insured. The Supreme Court of the United States has explained that in order for an arrangement to constitute insurance for federal income tax purposes, both risk shifting and risk distribution must be present. Risk shifting occurs if a person or enterprise facing the possibility of economic loss transfers some or all of the financial consequences of the potential loss to the insurer, such that a loss by the insured does not affect the insured because the loss is offset by a payment from the insurer. Risk shifting generally does not occur if the insurer is undercapitalized and (1) the insurer is indemnified by another entity, e.g., its parent company, to encourage an unrelated third party to enter into the transaction, or (2) if the insured agrees to contribute additional capital. Must look to the substance of any guaranty*. The balance sheet test is applied to determine whether an insured has shifted its risks to the insurer (under this test, it is assumed that a sole shareholder generally cannot shift its risks to its wholly owned captive subsidiary). *The area of parental guarantees and other similar arrangements is a complex area, subject to multiple legislative and judicial developments

22 Qualification as an Insurance Company Risk Distribution Risk distribution is viewed from the insurance company s perspective. Based on the actuarial principle of the law of large numbers, risk distribution entails spreading risks among a large group, allowing the insurer to reduce the possibility that one claim will exceed the premiums collected. While the courts have addressed the concept of risk distribution, no one case defines what constitutes adequate risk distribution in a captive arrangement (e.g., number of underlying insureds, number of entities). Nevertheless, while a specific quantity of risks has not been defined by the courts, the Tax Court has articulated principles that are useful. Recent Tax Court decisions, which contradict some of the previously IRS issued guidance, look more toward the statistically independent risk pooling unlike former IRS guidance where primary concern laid in the number of legal entities involved in the arrangement. We would like to note that IRS did not appeal any of the three Tax Court cases that it recently lost (Rent-a-Center, Securitas, and RVI)

23 Qualification as an Insurance Company Courts have looked to the following items to determine the common notions of insurance: Technical indicia of insurance, e.g., risk shifting and risk distribution Substance of the transaction Regulatory environment Adequate capitalization Arm s-length premiums Common Notions of Insurance Validity of the policies issued All facts and circumstances are considered not only terms of the arrangement, but also entire course of conduct of the parties.

24 Qualification as an Insurance Company Common Structures Parent/Sub Parent/subsidiary Parent Premiums Captive 100% Coverage of selfinsured risk Parent is deemed to have not shifted its risk to captive: Balance sheet approach Premiums paid from parent to captive are not deductible. Captive is not considered an insurance company.

25 Parent: Parent has not shifted its risk to captive: Balance sheet approach Premiums paid from parent to captive not deductible In certain cases, appropriate 3 rd party risk ratio may allow for parent risk to qualify Subsidiaries: Subsidiaries generally shift risk to captive. Brother/sister risks Premiums paid from Subsidiaries to captive are generally deductible, provided certain bona fides satisfied: premiums are arm s length, the captive is adequately capitalized and the captive is not propped up. Captive: Qualification as an Insurance Company Common Structures Brother/Sister Generally treated as an insurance company 100% Co Sub Co Subsidiaries Parent Premiums and reserves for losses Premiums and reserves for losses Captive

26 Qualification as an Insurance Company Common Structures 3 rd Party Premium Third-party risks Parent Premiums Third-party risk premiums Parent: Parent generally shifts its risk to captive, provided sufficient third-party risk present Third-party risk benchmark > 30% of total premium Premiums paid from parent to captive generally deductible, provided bona fides satisfied Subsidiaries: Subsidiaries generally shift risk to captive. Premiums paid from Subsidiaries to captive are generally deductible, provided bona fides satisfied. Captive: Subsidiaries Generally treated as an insurance company Premiums Captive

27 Qualification as an Insurance Company Common Structures Group Captives Group captives Insured Insured Insured Insured Insured Premiums Insured: Generally shift risk to captive Premiums paid from insureds to captive generally deductible, provided bona fides satisfied Captive: Generally treated as an insurance company Captive

28 Recent Developments & IRS Position In 2014 and 2015, the Tax Court handed down decisions in three cases that refined the judicial framework of insurance: Rent-A-Center, Securitas, and R.V.I. Guaranty. These cases significantly broadened the captive insurance market and related planning opportunities Judicial views with regards to insurance risk Acceptance by regulators Acceptance by external auditors IRS Views ILM PLR Notice

