OFFSHORE CAPTIVE TAX AND REGULATORY CONSIDERATIONS Angela J. Walitt, Partner Baker & McKenzie LLP February 13, 2017 1
Discussion Topics Benefits of Using an Offshore Captive Direct U.S. Taxation of Offshore Captives Election to be Taxed as a Domestic Corporation IRC Section 953(d) Controlled Foreign Corporations Passive Foreign Investment Company ("PFIC") Rules Federal Excise Tax Foreign Account Tax Compliance Act ("FATCA") 2
BENEFITS OF USING AN OFFSHORE CAPTIVE 3
BENEFITS OF USING AN OFFSHORE CAPTIVE REGULATORY ADVANTAGES More freedom to write third party business. More freedom to write unique types of coverages. Possibly lower capital requirements. Still need to show capital is adequate for business written. 4
BENEFITS OF USING AN OFFSHORE CAPTIVE TAX ADVANTAGES If captive can be decontrolled, income may be deferred until repatriated. Need to ensure that captive is not doing business in the U.S., or captive will be subject to U.S. Income and Branch Profits Tax. U.S.-controlled captive can elect to be taxed as a U.S. corporation and still be regulated as an offshore company. 5
DIRECT U.S. TAXATION OF OFFSHORE CAPTIVES 6
DIRECT U.S. TAXATION OF OFFSHORE CAPTIVES FOREIGN CAPTIVE IN A NON-TREATY JURISDICTION (E.G. CAYMAN ISLANDS) WILL BE SUBJECT TO DIRECT U.S. TAXATION IF IT IS "ENGAGED IN A U.S. TRADE OR BUSINESS". Courts generally define as "regular and continuous activity in the U.S. U.S. activity may be U.S. activity of employees or agents acting on behalf of the captive. No exception for independent agents. Trading stock or securities for its own account is not a trade or business. 7
DIRECT U.S. TAXATION OF OFFSHORE CAPTIVES IF THE CAPTIVE IS SUBJECT TO DIRECT U.S. TAX, IT WILL GENERALLY BE SUBJECT TO CORPORATE INCOME AND BRANCH PROFITS TAX. Effective tax rate may be as high as 54%. 8
DIRECT U.S. TAXATION OF OFFSHORE CAPTIVES FOREIGN CAPTIVE QUALIFYING FOR TREATY BENEFITS (E.G. BERMUDA CAPTIVE) WILL GENERALLY BE SUBJECT TO DIRECT U.S. TAXATION ONLY IF IT IS DOING BUSINESS THROUGH A PERMANENT ESTABLISHMENT IN THE U.S. A higher standard than engaging in a U.S. trade or business. Generally requires a fixed place of business. Regular use of an affiliate's office can be a permanent establishment. A place of management in the U.S. may be a permanent establishment. 9
DIRECT U.S. TAXATION OF OFFSHORE CAPTIVES AN AGENT IN THE U.S. BINDING THE CAPTIVE TO CONTRACTS WILL CONSTITUTE A PERMANENT ESTABLISHMENT, UNLESS IT IS AN INDEPENDENT AGENT ACTING IN THE ORDINARY COURSE OF ITS BUSINESS. Agent must be both economically and legally independent to qualify. WHERE DO ACTIVITIES OF THE CAPTIVE ACTUALLY TAKE PLACE? Where is the policy underwritten? Who negotiates and pays claims? 10
ELECTION TO BE TAXED AS A DOMESTIC CORPORATION IRC SECTION 953(D) 11
ELECTION TO BE TAXED AS A DOMESTIC CORPORATION IRC SECTION 953(D) WHY MAKE THE ELECTION? For many foreign captives, income is already subject to current tax in the U.S., either to the captive or its U.S. shareholders. Domestic election avoids branch profits tax concerns/operating restrictions and avoids federal excise tax on insurance premiums. Domestic election provides the most favorable tax treatment for most U.S.- owned single parent captives, while also affording them foreign regulation. Domestic regulation may entail higher capital requirements and greater expense, with more limited flexibility. 12
ELECTION TO BE TAXED AS A DOMESTIC CORPORATION IRC SECTION 953(D) DIVIDENDS PAID BY AN ELECTING CAPTIVE TO A U.S. CORPORATION QUALIFY FOR THE DIVIDENDS RECEIVED DEDUCTIONS; THOSE PAID TO INDIVIDUALS QUALIFY FOR REDUCED TAX RATE. ELECTING CAPTIVE ALSO ELIGIBLE FOR SECTION 831(B) ELECTION TO BE TAXED ONLY ON INVESTMENT INCOME. ELECTING CAPTIVE JOINS IN THE U.S. CONSOLIDATED RETURN IF OWNERSHIP REQUIREMENTS ARE MET. Net operating losses of electing captive are dual-consolidated losses, cannot offset income of other members of the group. No right to elect to use the losses. Capital losses of the electing captive are not dual-consolidated losses. 13
