NON-PROFIT & TAX EXEMPT ENTITIES TAX AND REGULATORY ISSUES

Transcription

1 NON-PROFIT & TAX EXEMPT ENTITIES TAX AND REGULATORY ISSUES Cayman Captive Forum 2017 Pre-Forum Tutorial The Ritz Carlton Grand Cayman, Cayman Islands November 28, 2017 Tom Jones, Partner McDermott Will & Emery LLP Andrew Blevins, Senior Manager KPMG Cayman Islands

2 CONTACT INFORMATION Tom Jones Partner McDermott Will & Emery LLP 444 West Lake Street, Suite 4000 Chicago, IL Tel: (312) Andrew Blevins Senior Manager KPMG Cayman Islands Cricket Square, Century Yard Grand Cayman KY Tel: (345)

3 CHOOSING THE RIGHT FORM FACTORS: - Tax Status of Parent/Founder(s) - Number and Tax Status of Potential Insureds - Related or Unrelated Status of Potential Insureds - Homogenous/Divergent Nature of Insureds Activities - Earnings Retention Objectives - Extent of Experience Rating Desired - Short or Long Tailed Line of Business - Typical Policyholder Retention Pattern - Desire to Minimize Operational Costs - Goal to Entrench Founders/Promoters? 3

4 CAPTIVE LEGAL/REGULATORY ISSUES State insurance laws and regulations Tax considerations (federal income and excise; state income and premium) Securities registration exemption/antifraud disclosure (applicable to group captives) Other legal considerations (e.g., Medicare fraud and abuse; Medicare secondary payer concerns) Management/governance (directors and committees) Coverage and policy questions Choice of form (stock/mutual/reciprocal) (onshore vs. offshore) 4

5 TAXATION OF NON-PROFIT OWNED CAPTIVES The key tax question: Will it be treated as insurance? 5

6 TAX DEFINITION OF INSURANCE No clear-cut definition in tax law Must analyze case law and IRS rulings Captive with tax exempt parent prefers to avoid insurance company tax status for itself and for its parent But covering unrelated parties such as independent (voluntary) physicians seeking premium deductibility as well as joint ventures will create tax complications 6

7 BASIC FEDERAL TAX REQUIREMENTS For insurance treatment, the U.S. Supreme Court held both risk shifting and risk distribution must be present: Risk shifting must be to a separate legal entity Risk distribution connotes enough independent risks pooled to invoke the actuarial law of large numbers Insurance risk must be present versus investment risk Common Notions of Insurance must be present 7

8 ONSHORE HOSPITAL CAPTIVES TAX STATUS If captive funds risk of only its tax exempt parent and its employees, then domestic captive can obtain an IRS determination letter granting tax exempt status Easier to obtain if captive is formed as a non-profit membership company with no shares issued (VT, HI, DC permit this form) Must file IRS Form 1023 with a description of intended activities cannot cover non-employed physicians or other third parties if a substantial portion of business (> 5%-10%) Thus limited scope of captive activities if formed onshore covering >10% ineligible parties can cause all income of the domestic captive to become fully taxable (35% rate currently) If not tax exempt then captive will be subject to corporate level tax on all its investment income (which actuaries didn t include in projections) 8

9 OFFSHORE HOSPITAL CAPTIVES - TAX ISSUES No corporate income taxes in the Cayman Islands Offshore captives are not tax-exempt so they can accommodate addition of nonemployed physicians, but there may be manageable tax ramifications - Federal excise tax (FET) on premiums (inbound or outbound) - Unrelated business taxable income to captive s U.S. shareholder on net income from covering independent ( voluntary attending ) physicians or non-controlled entities such as JVs But unlike onshore captives, covering third parties may generate some tax but it does not taint the entire captive if unrelated business is less than half of the captive s activities this is the principal reason most captives owned by tax exempt hospitals are domiciled offshore 9

