26th Annual Health Sciences Tax Conference International and offshore captive issues for exempt December 5, 2016
Disclaimer EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US. This presentation is 2016 Ernst & Young LLP. All rights reserved. No part of this document may be reproduced, transmitted or otherwise distributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, rekeying, or using any information storage and retrieval system, without written permission from Ernst & Young LLP. Any reproduction, transmission or distribution of this form or any of the material herein is prohibited and is in violation of US and international law. Ernst & Young LLP expressly disclaims any liability in connection with use of this presentation or its contents by any third party. Views expressed in this presentation are those of the speakers and do not necessarily represent the views of Ernst & Young LLP. This presentation is provided solely for the purpose of enhancing knowledge on tax matters. It does not provide tax advice to any taxpayer because it does not take into account any specific taxpayer s facts and circumstances. These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting advice. Page 2
Presenters Bob Lammey Ernst & Young LLP Boston, MA bob.lammey@ey.com +1 617 675 1433 Neelu Mehrotra Ernst & Young LLP Providence, RI neelu.mehrotra@ey.com +1 617 585 0387 Paul H. Phillips, III Ernst & Young LLP Dallas, TX paul.phillips@ey.com +1 312 879 2898 Page 3
Agenda Selected international topics Foreign captives and risks Importance of US foreign compliance International hot topics impacting exempt Country-by-country (CbC) reporting Section 385 regulations Understanding permanent establishment Local taxation issues Expatriate taxation Page 4
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 ). Generally, the original insureds are the principal beneficiaries. Given the six-decade history of captive insurance arrangements, multiple variations have surfaced, broadening the definition of captives. Page 5
Qualification as an insurance company General Insurance companies other than life insurance companies (property and casualty (P&C) insurance companies) are taxed under Internal Revenue Code (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. The term insurance company means 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 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. Page 6
Qualification as an insurance company General In turning to the US 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 US federal income tax purposes. Presence of insurance risk Risk shifting Risk distribution Commonly accepted notions of insurance 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. Page 7
Qualification as an insurance company Insurance risk Basic to any insurance transaction must be risk. An insured faces some hazard, and 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 risks and not insurance risks. Page 8
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 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. The substance of any guaranty must be considered. The balance sheet test is applied to determine whether an insured has shifted its risks to the insurer (under this test, a sole shareholder generally cannot shift its risks to its wholly owned captive subsidiary). Page 9
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 may be at odds with the Internal Revenue Service (IRS), which looks to the number of legal entities involved in the arrangement. Page 10
Qualification as an insurance company Common notions of insurance 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 Validity of the policies issued All facts and circumstances are considered not only the terms of the arrangement, but also the entire course of conduct of the parties. Page 11
Qualification as an insurance company Common structures Parent/subsidiary Parent/subsidiary risks Parent Premiums 100% Captive Coverage of self-insured 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 Page 12
Qualification as an insurance company Common structures Brother/sister Brother/sister risks Parent Parent has not shifted its risk to captive Balance sheet approach Premiums paid from parent to captive not deductible Subsidiaries Subsidiaries generally shift risk to captive 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 Generally treated as an insurance company 100% Hold Co Hold Co Subsidiaries Sub Parent Premiums and reserves for losses Premiums and reserves for losses Captive Page 13
Qualification as an insurance company Common structures Third-party premium Third-party premium risks Parent Premiums Third-party risk premiums Subsidiaries Premiums Captive 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 Generally treated as an insurance company Page 14
Qualification as an insurance company Common structures Group captives Group captives risks Insured Insured Insured Insured Insured Premiums Captive 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 Page 15
Recent developments and IRS position The Tax Court decided three cases in the last three years that refined the judicial framework of insurance: Rent-A- Center, Securitas and R.V.I. Guaranty. Judicial views with regard to insurance risk: Acceptance by regulators Acceptance by external auditors IRS views: Memorandum (ILM) 201511021 Private Letter Ruling (PLR) 201609008 Notice 2016-66 Page 16