ELECTION TO BE TAXED AS A DOMESTIC CORPORATION IRC SECTION 953(D) THE ELECTING CAPTIVE ENTERS INTO A CLOSING AGREEMENT WITH THE IRS. Captive must post a letter of credit unless it has sufficient assets in the U.S. Asset test may be met by an affiliate with an office in the U.S. and sufficient assets, in which case the affiliate signs the closing agreement. Procedure for electing is set out in Rev. Proc. 2003-47. 14
ELECTION TO BE TAXED AS A DOMESTIC CORPORATION IRC SECTION 953(D) NOTE THAT THE ELECTION IS ONLY AVAILABLE TO INSURANCE COMPANIES MORE THAN HALF THE COMPANY'S BUSINESS DURING THE TAXABLE YEAR MUST BE THE ISSUING OF INSURANCE OR ANNUITY CONTRACTS, OR THE REINSURING OF RISKS UNDERWRITTEN BY INSURANCE COMPANIES (SEE IRC 831(C), 816(A)). THE ELECTION ALLOWS THE CAPTIVE TO OPERATE FREELY IN THE U.S. WITHOUT ADVERSE TAX CONSEQUENCES Election does not affect State regulatory restrictions against carrying on an insurance business without a license. 15
CONTROLLED FOREIGN CORPORATIONS 16
CONTROLLED FOREIGN CORPORATIONS IF THE CAPTIVE IS: foreign, not doing business in the U.S., and has not elected to be taxed as if it were domestic, THE CAPTIVE ITSELF WILL NOT BE SUBJECT TO U.S. INCOME TAX. Federal excise tax will generally apply to premiums. If the captive is a controlled foreign corporation ("CFC"), U.S. shareholders will generally be taxed currently on their allocable share of the CFC's income. 17
CONTROLLED FOREIGN CORPORATIONS TWO TESTS: CLASSIC INSURANCE CFC U.S. shareholders individually owning 10% or more of the vote of the captive collectively own more than 25% of the vote or value of the captive. Ownership includes shares owned directly, indirectly through foreign entities, and constructively through attribution rules. If the test is met, 10% or greater U.S. shareholders include in income currently their allocable share of the captive's subpart F insurance income (generally all of its income). Exception: premium income from insuring risks located in CFC's home jurisdiction not taxable to shareholders under subpart F. 18
CONTROLLED FOREIGN CORPORATIONS DECONTROLLED INSURER (no insured U.S. shareholders or related persons) Foreign Shareholders (Unlimited) U.S. Shareholders (10% or more vote, but not more than 25% aggregate vote or value) U.S. Shareholders (Unlimited) (Less than 10% vote) Offshore Captive 19
CONTROLLED FOREIGN CORPORATIONS RELATED PERSON INSURANCE INCOME ("RPII") CFC Designed to address the 11 member group captive, where captive insures substantial related party risk, but no U.S. person owns 10% or greater voting interest in the captive. RPII is defined as underwriting and investment income attributable to a policy of insurance or reinsurance if the insured is: (i) a U.S. shareholder or (ii) "related" to a U.S. shareholder (includes CFC income from insuring foreign related persons). "Related" likely interpreted as requiring controlling (>50%) ownership interest in the insured by a particular U.S. shareholder of the CFC, or vice versa. U.S. shareholders taxed on RPII if the U.S. shareholders, regardless of their individual ownership levels, own 25% or more of the vote or value of the captive, in the aggregate. Again, ownership may be direct, indirect or constructive (slightly different attribution rules). 20
CONTROLLED FOREIGN CORPORATIONS RPII CFC If the rules apply, all U.S. shareholders, regardless of individual ownership percentages, include in income currently their proportionate share of the captive's RPII. U.S. shareholder does not have to be insured or related to an insured to receive a RPII allocation. RPII allocated first to U.S. shareholders, up to their proportionate share of total CFC income. CFC can elect to pay U.S. tax resulting from RPII directly, as U.S. trade or business income, rather than having its U.S. shareholders report the income. > Election also exempts U.S. risk premiums from federal excise tax. > IRS consent required to revoke election. 21