10 ADVANTAGES OF NON-INSURANCE STATUS FOR TAX EXEMPT OWNER OF OFFSHORE CAPTIVE Amounts paid to captive generally not subject to a federal excise tax (4% of the premium for direct insurance and 1% for reinsurance or life insurance) - Not premiums if not insurance; just non-taxable capital contributions - But premiums from unrelated parties may create excise tax obligations Can avoid attribution of any unrelated business taxable income to captive s tax-exempt parent - If not insurance then no UBTI - But premiums from unrelated parties may create UBTI to captive parent State premium tax - known as (i) direct placement tax or (ii) self-procurement tax or (iii) independently procured insurance tax would apply (about 30 states impose this type of tax) with 3%-5% rate typical Note domestic captives must pay some premium tax to domicile state (<.5%) in most states + DC (but none AZ or UT); no premium tax in Cayman 10

11 AVOIDING A U.S. TRADE OR BUSINESS Foreign insurance companies operating exclusively offshore generally is not subject to direct U.S. taxation But indirect U.S. taxation could occur if foreign captive is owned by U.S. shareholders - Taxable U.S. shareholders must recognize tax under anti-deferral rule - But tax exempt U.S. owners are not subject to federal income tax from owning captive However, a foreign insurer may be subject to direct U.S. tax if it is considered to be engaged in a U.S. business Net income taxed at 35% (determined under U.S. corporate income tax rules) Additional 30% branch profits tax on amounts withdrawn from U.S. Total tax rate could be as much as 54.5%! Note: also potential state insurance legal/regulatory problems if captive is conducting an unauthorized business of insurance onshore could become subject to a cease and desist order 11

12 AVOIDING A U.S. TRADE OR BUSINESS To avoid being engaged in a U.S. business, foreign captive should: - Hold all board and board committee meetings outside the U.S. - Execute all contracts (including issuance of policies, investment management agreements) outside the U.S. - Issue indemnity rather than pay on behalf of policies - Approve asset allocation policy outside the U.S. - Use only independent agents in the U.S. - Avoid having risk management employees as officers or board members of foreign captive; he/she should present claims report, etc. in capacity of consultant to the board 12

13 OFFSHORE CAPTIVE INVESTMENTS A 30% non-recoverable federal withholding tax is imposed on certain U.S. investments: - All dividends paid on equities (common and preferred shares, ETFs) of U.S. issuers (except American Depository Receipts) No 30% tax on: - bond portfolios comprised of individual bonds that meet the portfolio interest exception - Tax exempt bonds and U.S. government bonds - Clone bond funds formed in Ireland (UCITS) or Luxembourg (SICAVs) avoid this tax under applicable U.S. tax treaties (but generally higher fees and commissions) - U.S. source capital gains (long term or short term) not taxed unless U.S. real property Certain income of U.S. regulated investment companies, e.g., RIC s or mutual funds Avoid investments taking the form of trusts or partnerships engaging in a U.S. business which may cause the captive to be considered so engaged 13

14 1996 FEDERAL INCOME TAX LEGISLATION APPLICABLE TO OFFSHORE CAPTIVES OWNED BY TAX EXEMPT ORGANIZATIONS Insurance income (e.g., underwriting and investment) generally creates unrelated business taxable income to tax exempt owners but does not cause the entire captive to become fully taxable as with domestic captives IRC 512(b)(17) imposes a look through rule invoking IRC 501(m) commercial type insurance UBTI on Subpart F allocation of insurance income (includes both underwriting and investment income) Special exemption for offshore group captives formed by exempt hospitals, colleges and universities exclusively using policyholder (not shareholder) dividends 14

15 1996 FEDERAL INCOME TAX LEGISLATION APPLICABLE TO OFFSHORE CAPTIVES OWNED BY TAX EXEMPT ORGANIZATIONS Certain tax exempt affiliates are considered within the economic family if significant common purposes and substantial common ownership exist In general, captive s coverage of hospital based physicians (e.g., ED, pathology, radiology, etc.) groups under exclusive contract with hospital do not create UBTI Note: IRC 512(b)(17) is inapplicable if no insurance is present (e.g., most single parent captives are unaffected) 15

16 U.S. TAX COMPLIANCE OFFSHORE CAPTIVES Parent deemed to have not shifted its risk to Captive Balance sheet approach Premiums paid from Parent to Captive are not deductible Parent / Subsidiary Captive is not considered an insurance company Premiums Parent Coverage of Self insured risk Captive 16

