Tax Update. New Proposed Regulations May Eliminate the Tax Benefits of Captive Insurance Companies

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1 November 2007 New Proposed Regulations May Eliminate the Tax Benefits of Captive Insurance Companies New proposed U.S. Treasury Department regulations may eliminate the federal income tax benefits available to certain affiliated corporate groups that have a captive insurance company as a member. 1 Specifically, the new proposed regulations, issued on September 27, 2007 under Treasury Reg. Section (e), essentially defer the deduction by certain captives for loss reserves until the amount is actually paid. The new proposed regulations, once promulgated in temporary or final form, would apply to all transactions entered into after the effective date of the temporary or final regulations by both existing and newly formed captive insurance companies. Current Captive Rules Under the current rules for captive insurance companies, domestic captives (and foreign captives that elect under Section 953(d) to be treated as a domestic captives) generally qualify for certain insurance-related federal income tax benefits. 2 In a typical setting where the captive is a member of an affiliated group of corporations filing a consolidated return for federal income tax purposes (a consolidated group), the premium payer, also a member of the consolidated group, deducts the premium payment and the recipient captive includes the premium in income. Under the current rules the captive may apply favorable tax rules related to insurers under which the captive establishes and deducts certain reserves for federal tax purposes, including a loss reserve. 3 The net result for a consolidated filer is to defer a portion of the premium recognized by the captive insurance member. Policy Shift Limits Benefits The proposed regulations represent a shift by the Treasury Department and the Internal Revenue Service (IRS) away from the current captive rules and away from the IRS s historically unsuccessful arguments against the tax benefits obtained with captives. Previously, the IRS had WEBINAR: So You Are Thinking About Buying A Loss Company? Thursday, December 13, :00-1:00 p.m. Topics: what tax issues arise in unlocking the use of the NOLs understanding the company s equity change history what types of investment can be used without counting for Section 382 purposes freeze current shareholder equity interests how to monetize the losses Speakers: Annette M. Ahlers, Partner, Pepper Hamilton llp Bryan D. Keith, Project Manager, Pepper Hamilton llp Todd B. Reinstein, Partner, Pepper Hamilton llp Register online at or contact Brian Dolan at dolanb@pepperlaw.com. in this issue 1 New Proposed Regulations May Eliminate the Tax Benefits of Captive Insurance Companies 1 WEBINAR: So You Are Thinking About Buying A Loss Company? 3 Speakers Corner, Notables, Podcasts and Publications 4 Proposed IRS Rules Target Patented Tax Strategies 6 Pepper Hamilton s Tax Practice Group

2 attempted to disallow the deduction by captives for loss reserves by arguing that the captive s loss reserves did not relate to insurance. 4 This strategy was not, for the most part, a successful one. 5 Now, after losing on their initial arguments and after several years of acquiescence to the tax benefits from captives, the IRS is changing its strategy and is promulgating consolidated return regulations that more clearly reflect its current views. 6 The new proposed regulations limit the tax benefits available to a captive within a consolidated group by providing that the captive may not deduct loss reserves until the loss is actually incurred. Thus, a single entity theory must be applied to the consolidated group and the insurance losses will only be allowed under the general tax principles of Sections 162 (ordinary and necessary) and 461 (all events test). Thus, the captive transaction is essentially relegated to non-insurance status for federal income tax purposes and the previously deductible reserves may not be deducted until actually paid. Generally, the proposed regulations do not affect the captive s status as an insurance company for non-tax purposes. Furthermore, the new proposed regulations do not apply to all captives. For example, foreign captives that have not elected to be treated as a domestic captive for U.S. federal income tax purposes and domestic captives that are not in the same federal consolidated group as the premium payer are not affected by the new rules. In addition, a captive within the same consolidated group as the premium payer is not affected if the captive collects greater than 95 percent of its premiums from non-member payers. Self Help Measures To minimize the potential loss of tax benefit under the new proposed regulations, taxpayers might attempt to deconsolidate a domestic captive by imposing a nonconsolidated entity between group members and the captive. Generally, deconsolidation would remove the captive from the scope of the new proposed regulations and permit the captive to continue to deduct its loss reserves. Of course, such a deduction would be restricted to just the captive and the loss would no longer be available to the consolidated group. There is a risk to this strategy as the IRS might assert the anti-abuse rules under Treas. Reg. Section (h) apply to prevent a taxpayer s attempt to deconsolidate its captive in this manner. The new proposed regulations limit the tax benefits available to a captive within a consolidated group by providing that the captive may not deduct loss reserves until the loss is actually incurred. Under the anti-abuse rules, the IRS can require a nonconsolidated member to be included in the consolidated group, which would negate the effect of interposing an entity to break consolidation. For example, the IRS used the consolidated anti-abuse rules against the taxpayer in the recent Chief Counsel Advice (CCA) to require a consolidated group to include a cooperative in the group. The consolidated return anti-abuse provision provides that adjustments must be made if a transaction is engaged in or structured with a principal purpose to avoid the purposes of the consolidated return rules. 