CONTROLLED FOREIGN CORPORATIONS RPII CFC Exceptions to RPII CFC status De Minimis Income Exception: Less than 20% of CFC's gross insurance income is RPII (i.e., income from insuring U.S. shareholders or persons related to the U.S. shareholders). > Income from insuring (i) foreign shareholders that are not related to any U.S. shareholder or (ii) U.S. persons that are not related to any U.S. shareholder, would not be RPII. > Difficult to plan into exception, because anti-abuse rules apply and because some income items cannot reliably be controlled. (E.g., decrease in reserves can affect gross income; investment income included in RPII). > Exception does not apply if CFC has elected to pay U.S. tax resulting from RPII directly. 22
CONTROLLED FOREIGN CORPORATIONS RPII CFC Exceptions to RPII CFC status Ownership Exception: Less than 20% of CFC shares (vote and value) are owned by U.S. insureds or persons related to insureds. > Ownership by foreign shareholder/insureds that are not related to U.S. shareholders/insureds should not count as shareholder/insureds for purposes of the Ownership Exception. > In applying test, the Regulations calculate the value of the stock owned by including the value of all policies held. > Exception does not apply if CFC has elected to pay U.S. tax resulting from RPII directly. 23
CONTROLLED FOREIGN CORPORATIONS DECONTROLLED INSURER (insured US shareholders or related persons) Foreign Shareholders (Unlimited) U.S. Shareholders (10% or more vote, but not more than 25% aggregate vote or value) U.S. Shareholders (Unlimited) (Less than 10% vote) Offshore Captive MEET EITHER EXCEPTION: (A) (B) LESS THAN 20% OF INCOME IS RPII INCOME LESS THAN 20% SHARES (VOTE OR VALUE) ARE OWNED BY U.S. INSUREDS OR RELATED PERSONS 24
CONTROLLED FOREIGN CORPORATIONS ALTERNATIVE Agents, brokers or businesses sometimes achieve tax-deferral by establishing captives to insure customers. Arrangement should work provided that: U.S. shareholders individually owning 10% or more of the vote of the captive do not collectively own more than 25% of the vote or value of the captive, and No U.S. shareholders or related persons are insured. 25
CONTROLLED FOREIGN CORPORATIONS DECONTROLLED INSURER (no insured US shareholders or related persons) Foreign Shareholders (Unlimited) U.S. Shareholders (10% or more vote, but not more than 25% aggregate vote or value) Offshore Captive U.S. Shareholders (Unlimited) (Less than 10% vote) Shareholders are noninsureds (e.g. agents, brokers, MGAs). "Captive" insures customers. 26
PASSIVE FOREIGN INVESTMENT COMPANY ("PFIC") RULES 27
PASSIVE FOREIGN INVESTMENT COMPANY ("PFIC") RULES A FOREIGN COMPANY WILL BE A PFIC IF 75% OR MORE OF THE COMPANY'S GROSS INCOME IS PASSIVE INCOME. OR 50% OR MORE OF THE COMPANY'S ASSETS ARE HELD FOR PRODUCTION OF PASSIVE INCOME. PFIC rules apply even if total U.S. ownership is under 25%, and no 10% U.S. shareholders. U.S. persons owning shares are taxed on excess distributions, and gains on sale of stock, as if earned ratably over ownership period, plus interest. 28
PASSIVE FOREIGN INVESTMENT COMPANY ("PFIC") RULES PFIC RULES WON'T APPLY TO MOST CAPTIVES. PFIC rules won't apply to 10% or greater U.S. shareholders of a CFC or RPII shareholders of a RPII CFC. PFIC rules don't apply to foreign corporations primarily engaged in the active conduct of the insurance business, provided the insurer is not overcapitalized. Legislation has been introduced and regulations proposed that would further define and clarify when an insurance business is "actively" conducted and when the company is overcapitalized. If the transactions do not qualify as insurance, and the captive is widely held so CFC rules don't apply, PFIC rules act as a backup anti-deferral regime. 29