17 SUMMARY OF OFFSHORE SINGLE U.S. TAX EXEMPT OWNER CAPTIVE STATUS Assumes only institutional & employee risks are being funded Not an insurance company for tax purposes - No federal excise tax imposed on premiums ceded to captive - No unrelated business taxable income to sole S/H - Premiums are not deductible for taxable affiliates No violation of state insurance law - No captive activity in state where risks are located - Self-funding, not true insurance - Policyholders representing most of the premium also could qualify as industrial insureds in 22 states with favorable statutes Foregoing not changed with coverage of employees or controlled affiliates But major changes if non-employed physician practices are covered in the future 17

18 U.S. TAX COMPLIANCE OFFSHORE CAPTIVES The captive s U.S. shareholder(s) generally file the following forms annually: - IRS Form 5471: Typical single parent hospital shows captive as an investment rather than an insurance company - IRS Form 926: report all transfers to captive as capital contributions Other potential forms for company and/or U.S. shareholders: - FinCEN Form 114 ( FBAR ) - IRS Form 1120-F (Protective Filing) - IRS Form 720 (Federal Excise Tax or FET) 18

19 U.S. TAX COMPLIANCE (CONTINUED) FinCEN Form 114 ( FBAR ): all U.S. persons must disclose a financial interest in or signatory authority over foreign bank or other financial accounts if balance > $10,000 at any time: - Includes captive s parent plus any U.S. citizens or residents - Always on calendar year basis - Due on April 15 of the year following the calendar year being reported; automatic extension granted until October 15 (no request needed) - Must be electronically filed on FinCEN s BSA E-filing system - Applies to offshore bank operating accounts and foreign mutual fund investments (which are available to the general public and have a regular net asset value) - Foreign hedge funds and private equity funds are currently not included as a financial account 19

20 U.S. TAX COMPLIANCE (CONTINUED) Making a Protective IRS Form 1120-F Filing: - A foreign corporation that is engaged in a U.S. trade or business is subject to U.S. tax on its net income, not its gross income, but ONLY if it files a U.S. return in that year - If a foreign corporation is found to be engaged in a trade or business on audit and has not filed a U.S. return for the year in question, it will generally be taxed in the U.S. on its gross income (i.e., no deductions or credits allowed) - A foreign corporation can make a protective filing in any year even if it does not believe it has a U.S. trade or business by filing a Form 1120-F and indicating that the form is being filed for protective purposes - No need to show numbers; just name, address & FEIN 20

21 U.S. TAX COMPLIANCE (CONTINUED) IRS Form 720 Federal Excise Tax Filing: - Calendar quarter filing to report excise tax on insurance/reinsurance premiums - Reinsurance premiums ceded by captive are subject to FET - Non-insurance company offshore captives incur 4% FET on reinsurance purchased from non-treaty protected reinsurers (e.g., Bermuda, Cayman and Barbados) - Timely deposit of FET is required - Potential IRS Form 8833 treaty-based return position disclosure required for United States risk insured/resinsured with a counter party resident in a treaty country which has entered into a closing agreement with the IRS (obtain copy of the closing agreement for records) to eliminate FET 21

22 U.S. TAX COMPLIANCE (CONTINUED) A captive s U.S. officers and directors generally must file Form 5471 if a U.S. Shareholder obtains 10% or an additional 10% interest in a foreign corporation Exception from filing if immediately after the reportable stock acquisition, three or fewer U.S. persons own 95% or more in value of the foreign corporation and the U.S. person making the acquisition files a return for the acquisition as a Category 3 filer 22

23 FOREIGN ACCOUNT TAX COMPLIANCE ACT (FATCA) Enacted by Congress in 2010 to detect & prevent offshore tax evasion enforced via a new federal withholding tax 30% tax on payments from U.S. unless Cayman hospital captive, a Non-Financial Foreign Entity (NFFE), supplies IRS Form W-8BEN-E to U.S. payers Cayman hospital captive (holding an insurance license) will be a NFFE, not a Foreign Financial Institution (FFI) which under more onerous rules must register with & file reports to IRS to avoid 30% tax Cayman has signed an Intergovernmental Agreement (IGA) with the IRS as a Model 1 jurisdiction so FFIs can report to Cayman Government which will share data with IRS but N/A to NFFEs like hospital captives 23