8 In CCA , members of the taxpayer s consolidated group incorporated to obtain certain tax benefits related to a cooperative s ability to deduct patronage dividends from gross income under Section 1382(b). The anticipated tax benefits would only be available if the cooperative was not a member of the taxpayer s consolidated group. To achieve this, the consolidated group members recapitalized the equity so that they collectively owned less than 80 percent of the voting power under Section 1504(a)(2) in the cooperative and certain foreign entities owned the remaining voting power. The IRS applied the consolidated anti-abuse rules, disregarded the equity recapitalization, and held that the cooperative should be included as a member of the consolidated group, notwithstanding Section 1504(a)(2). The IRS reasoned that the structure was tax-motivated and did not reflect the underlying economic interests of the participating parties. It is unclear whether the IRS will assert the consolidated anti-abuse rules against taxpayers that attempt to deconsolidate their captives in response to theses new rules. Unlike the facts in CCA , most captive insurance arrangements serve business purposes other than just tax savings. However, it could be argued that a deconsolidation in response to the proposed regulations has a principal purpose that is driven by federal taxes. -2-

3 Pepper Perspective The new proposed regulations could eliminate the federal tax benefits available to companies utilizing captive insurance arrangements. 9 Although the delayed deduction for the captive is a timing matter and generally not a permanent item, the net present value savings from the timing difference could be a substantial amount for many existing captives. In effect, the captive is reduced, at least for federal tax purposes, to nothing more than simple self insurance. As mentioned, the proposed regulations are not effective until issued in temporary or final form and comments on the proposed regulations are due by December 27, Companies with significant issues related to the new proposed regulations should consider submitting comments, especially if the proposed regulations will cause negative unintended consequences. As of the date of this newsletter, the Treasury Department and the IRS have not indicated any intent to withdraw or significantly modify the proposed regulations and, thus it is possible that the regulations could be issued in temporary or final form shortly after the end of the comment period. Taxpayers with captives should consider the effects of the new proposed regulations on their captive and contemplate whether restructuring might alleviate the detrimental consequences. External financial auditors, however, may assert that there is a significant federal tax risk to deconsolidating the captive in light of the recent CCA that applied the anti-abuse rules and deny the captive s tax benefits for financial reporting purposes in the current FIN 48 environment. Taxpayers may want to consider requesting a private letter ruling from the IRS that the deconsolidation of the captive does not run afoul of the anti-abuse rules. Authors: Todd Reinstein reinsteint@pepperlaw.com -speakers corner Steve Bortnick spoke at a 3-hour workshop entitled Maximize your Fund s Value by Utilizing the Most Advantageous Tax, Legal, Regulatory and Valuation Methodologies on November 28, The workshop is part of the Private Equity Fund-of-Funds seminar at the Hyatt Regency in Boston, November Charles Potter spoke on Unrelated Business Tax Issues for Private Clubs, to Hospitality Accountants in Pittsburgh on November 28. Ellen McElroy and Todd Reinstein will be speaking on Tax Methods Update: Focus on Tier 1 and Tier 2 Exam Issues at the Tax Executives Institute s Denver Chapter Meeting in Denver on November 29. Leonard Schneidman will be speaking on Structuring Offshore Funds for Tax Efficiency: Challenges and Benefits at the 9th Annual Effective Hedge Fund Tax Practices in New York City on November 29. Joan Arnold will be speaking on Private equity investing in Mexico and Brazil at the International Fiscal Association s New York chapter in New York City on November 29. Charles Potter will be speaking on State and Local Tax Update at the PICPA, Southwest Chapter Meeting in Latrobe, PA on December 7. Joan Arnold will be speaking on Current Inbound and Outbound Developments at George Washington University/IRS International Tax Symposium at George Washington University in Washington, DC on December 13. notable Steve Bortnick named to the advisory board of Practical U.S./International Tax Strategies. Practical Tax Strategies keeps in-house tax counsel and tax managers of large, multinational companies informed on tax planning, strategies, tax methodologies and tax changes that can benefit their company. Bryan Keith keithb@pepperlaw.com Mr. Keith is a project manager in our Washington, D.C. office.