Recent developments and IRS position Judicial views with regard to risk shifting: Use of a guaranty Use of cash Netting of payments Judicial views with regard to risk distribution: Statistical, independent risks IRS views Risk distribution: Revenue Ruling 2005-40 Revenue Ruling 2002-90 Page 17
Recent developments and IRS position Judicial views with regard to common notions of insurance: Insurance defined in the commonly accepted sense Fortuity IRS views Common notions: PLR 201609008 Notice 2016-66 Page 18
Next steps The recent decisions may provide a health care organization the opportunity to: Review current risk management practices Consider placing new risks into a captive insurance company Review the current structuring of the captive insurance arrangement to ensure desired characterization Page 19
International tax reporting and compliance The importance of getting it right Automatic monetary penalties for failure to file and/or late filing of Form 5471 under 6038: US$10,000 per period per entity An additional US$10,000 if form not filed within 90 days of IRS notice and US$10,000 for each 30 days thereafter, up to US$50,000 Loss of foreign tax credit (FTC) under 901, 902 and 960 10% of foreign taxes capped at greater of : US$10,000 Annual income of controlled foreign corporation Potential criminal penalties for failure to file or for filing false or fraudulent information 6501 Extension of statute of limitation 6038B Penalties related to non-compliance of reporting of transfers to foreign corporations or partnerships from US persons Lose benefit of any exceptions to gain recognition Monetary penalty equal to 10% of fair market value of property transferred (limited to US$100,000) Extension of statute of limitations Page 20
Passive foreign investment company (PFIC) reporting Who must file Form 8621? US person that is a shareholder of a PFIC who meets one of the following criteria: Receives certain distributions from a PFIC Recognizes gain on disposition of PFIC stock Makes certain elections Is required to file an annual report pursuant to 1298(f) When does this impact tax-exempt (TEOs)? Schedule K-1 reports PFIC information or client directly invests in PFIC PFIC stock is debt financed (fund level or client level) Form 8621 has not already been filed on client s behalf Page 21
Failure to file Form 8621 Three-year statute of limitations is suspended for the entire tax return if information is omitted Technical correction If failure is due to reasonable cause, then suspension of statute applies to unfiled information Applicable to returns: Filed after March 18, 2010 Filed on or before that date if the 6501 limitation period for the return is still open Monetary penalties similar to those for other information returns could apply Page 22
Section 385 regulations and CbC reporting Page 23
Section 385 Final related-party debt-equity regulations under IRC 385 released on October 13, 2016 Part of larger package addressing inversions Three major effects: IRS to determine if an instrument can be part debt, part equity Documentation requirements necessary for certain related-party instruments to be treated as debt (the Documentation Rule ) Issuances of debt instruments in certain related-party Subchapter C transactions will be recharacterized as equity (the Recharacterization Rule ) Page 24
Section 385 documentation and operational considerations Four categories of documents required for related-party instrument to be respected as debt Failure to satisfy any category will result in debt being treated as stock for all US federal income tax purposes Satisfaction of documentation requirements does not ensure debt treatment Effective dates: The Recharacterization Rule generally applies to tax years ending on or after 90 days after the final regulations are published in the Federal Register (i.e., January 2017). It does not apply to debt instruments issued prior to April 5, 2016. The Documentation Rule generally applies to debt instruments issued on or after January 1, 2018. Page 25
Section 385 application to tax-exempt The proposed regulations would not apply to debt instruments between members of a consolidated group. Because EOs cannot join a consolidated group filing, these rules would apply to EOs and their related taxable corporations. If a direct loan from an EO to a taxable affiliate that is a member of a consolidated group fails the documentation requirements, the EO s resulting equity interest could cause the taxable corporation to fail the affiliation requirements to be included in the consolidated group. Equity treatment could also negatively impact the taxable affiliate s interest expense deduction related to the loan. From an EO s perspective, a recharacterization could reduce unrelated business income since unlike interest income, dividends and capital gains are not covered by Section 512(b)(13). However, note that the proposed regulations contain anti-abuse provisions that generally indicate that they will not apply if the principle purpose of noncompliance is tax avoidance. Page 26