PASSIVE FOREIGN INVESTMENT COMPANY ("PFIC") RULES PROPOSED REGULATORY CHANGE TO PFIC RULES. April 2015 Proposed Regulations would define the term "active conduct" to provide that a corporation actively conducts an insurance business only if its own officers and employees carry out substantial managerial and operational activities. Activities performed by independent contractors or by the officers or employees of a related party would not count for purposes of meeting the active conduct test. Rule is intended to target hedge fund reinsurers, but ignores that it is common in the industry to use independent contractors or shared staff to perform insurance administration and investment management functions. Proposed Regulations have been extensively criticized by commentators and seem unlikely to survive in its current form. Proposed Regulations also requested comments on how to determine the portion of an insurance company's assets that are held to meet obligations under insurance contracts. 30
FEDERAL EXCISE TAX 31
FEDERAL EXCISE TAX APPLIES TO PREMIUMS PAID BY U.S. PERSONS, TO NON-U.S. INSURERS, WITH RESPECT TO RISKS WHOLLY OR PARTLY IN THE U.S. Does not apply to premiums paid to domestic electing captive. Applies to premiums paid by a U.S. captive (including a domestic electing captive) to a non-u.s. reinsurer. FET RATE IS 4% FOR DIRECT INSURANCE, 1% FOR LIFE INSURANCE AND ALL REINSURANCE. FET applies to gross premiums; do not net out commissions, etc. Applies in funds-withheld arrangements. 32
FOREIGN ACCOUNT TAX COMPLIANCE ACT ("FATCA") 33
FOREIGN ACCOUNT TAX COMPLIANCE ACT ("FATCA") FATCA PROVISIONS ARE BROADLY DESIGNED TO PREVENT TAX EVASION BY U.S. INDIVIDUALS THROUGH THE USE OF OFFSHORE ACCOUNTS Requires 30% withholding on "withholdable payments" to foreign financial institutions ("FFIs"), unless the FFI enters into an agreement with the IRS to (i) collect and report information regarding U.S.-owned "accounts", and (ii) withhold on U.S.-source payments, under certain circumstances. Also requires 30% withholding on withholdable payments to non financial foreign entities ("NFFEs") under some circumstances. 34
FOREIGN ACCOUNT TAX COMPLIANCE ACT ("FATCA") THE TERM "FINANCIAL INSTITUTION" IS DEFINED IN THE CODE AS ANY ENTITY THAT: accepts deposits in the ordinary course of a banking or similar business, holds financial assets for the account of others as a substantial portion of its business, or is engaged or holds itself out as being engaged primarily in the business of investing, reinvesting or trading in securities, partnership interests, commodities, or any interests in such securities, partnership interests or commodities. AN FFI IS ANY FINANCIAL INSTITUTION THAT IS A FOREIGN ENTITY. 35
FOREIGN ACCOUNT TAX COMPLIANCE ACT ("FATCA") REGULATIONS ADDRESS FATCA STATUS OF INSURANCE COMPANIES AND INSURANCE AND ANNUITY CONTRACTS FATCA Regulations create a separate FFI category for insurance companies issuing: (i) insurance contracts with a cash value in excess of $50,000 or (ii) annuity contracts (a "specified insurance company"). Non-cash value insurance or annuity contracts will not constitute "accounts" for FATCA purposes. An insurance company's reserve activities with respect to its insurance contracts will not be taken into consideration in determining whether the company qualifies as another type of FFI. These rules should generally exempt most non-life captives from the definition of FFI, because they will not maintain "accounts". 36