4 podcasts Todd Reinstein will be participating on the AICPA webcast Federal Corporate Income Tax Update 2007 in New York from 1:00 to 3:00 p.m. on December 6, For registration details please visit publications Steve Bortnick's article Proposal Targets Offshore Deferred Compensation and Carried Interests was republished in Practical US/International Tax Strategies, October 31, 2007, Volume 11, Number 19. Todd Reinstein and Timothy Leska s article Tax Certainty Available to Developers and Investors in Wind Energy Partnerships was republished in the BNA Daily Tax Report on November 26, Endnotes 1 Prop. Treas. Reg. Section (e). Unless otherwise stated, all references to Section are to the Internal Revenue Code of 1986, as amended, and all references to Treas. Reg. Section are to the Treasury Regulations promulgated thereunder. 2 See Rev. Rul , C.B. 984; Rev. Rul , C.B. 984; Rev. Rul , C.B See Section 832(b)(5). 4 Rev. Rul , C.B. 53, obsoleted by Rev. Rul , C.B See, e.g., Humana Inc. v. Comm r, 881 F.2d 247 (6th Cir. 1989). 6 See Rev. Rul ; Rev. Rul ; Rev. Rul CCA (Apr. 11, 2007). Chief counsel advice may not be cited as authority by a taxpayer, but it does evidence an IRS position on the matter. 8 Reg. Section (h)(1). 9 These regulations may create a significant disincentive against forming a captive insurance company. See 2007 TNT-21621, Vermont governor cites concerns with proposed Regulations on Treatment of Intercompany Obligations, (November 7, 2007) and 2007 TNT , Treasury responds to Vermont Governors concerns with proposed Regulations on Treatment of Intercompany Obligations (November 16, 2007). Proposed IRS Rules Target Patented Tax Strategies Under recently issued proposed regulations, 1 taxpayers and their advisors would be required to disclose to the IRS their participation in transactions that use patented tax strategies. 2 These regulations were prompted by IRS concerns that taxpayers may interpret a patent for a tax strategy as approval by the IRS and Treasury Department of the transaction, which might impede the government s collection of information and negatively impact effective tax administration. 3 Once finalized, the proposed regulations would be effective for transactions entered into on or after September 26, Transactions Required to be Disclosed For a taxpayer to have a disclosure obligation under the proposed rules, there must be both a patented transaction and participation in a patented transaction. Patented Transactions. The proposed regulations provide that a patented transaction can occur in one of two ways. First, a patented transaction occurs if the taxpayer pays, directly or indirectly, a fee to a patent holder or the patent holder s agent for the legal right to use a tax planning method that the taxpayer knows or has reason to know is the subject of the patent. 5 Second, a patented transaction occurs if the taxpayer is the patent holder 6 or the patent holder s agent 7 and has the right to payment for another person s use of a tax planning method that is the subject of the patent. 8 Where amounts are paid in settlement of, or as the award of damages in, a suit for infringement of the tax patent, a patented transaction is considered to have occurred with respect to the recipient of the amounts, but not with respect to the payor. A tax planning method is defined broadly to mean any plan, strategy, technique, or structure designed to affect federal tax. However, patents issued for tax preparation software or other tools used to perform or model mathematical calculations or to provide mechanical assistance in the preparation of tax or information returns do not constitute tax planning methods. 9 A tax planning method is considered the subject of a patent not only where a patent has been granted, but also where a patent has been applied for but not yet granted

5 Participation in a Patented Transaction. A taxpayer will be considered to have participated in a patented transaction if the taxpayer s tax return reflects a tax benefit from the transaction, including a deduction for fees paid to the patent holder or its agent. A patent holder or its agent will be considered to have participated in a patented transaction if its return reflects a tax benefit in relation to obtaining a patent for a tax planning method (e.g. deductions for amounts paid to the Untied States Patent and Trademark Office or for attorney s fees) or reflects income from a payment received from another person for the use of the tax planning method that is the subject of the patent. 11 Material advisors who provide tax advice in connection with a patented transaction and who derive gross income in excess of a specified threshold amount also would be required to report the transactions and participants to the IRS and maintain certain lists of information relating to the transaction. 