29 Recent Developments & IRS Position (Continued) Judicial views with regards to risk shifting Use of a guaranty Use of cash Netting of payments Capital contributions Judicial views with regards to risk distribution Statistical, independent risks IRS View Risk Distribution Revenue Ruling Revenue Ruling

30 Recent Developments & IRS Position (Continued) Judicial views with regards to common notions of insurance Insurance defined in the commonly accepted sense Fortuity IRS Views Common Notions PLR Notice

31 Rent-A-Center Inc. v. Commissioner Rent-A-Center Inc. v. Commissioner 142 T.C. No. 1 (Jan. 14, 2014) Facts & Background Dealt with Company s ability to deduct insurance premiums paid through captive insurance arrangement, despite parental guarantee A divided Tax Court held that transactions between a captive insurance company located in Bermuda and its 15 sister corporations qualified as insurance for federal income tax purposes and that the premiums were deductible. The majority opinion concluded that insurance risk was present, risk shifted and was distributed, and the arrangement resembled insurance in its commonly accepted sense (the requirements for concluding that insurance exists). There was no finding that the arrangement was a sham or that there was an impermissible circular flow of funds. The Tax Court reached this conclusion despite the Service's claims that Rent-A-Center's (RAC's) guaranties of the value of the captive's deferred tax assets (DTAs) and its liabilities under the Bermuda Insurance Act up to $25 million vitiated any risk shifting that might otherwise be found to occur in a brother-sister insurance arrangement.

32 Rent-A-Center Inc. v. Commissioner Findings The parental guaranty did not affect the balance sheet or net worth of the subsidiaries, was limited or did not shift away the ultimate risk of loss back from the captive, did not involve an undercapitalized captive; and was not requested by an unrelated insurer Conclusion: the parental guaranty did not negate risk shifting RAC s subsidiaries owned between 2,623 and 3,081 stores; had between 14,300 and 19,740 employees; and operated between 7,143 and 8,027 insured vehicles RAC s subsidiaries operated stores in all 50 States, D.C., Puerto Rico and Canada Risk distribution occurs when an insurer pools a large enough collection of unrelated risks. RAC s subsidiaries had a sufficient number statistically independent risks. As such, Legacy achieved adequate risk distribution Netting, or the use of journal entries to account for intercompany funds on a net basis, was deemed acceptable provided complete and accurate records are maintained

33 Securitas Holdings, Inc. and Subsidiaries Securitas Holdings Inc., et al. v. Commissioner TC Memo (Oct. 29, 2014) Dealt with Company s ability to deduct insurance premiums paid through captive insurance arrangement, despite parental guaranty of captive s performance Tax Court held that: v. Commissioner Facts & Background (1) risk shifting may exist despite the parent s guaranty of the captive s performance, (2) risk distribution may exist despite that in one year a captive may insure only certain number (in this case 4) of sister corporations, one of which may own a very significant (i.e., close to 90%) %s of the risk, and (3) insurance in its commonly accepted sense may exist despite a captive s relatively low gross premium to surplus ratio and the group s use of offsetting journal entries to credit premiums and claim payments.

34 Securitas Holdings, Inc. and Subsidiaries v. Commissioner Findings Cited Rent-A-Center in stating that the Tax Court previously held that the existence of a parental guaranty by itself is not enough to justify disregarding the captive insurance arrangement Found that the captive was adequately capitalized and stated no payments were made with respect to the guaranty Addressed netting, restating that it is unrealistic for members of a consolidated group to cut checks to each other and using journal entries to keep track of the flow of funds is commonplace Accordingly, held the captive arrangement as a whole adequately shifted risk Securitas AB Group employed over 200,000 people in 20 countries, and the SHI Group, alone, employed approximately 100,000 people each year and operated over 2,250 vehicles Risk distribution is viewed from the insurer s perspective. As a result of the large number of employees, offices, vehicles, and services provided by the U.S. and non U.S. operating subsidiaries, the arrangement was exposed to a large pool of statistically independent risk exposures Statistically independent risk exposures do not change merely because multiple companies merged into one The risk associated with those companies did not vanish once they all fell under the same umbrella Court held that by insuring the various risk of U.S. and non U.S. subsidiaries, the captive achieved risk distribution