FOREIGN ACCOUNT TAX COMPLIANCE ACT ("FATCA") 953(D) COMPANIES GENERALLY TREATED AS U.S. COMPANIES FOR FATCA PURPOSES. Exception: 953(d) companies that are (i) specified insurance company FFIs and (ii) not authorized to do business in the U.S., are treated as foreign corporations under FATCA. WITHHOLDABLE PAYMENTS "Withholdable Payments" are defined as U.S. source "fixed or determinable annual or periodical" (FDAP) income, which includes interest, dividends, premiums, annuities and similar types of income, as well as gross proceeds from the sale of property which produces U.S. source interest or dividends. Specified "nonfinancial" payments are excluded from withholding. Although insurance premiums subject to FET are generally excluded from US withholding tax, they are not excluded from FATCA withholding. 37
FOREIGN ACCOUNT TAX COMPLIANCE ACT ("FATCA") FOREIGN INSURANCE COMPANIES THAT ARE NOT FFIS ARE SUBJECT TO FATCA REQUIREMENTS GOVERNING NFFES WITHHOLDABLE PAYMENTS TO NFFES ARE SUBJECT TO 30% WITHHOLDING UNLESS THE RECIPIENT: Certifies that it is receiving the payment on its own behalf, and either: Provides the payor or withholding agent with certification that it has no substantial U.S. owners, or Provides the name, address and TIN of every substantial U.S. owner. > A "substantial U.S. owner" of a corporation is any 10% or greater U.S. shareholder, by vote or value. NFFEs can provide information to payors on Form W-8BEN-E. "Direct reporting" NFFE may report substantial U.S. owners directly to IRS. 38
FOREIGN ACCOUNT TAX COMPLIANCE ACT ("FATCA") WITHHOLDING DOES NOT APPLY IF THE NFFE RECIPIENT OF THE PAYMENT IS, INTER ALIA:* A corporation, the stock of which is regularly traded on an established securities market. A corporation which is a member on the same expanded affiliated group as such a publicly traded corporation. Any entity organized under the laws of a U.S. territory which is wholly owned by one or more bona-fide residents of such territory. Certain retirement funds. An "excepted" nonfinancial entity (includes start-up companies and companies in liquidation). An "active" nonfinancial entity (insurance companies generally won't qualify). * Not an exclusive list. 39
FOREIGN ACCOUNT TAX COMPLIANCE ACT ("FATCA") TWO MODEL INTERGOVERNMENTAL AGREEMENTS ("IGAS") ISSUED BY IRS PROVIDE ALTERNATIVES TO FATCA REGULATIONS; TREASURY HAS NEGOTIATED IGAS WITH DOZENS OF COUNTRIES. IGAs are intended to allow countries with local law information-reporting impediments to provide information on U.S. accounts held by FFIs. Under Model 1 IGA, FFI provides account information to home country tax authorities, and does not register directly with the IRS. Under Model 2 IGA, FFI enters into agreement with IRS and provides aggregate account information regarding account holders not consenting to provision of specific information, but must comply with follow-up requests for specific information. OVER 80 IGAS SIGNED, INCLUDING BAHAMAS, BERMUDA, CAYMAN ISLANDS, GUERNSEY, IRELAND, JERSEY, SWITZERLAND AND UK. 40
LEGISLATIVE DEVELOPMENTS SEPTEMBER 2016 WARNER/NEAL BILL Proposes disallowance of deduction for payment of reinsurance premiums by U.S. insurance company to related foreign company covering non-life risks, to the extent that that the foreign reinsurer (or its parent company) is not subject to U.S. income tax with respect to the premiums received. Related reinsurance recoverables, return premiums and ceding commissions would be excluded from income Foreign reinsurer could instead elect to treat the reinsurance premium as effectively connected with a U.S. trade or business. Would affect foreign-parent reinsurance captives. 41
QUESTIONS? Angela J. Walitt, Partner Baker & McKenzie LLP 815 Connecticut Ave., NW, Washington, D.C. (202) 835-4248 angela.walitt@bakermckenzie.com Pursuant to requirements relating to practice before the Internal Revenue Service, any tax advice in this presentation is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties imposed under the United States Internal Revenue Code, or (ii) promoting, marketing or recommending to another person any tax related matter. 42