24 IMPACT OF THE COMMON REPORTING STANDARD (CRS) Worldwide, the financial services industry is by now very familiar with FATCA the U.S. Foreign Account Tax Compliance Act CRS is a similar to FATCA but far more extensive More than 100 Participating Jurisdictions have committed to the automatic exchange of information (AEOI) under the CRS The U.S. is not a Participating Jurisdiction IRC 953(d) election is not recognized by the CRS All Cayman Islands Financial Institutions required to complete due diligence procedures for entity account holders by December 31,

25 COMMON REPORTING STANDARD (CRS) STEPS TO PREPARE 1. Entity Classification - Each Cayman entity will need to determine if they are a Financial Institution ( FI ) or a Non- Financial Entity ( NFE ) under CRS. Generally, if a FFI under FATCA, the entity will also be a FI under CRS. - If an entity was a Passive NFFE or met an exempted category under FATCA, they need to review their classification under CRS to determine their status. 2. Complete U.S. withholding tax / CRS self-certification forms - Cayman issued an updated combined CRS/FATCA Form on June 22, 2017 is expected to be requested by counterparties, prime brokers, etc. - Each may request their own, no requirement to use Cayman standard form - Identification of a Controlling Person for Passive NFEs is key. 25

26 COMMON REPORTING STANDARD (CRS) CONTROLLING PERSON The biggest issue for Passive NFEs is a Controlling Person is required to be identified on selfcertification forms. In particular, CRS has a concept of senior managing official, which will apply to most captives. - Challenge will be getting forms signed and documentation complete. - If there are no natural person(s) who exercise control of the captive, then the Controlling Person will be the natural person(s) who holds the position of senior managing official. Form documentation - No universal form. - Each third party can request a different form, and some of them are very complicated. 26

27 27 U.S. Healthcare Law Reform Impact on Captives

28 THE UNDERLYING LAW March 23, 2010: Patient Protection and Affordable Care Act (a/k/a PPACA or the ACA or Obama-care ) enacted - Law includes a number of provisions designed to: - Improve the quality of Medicare services - Support innovation - Establish new payment models - Better align Medicare payments with provider costs - Strengthen Medicare s financial footing Basics of PPACA remain in effect after recent failed attempt to repeal 28

29 THE GOAL All sides agreed on reform objectives - Delivery system reform (e.g., Accountable Care Organizations (ACOs)) - Wellness and prevention (e.g., Medical Homes) - Need for cost containment (e.g., Bundled Payments) 29

30 HOSPITALS RUSH TO HIRE PHYSICIANS: THE FUTURE MODEL All across the country hospital systems are employing physicians at an unprecedented rate. Impacts to be considered include: - Financing of tail coverage - Increased loss exposure in hospital captives - Need for increased attention to underwriting by captives - Claim management demands - Adjustments to actuarial models - Excess market attachment points - Reduced commercial market share as physicians leave private practice - Increased focus on ART programs as hospital-owned captives grow in numbers and size 30

31 % OF PHYSICIAN PRACTICES OWNED BY HOSPITALS/HEALTH SYSTEMS 2005: 25% 2008: 50% 2015:????????? Source: Medical Group Management Association 31

32 THE EXISTING STRUCTURE Medical Staff Community Physicians Hospital Employed Physicians Insurance Source: Commercial, RRGs Insurance Source: Hospital-Owned Captive Reinsurance Market Reinsurance Market 32

33 THE NEW STRUCTURE Hospital System ACO Physicians Hospital Captive Reinsurance Market Future Alignment Strategies - Physician employment (including foundation models) - Leasing arrangements with physician groups - Inclusion of unrelated assisted living, rehabilitation, home healthcare, etc. facilities - Management ventures: cardiac care, women s health, cancer care, etc. - A possible combination of some or all of the above 33