35 RVI Guaranty Co. Ltd. et al v. Commissioner RVI Guaranty Co. Ltd. et al v. Commissioner 145 T.C. 9 (Sept 21, 2015) Facts, Background & Findings Dealt with Company s ability to treat its residual lease value insurance products as bona-fide insurance, subject to insurance tax treatment Tax Court held that: Insurance risk includes speculative risk Insurance can involve a substantial investment element The existence of other potential means of covering risk is irrelevant Deference should be given to regulatory and accounting treatment The concept of fortuity should be viewed broadly The fact that a product is not traditional does not negate its insurance nature

36 State and Local Tax Income Tax States attempting to include captives in combined returns Most states have an exclusion from income taxation for insurance companies Variation of language used for exclusion, e.g., subject to premium tax

37 State and Local Tax Indirect/Premium Tax Self-procurement tax considerations and state by state application Home state exception NRRA (Non-Admitted and Reinsurance Reform Act of 2010) Applies to direct insurance (not reinsurance) No state other than home state may require a premium tax payment for non-admitted insurance ( 521) Non-admitted includes independently directly procured insurance and surplus lines ( 527(9)) What about Captives?

38 Micro-captives in Today s Environment Tax Update and IRC 831(b) March 14, 2017

39 Overview of Section 831(b) Election Tax Update and IRC 831(b) March 14, 2017

40 Section 831(b) Election IRC Section 831(b) provides that: Insurance companies with not greater than $2.2 million of annual written premium pay $0 income tax on insurance underwriting profits (adjusted for inflation if certain benchmarks are met in 2017 and subsequent years) Investment income is taxed as income to Subchapter C-corporation 831(b) status must be timely elected and cannot be revoked without the permission of the secretary Exceeding $2.2 million (plus any inflation adjustments) removes qualification for 831(b) treatment for that year

41 831(b) Election- Controlled Group Rules Insurance companies owned by related parties aggregated- one $2,200,000 limit, adjusted for inflation Section 1563 governs, modified by using a 50% threshold versus 80% Rules are complex and must be reviewed in each case

42 The Ground Rules First & foremost: this is an insurance company Non-tax business purpose Risk shifting and risk distribution Same tests as those taxed under Section 831(a) Premiums and policies must be market-comparable Actuarial/underwriting support mandatory

43 The Ground Rules (Cont d) Reasonable Capitalization No guarantees Regulation Policy terms Reserves Separate operation and corporate formalities Insurance formalities complied with

44 Sample Captive Insurance Policies Everything a business currently self-insures: Deductibles Excess losses above coverage limits Environmental liability Loss of income as a result of: Losing key employee/salesperson Loss of license/professional risks (professionals) Loss of a key contract (Gov t. Contractors) Weather, terrorism, etc. Liability defense expenses: Employee lawsuits sexual harassment, wrongful termination, discrimination, etc. Environmental issues Professional claims

45 Sample Captive Insurance Policies (Cont d) Professional Liability Gap Coverage HIPAA/Billing Audit Liability Contractual Liability Cyber Liability Environmental Liability Excess Environmental Liability Labor Shortage/Strike Loss Reimbursement Employment Practices Employee Dishonesty Patent Infringement/Intellectual Property General Liability Gap Property Management Professional Professional Misconduct Product Recall FDA Administrative Actions Liability Product Liability Gap Directors And Officers Liability Punitive Damages Loss Of Key Employee Wind Deductibles On Property

46 Domicile Considerations Form CIC in US domicile, which would include several states such as DE, GA, HI, KY, MO, MT, NC, NV, SC, or UT Other states developing a favorable climate as well If foreign, would have to elect 953(d) status as well Favorable captive legislation regarding fees and investment options

47 Path Act Revisions Tax Update and IRC 831(b) March 14, 2017

48 Section 831(b) Path Act Law Changes Effective 2017 Effective January 1, 2017, the annual premium limit was raised to $2.2 million, adjusted for inflation A Diversification requirement imposed that provides that to continue to qualify under Section 831(b) either: o 20 percent or less of net written premium (or if greater direct written premium) is attributable to one policyholder (related persons considered one policyholder), OR o No owner of captive who is a lineal descendant or spouse of any owner of insured business owns more than two percentage points of captive than their respective ownership in insured business Annual reporting on diversification to be required