Action 13 CbC reporting What happened Questions to ask Reporting required by multinational corporations (MNCs) with revenue of 750 million or more To be implemented for fiscal years beginning on or after July 1, 2016 What entities are in your company s group? Does your company meet or exceed the de minimis threshold? Will that change year to year? Generally filed in country of tax residence of ultimate parent entity and shared with other countries through automatic exchange of information Aggregate country information on revenues, profit, cash taxes, accrued taxes, stated capital, accumulated earnings, employees and tangible assets Is your company headquartered in a jurisdiction that will implement CbC reporting? What if your company is headquartered in a country that will not implement such reporting? How will tax authorities look at your CbC report? What happens if a non-treaty, non-hq country requests a CbC report? Other considerations Potential for public reporting Expansion of EU public reporting requirements Page 27
US proposed CbC reporting regulations Prop. Treas. Reg. 1.6038-4(a) In January 2016, 31 countries entered into the Multilateral Competent Authority Agreement (MCAA), following the direction of the Organisation for Economic Co-operation and Development (OECD) Base Erosion and Profit Shifting (BEPS) Action Item 13. The MCAA provides for automatic exchange of CbC reports between parties. The US and China were not parties to the MCAA. The US intends to enter into bilateral agreements to share CbC reports. Page 28
US CbC reporting regulations Final regulations were issued on June 29, 2016, and largely follow the OECD BEPS model CbC legislation, with some deviations. The OECD also issued guidance on June 29, 2016. The regulations are intended to aid tax authorities with high-level transfer pricing risk identification and assessment. They are not intended as a substitute for transfer pricing analysis or as a basis for transfer pricing adjustments. The preamble reasserts the primacy of the arm s-length standard. Effective date and time of filing: Effective for taxable years beginning on or after July 1, 2016 CbC report would be filed with tax return OECD model recommends effectiveness for tax years beginning on or after January 1, 2016, and recommends filing deadline of 12 months after end of fiscal year Page 29
US CbC reporting regulations Annual CbC reporting would be required for certain ultimate parents of US multinational groups (US MNE group). Group would be determined based on US generally accepted accounting principles (GAAP) consolidation (actual or hypothetical) Group would be required to include at least one non-us constituent entity US CbC reporting would not be required if the MNE group was foreign-parented, determined based on foreign GAAP consolidation (either actual or hypothetical). CbC reporting would not be required if the US MNE group had revenue of less than $850 million for the relevant annual accounting period. Page 30
What happens when a permanent establishment (PE) is created? When a PE is created, the US entity becomes subject to tax reporting in the foreign country. This can include federal and local income tax as well as valueadded tax (which might be required even if no PE is created). The US entity likely will need to register with some governmental agency or tax authority in order to complete required filings. PE could be created by employees who have only traveled to the foreign country on a short business trip. Depending upon the time spent in the local country, the individual employees of the US entity may have local tax filing requirements. Page 31
Basic PE flowchart Fixed place Agency Services Preparation or auxiliary activities Incomegenerating activities Independent agent Dependent agent PE (if it lasts beyond certain time) No PE PE No PE PE (if certain criteria met) PE (if contract negotiated or concluded) Note: Construction PE considerations not included Page 32
Short-term business travelers The rules of when a US employee may trigger individual tax reporting (and social insurances) vary by country. Factors to consider (individual taxes only): Is the country of travel a treaty country with the US? Does the company have a PE based on activities? Will the employee be traveling for longer than a business trip? Is a local organization sponsoring your employee s visa? US treaty countries tend to provide tax relief in the host country for 90-183 days in a 12-month period. Non-treaty countries may impose nonresident tax liability from day one, practically applied if the visit is more than a business trip. Page 33
Immigration considerations Applies to any foreign national crossing a border Without correct visa, employee is illegally in country Tourist visas generally not a compliant form of documentation for employees working in a foreign country US company may be considered responsible if employee is traveling on company business Business visas often require a local host to sponsor Tax treaties do not provide exemptions for immigration Page 34
Expat and third-country national considerations Long-term assignments and secondments Often different immigration requirements Can be very expensive to support (two to three times base salary) Shadow payroll, tax equalization and hypo tax are all complicated issues that require third-party assistance Employer usually responsible for tax and social insurance withholdings and remittance Normally, a US citizen can credit any income taxes paid to the foreign country against his or her US income tax liability; US citizens also may be eligible for the foreign earned income exclusion Financial Crimes Enforcement Network Form 114, Foreign Bank Account Report Page 35
Questions? Page 36
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