34 PRIVATE PHYSICIANS IN A HOSPITAL CAPTIVE: THE CURRENT AND PAST MODEL Historically, professional liability insurance presented an opportunity to align hospital and physician interests in quality improvement, patient safety and risk management through a joint risk funding vehicle The risk funding vehicle most commonly used is a hospital-owned captive insurance company Inclusion of voluntary physicians (i.e., non-employed physicians) in the hospital s risk funding vehicle, such as a captive, requires navigation through a number of obstacles, including insurance regulatory, tax and health care fraud and abuse laws These issues do not apply to hospital employed physicians 34

35 WHY COVER NON-EMPLOYED PHYSICIANS IN THE HOSPITAL S CAPTIVE? They are largely the hospital s risk already vicarious liability and other theories of deep pocket liability Hospitals can improve quality and enhance the hospital s own risk management program by aligning hospital and physician interests Physicians sometimes ask for help - High malpractice premiums in many states, including crises in NY and NJ - Carriers leaving the market or suffering ratings downgrades - High cost of tail (extended reporting period) coverage if physician moves - MICRA California tort reform law since 1975 reaffirmed in 2015 by close vote In the past, physicians retired or relocated rather than paying escalating commercial premiums 35

36 OVERVIEW OF CONCERNS APPLICABLE TO COVERING NON-EMPLOYED PHYSICIANS State insurance regulatory issues Health care regulatory issues - Financial relationships between hospitals and physicians trigger legal concerns that are unique to the health care arena - Any element of a physician program that can be characterized as subsidizing physicians or providing non-commercially reasonable terms triggers Medicare fraud and abuse issues and, for tax exempt hospitals, private inurement/tax exemption concerns 36

37 COVERING INDEPENDENT PHYSICIANS INSURANCE/REGULATORY ISSUES Coverage of only a hospital, its employees and controlled affiliates generally is not considered to be the business of insurance and does not trigger state insurance regulation Extending coverage to voluntary attending physicians (i.e., non-employed physicians) rather than only a hospital and controlled affiliates generally will be considered the business of insurance, triggering insurance regulation issues Addressing these issues primarily depends on the law of the state where risks being pre-funded are located Often the only safe solution is to engage a fully licensed fronting carrier (e.g., CNA or Lexington) to write the physician coverage and reinsure it with the captive (requires providing collateral to the front ) 37

38 SOURCES OF HEALTHCARE FRAUD AND ABUSE LEGAL GUIDANCE The law: Two key federal fraud and abuse laws affect hospital financial relationships with physicians: - Anti-Kickback Law - Stark Law The analysis to determine whether an arrangement is permitted for fraud and abuse purposes generally is parallel to the private inurement analysis for tax-exemption purposes Key is to avoid any tax exempt hospital subsidy of private physician premiums 38

39 ESTABLISHING ABSENCE OF SUBSIDY Premiums must be actuarially determined Actuarially determined premiums may be less than commercial premiums, for reasons such as: - Joint defense - Participation in enhanced risk management - Other differences between captive and commercial premium calculation 39

40 PPACA IMPACT ON OFFSHORE CAPTIVES Because more physicians are becoming hospital employees to support integrated clinical services and financial incentives - Legal reason for a captive may disappear since an onshore trust legally can fund the institutional & employed physician liability risks - But strong counter-arguments for keeping captive include access to reinsurers & focus on patient safety due to captive s enhanced RM Offshore captives could especially benefit from ACO risk funding (which involves covering unrelated partners, JVs, etc.) - Onshore captives can write only 5-10% unrelated risk without being fully taxed - But offshore captives can write up to 50% unrelated risk with only minor taxes 40

41 FUTURE SPECULATIVE CONTINGENCIES Providers get fixed fee for an indeterminate amount of care Places providers in a position of incurring patient utilization risk Perhaps some of the downside exposure of providers can be pre-funded in a captive 41

42 42 Developments in the Cayman Islands for Captives

43 WHY CAYMAN? Proven Track Record Harvard Medical Started in 78 - Flexible but responsible regulatory regime - Healthcare focus (almost half its captives) - Strong medical malpractice infrastructure/orientation - Major federal tax advantages offshore for U.S. tax exempts 43

44 THE CAYMAN REGULATORY ENVIRONMENT Judicious discretion with limited statutory rules - Cayman s Insurance Act provides the basic framework - The Cayman Monetary Authority sets financial parameters using a holistic approach and rules of thumb rather than rigid rules - The captive s filed business plan, as amended from time to time, establishes its responsibilities and undertakings - By statute the local insurance managers play a contingent but important regulatory role 44