49 Section 831(b) 2017 Law Changes (Cont d) Examples- assume in 2017 captive does not meet the maximum 20% premiums attributable to one policyholder diversification test; Business is owned 70 percent by Father, 30 percent by Daughter Example 1- Captive is owned 100 percent by Daughter. Captive does not meet diversification rules (100 percent is more than two percentage points above 30 percent) and does not qualify under Section 831(b) in 2017 Example 2- Captive is owned 30 percent by Daughter, 70 percent by Father. Captive meets diversification rules (interest in both by Daughter are equal) and could qualify under Section 831(b) in 2017 Bottom line- Daughter needs to own 32 percent or less of captive for 831(b) qualification in 2017, if 20 percent premium test not met

50 Section 831(b) 2017 Law Changes (Cont d) Unanswered questions- what about multiple related insured businesses owned in different percentages? Does a pool that insures 100 participants and reinsures to a captive constitute one policyholder or 100 for purposes of diversification? Will IRS regulations negate the two percent de-minimis rule? Other guidance needed but not forthcoming.

51 IRS Notice Tax Update and IRC 831(b) March 14, 2017

52 IRS Notice As Amended By IRS Notice Lists most Section 831(b) arrangements as a transaction of interest, requiring disclosure under Treasury Reg. Section for transactions after November 2, Conditions for disclosure: Insured or related person owns at least 20 percent in vote or value of captive, and either 1) the captive has a loss and claims admin expense ratio of less than 70 percent of premiums less policyholder dividends during most recent five years, or if less than five years, during entire existence; OR, (2) captive has made available financing to owners, insureds or related entities during same period.

53 IRS Notice As Amended By IRS Notice (Cont d) Participants have disclosure obligation; participants include owners of insured, insured company, captive, reinsurance pool Form 8886 is form for participants Promoters also have disclosure and list maintenance obligations under Section 6111 and 6112 (Form 8918 and list maintenance) Original due date for disclosure of transactions of interest as of November 1, 2016 (entered into after November 1, 2006) was January 30, 2017; extended per IRS Notice to May 1, 2017

54 IRS Activity And Litigation Tax Update and IRC 831(b) March 14, 2017

55 IRS Activity IRS has initiated investigations of certain captive managers To date, targets of scrutiny have generally been captive managers that manage captives and pools domiciled offshore Extensive information requested regarding promotion and operation of captives If creation and operation of captive is done right, there should be no IRS audit issue; if capitalized with minimal amounts, premiums identical for a coverage among many insureds, and not run as a true insurance company, there will be issues

56 IRS Activity (Cont d) IRS news releases ( Dirty Dozen lists) in past several years lists abusive captive insurance as an abuse of a legitimate tax structure The release describes poorly drafted insurance binders, policies that cover esoteric, implausible risks for exorbitant premiums, and missing or insufficient underwriting and actuarial substantiation

57 Section 831(b) Related Litigation Avrahami v. Commissioner, Tax Court Docket Numbers , : first case disputing IRS challenge to a Section 831(b) captive tried March 2015 IRS argued, among many arguments, that transaction lacked economic substance, was not arms-length, risk distribution did not occur, loans should be treated as distributions, and Section 953(d) election was invalid Amicus brief filed by Self-Insurance Institute of America Full Tax Court review Decision expected in 2017

58 Section 831(b) Related Litigation (Cont d) Caylor Land & Development, Inc. v. Commissioner, Tax Court Docket Numbers , , , , , , , , , and ; similar case disputing IRS challenge to a Section 831(b) captive tried June 2016 During hearing IRS presented evidence (used for limited purposes of impeachment and refresh a witness recollection) revealing that the IRS had recoded conversations with an unnamed party whom the captive manager thought was a prospective client

59 Section 831(b) Related Litigation (Cont d) Third case, James L. Wilson and Vivien Wilson, et. al. v. Commissioner, Tax Court Docket Numbers , , , and ; tried August 2016 Decisions on these cases also expected in 2017

60 Questions? Tax Update and IRC 831(b) March 14, 2017

61 Disclaimer This presentation contains general information only. CICA and its guest speakers are not, by means of this presentation, rendering insurance, financial, investment, legal, tax or other professional advice or services. This presentation is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Neither CICA nor its guest speakers shall be responsible for any loss sustained by any person who relies on this presentation.