12 Under the proposed regulations, the threshold fees for material advisors are very low, 13 such that virtually any tax advisor 14 will be subject to the disclosure rules. Pepper Perspective Although a legislative prohibition on tax patents has been proposed, 15 patents for tax strategies do exist under current law. Accordingly, taxpayers should be aware that engaging in a patented tax strategy will subject them to the disclosure requirements discussed herein if and when these regulations become final. This disclosure obligation can span several years. Failing to disclose can result in a $10,000 or $50,000 penalty, depending upon whether the taxpayer is a natural person, and also may subject taxpayers to higher accuracy related penalties. Finally, taxpayers who are patent holders or their agents also should recognize that they could be treated as material advisors, and therefore subject to disclosure and list maintenance obligations, that each carry penalties for noncompliance. Authors: Joan Roll rollj@pepperlaw.com Timothy Leska leskat@pepperlaw.com Endnotes 1 72 FR 54615, REG (September 26, 2007). 2 The participating taxpayer will disclose its participation using Form 8886, and the advisor to the taxpayer will make its disclosure using Form Treas. Reg and Advisors also will have a list maintenance obligation under IRC Preamble to 72 FR 54615, REG Prop. Treas. Reg (h)(2); Prop. Treas. Reg (i)(2). 5 Prop. Treas. Reg (b)(7)(i). 6 See Prop. Treas. Reg (b)(7)(ii)(C) (providing that a person is a patent holder if (1) the person is a holder as defined in Treas. Reg (d) and (e), (2) the person would be a holder as defined in Treas. Reg (d)(2) if the phrase S corporation or trust was substituted for the word partnership and the phrase shareholder or beneficiary was substituted for the words member and partner, (3) the person is an employer of a holder as defined in Treas. Reg (d) and the holder transferred to the employer all substantial rights to the patent as defined in (b), or (4) the person receives all substantial rights to the patent as defined in Treas. Reg (b) in exchange (directly or indirectly) for consideration in any form. 7 See Prop. Treas. Reg (b)(7)(ii)(D) (providing that a patent holder s agent is any person who has the permission of the patent holder to offer for sale or exchange, to sell or exchange, or to market a tax planning method that is the subject of the patent). 8 Prop. Treas. Reg (b)(7)(i). 9 Prop. Treas. Reg (b)(7)(ii)(F). 10 Prop. Treas. Reg (b)(7)(ii)(B). 11 Prop. Treas. Reg (c)(3)(i)(F). 12 IRC 6111, 6112; Prop. Treas. Reg Under Treas. Reg (b)(3)(i)(A), the threshold amount of gross income is generally $50,000 in cases where the tax benefits of the transaction are provided to natural persons, and is $250,000 for all other transactions. Under the proposed regulations, these amounts are reduced to $250 and $500 respectively. 14 Under the proposed regulations, the patent holder or the patent holder s agent can be considered a material advisor with respect to the patented transaction. See Prop. Treas. Reg (treating any statement made or provided by the patent holder or the patent holder s agent that concerns the tax planning method that is the subject of the patent to be advice). 15 H.R

6 Pepper Hamilton llp Tax Practice Group Federal and International Tax Issues Annette M. Ahlers Joan C. Arnold James W. Barson Steven D. Bortnick / Gordon R. Downing W. Roderick Gagné Howard S. Goldberg Benjamin M. Hussa Bryan D. Keith* Timothy J. Leska Ellen McElroy** Marc D. Nickel*** Michelle Parten*** Lisa B. Petkun Todd B. Reinstein Joan M. Roll Leonard Schneidman James H. Stevralia Laura D. Warren Christian T. Wood R. D. David Young State and Local Tax Issues Philip E. Cook, Jr Lance S. Jacobs Charles L. Potter, Jr Employee Benefits Issues Jonathan A. Clark David M. Kaplan Andrew J. Rudolph Eric R. Stern *Project manager, not admitted to practice. **Admitted in Colorado only; supervision by principals of Pepper Hamilton llp who are members of the DC Bar. ***Law clerk, not yet admitted to practice. For more information about any of our tax professionals listed, please visit our Web site, The material in this publication is based on laws, court decisions, administrative rulings and congressional materials, and should not be construed as legal advice or legal opinions on specific facts. Berwyn Boston Detroit Harrisburg New York Orange County Philadelphia Pittsburgh Princeton Washington, D.C. Wilmington 2007 Pepper Hamilton llp. All Rights Reserved. This publication may contain attorney advertising. --