45 DIRECTORS DUTIES UNDER CAYMAN LAW Duty of skill, care and diligence Oversight role - duty to adequately supervise competent service providers Fiduciary duties - directors must act in the best interests of the captive and must disclose to other directors any material conflict of interest Director indemnification - except for dishonesty, willful default or gross negligence 45

46 CAYMAN INSURANCE LAW Enacted in 2010, amendments effective 11/1/12 Motivators: IMF compliance and Hurricane Ivan domestic property insurance aftermath Key elements: Greater oversight of Class A license holders (writers of Cayman risks) Splits Class B into three categories - B-1: 95% or more related party risk - B-2: > 50% related party risk - B-3: < 50% related party risk New Class C for SPVs (Special Purpose Vehicles) like cat bonds, insurance linked securities and other transformers New Class D for commercial reinsurers Expands non-compliance penalties & whistle blowing provisions 46

47 CAYMAN INSURANCE LAW Impact on health care captives: Modifications have had little or no effect on most single hospital parent captives Main reason is favorable definition of related party risk - Measured by the captive s net written premium (retained/not reinsured) - Includes not just parties under common ownership or legal control of the hospital, but also parties participating in the hospital s common risk management plan - Thus, most joint professional liability insurance programs that include independent (voluntary attending) physicians or joint ventures should remain in the Class B-1 category of license holder 47

48 48 General Background on Cell Captives

49 OVERVIEW Generic term cell company Developed from inherent weakness in attempted segregation in traditional contractual rent-a-captives Cells are comprised of separately identified and legally segregated assets and liabilities within a single company statutorily firewalled from each other Guernsey was the first in 1997; others quickly followed; upwards of 50 jurisdictions today including a number of US states Cayman law enacted in 1998 Cayman: a cell is called a segregated portfolio and the entity is called a segregated portfolio company Cayman 30 September 2013: 137 Segregated Portfolio Companies with 589 cells out of 755 captives September 13, 2010 IRS issues Proposed Regulations which would treat foreign cells engaged in an insurance business as separate entities for U.S. tax purposes 49

50 VARIED USES OF CELL CAPTIVES What types of captive programs are in cells? Hospital/clinics/independent physicians Combining 2 captives into 1 post-merger Collaborative efforts by unrelated healthcare providers Pure/single parent risks (conglomerates) - Separation - By product line - By geographic area Group and/or association shared risks Transformers, funds & financial guaranty companies Agency risk participation Composite insurers separating life & non-life lines 50

51 51 General Background on Incorporated Cell Captives

52 LATEST DEVELOPMENT ICC S ICC = Incorporated Cell Company Originated in Jersey (Not New Jersey) Legislation enacted in Cayman Bermuda considering By statute, each cell is a distinct legal entity and can have its own governing body (cell walls higher and thicker ) Addresses cell participants demand for intra-cell contracts and diverse governance input 52

53 LATEST DEVELOPMENT ICC S (CONT D) ICC tax status is clearer than PCCs each cell is a separate entity for U.S. tax purposes Insolvency law status also is clearer each cell is a separate juridical person Usual rules to apply creditor hierarchy but only within the incorporated cell entity Must apply piercing the corporate veil case law to cut through an IC wall 53

54 ENABLING ICCS: NEXT LOGICAL STEP FOR CAYMAN Regular segregated cell is not a separate legal entity This creates drawbacks - Intra-cell contracting not possible in Cayman - Uncertain federal tax status of unincorporated cells - Restricted to a single board at the core level Enter the portfolio insurance company ( PIC ) 54

55 RECENTLY ENACTED CAYMAN PIC LAW Wording of PIC enabling law (passed 3/25/13) is user friendly Insurance specific part of the Insurance Law An SPC s board can choose to incorporate one or more of its cells by the cell s establishing a wholly owned subsidiary PIC The PIC is an exempted company beneath a cell which, generally, replaces the cell Thus, the legal relationship between the core and its cells is that of a parent/subsidiary PIC board chosen by core board but can be comprised of different persons 55

56 56 QUESTIONS