If you are a member of the captive owners club, your world may soon be turned upside down by the recently proposed Internal Revenue Service (IRS) regulations relative to insurance between members of a consolidated group—also known as single-parent captives.
The proposed regulation would defer the tax deductibility of incurred losses, i.e., a captive's loss reserves and the parent's premium, obtained from related party business (the captive's parent), until the loss is actually paid. This means that for tax purposes, the once-acceptable insurance transaction between parent and captive would be disallowed.
The proposed regulation would extend to the furthest reaches of the IRS's grasp. This includes primarily two groups.
- All domestically domiciled single-parent captives, and
- All foreign domiciled captives that elected, under Section 953(d) of the IRS Code, to be taxed as if they were domestic companies.
Those of you unfamiliar with the 953(d) election may wonder why in the world would any offshore captive actually volunteer to be taxed by the U.S. Internal Revenue Service. The main reason is that the U.S. shareholders of a foreign captive are subject to U.S. taxation anyway. Since 1986, owners of what are known as controlled foreign corporations (CFCs) must declare such ownership and pay taxes commensurate with their respective earnings. The captive itself, as a CFC, is not taxed, but the shareholders are, which washes out the pre-1986 tax advantage of forming a CFC. The 953(d) election is, of course, irrevocable.
Proposed New Regulation
The proposed regulation applies to captives that are consolidated in its parent's tax return wherein the parent owns 80 percent or more of the captive's voting stock—the definition of almost every garden-variety single-parent captive. The net effect of the proposed change would be that the IRS would become entitled to the tax revenues generated on the captive's earnings sooner than it would have been under the current system. It is nothing more than a timing issue, but given the fact that the majority of the affected captives rely on the accelerated deductions to enhance profitability and offset frictional costs, its impact would be significant.
It is obvious to me that either the IRS does not fully understand the impact of such a change, or, it is certifiably insane. While the latter possibility serves to explain quite a bit of the Service's behavior, I have a suspicion that the first guess is probably correct.
Unfortunately for the IRS and the roughly 26 U.S. captive domiciles, this proposed regulation would have the polar opposite effect of that which its creators intend—it would cause a loss of tax revenues at both the federal and state levels resulting from a not insignificant exodus of U.S. domiciled captives to offshore locales, and the certain reduction in the numbers of newly formed domestic captives.
While the proposed regulation would disallow a captive to restructure itself specifically to avoid applicability, there is no law that forbids a captive's parent from forming an offshore company into which the domestic captive would move 100 percent of its business, thus winding down the domestic captive, or, engaging in any number of other legal strategies that would protect its insurance accounting status.
The Economic Family Theory
The proposed IRS regulation perhaps wouldn't cause as much heartache if it weren't for the tortured history of how related-party insurance transactions evolved. It all began back in 1977, when the IRS issued Revenue Ruling 77-316 which disallowed insurance status to any captive whose only business was derived from its parent. The ruling codified the Economic Family Theory, which reasoned that since the captive was a wholly owned subsidiary of the parent, and it wrote no unrelated third-party insurance business, it did not meet the two-prong tests for an insurance company: risk transfer and risk distribution. Both the parent and the captive were members of the same "economic family," therefore, the risks in the captive had not been actually transferred off the balance sheet and certainly not distributed over a pool of unrelated entities.
Over many years and many shareholder challenges, the Service finally relented and in 2001 issued Revenue Ruling 2001-31, which acknowledges that the Economic Family Theory was insufficient unto itself to judge a captive's status as an insurance company, as evidenced by the succession of shareholder victories in the tax and circuit courts. Now, as if none of the hard-won case law existed, including its own 2001 revenue ruling, the IRS is attempting to turn back the clock to 1977—to its ultimate detriment.
CFC Status
Earlier I mentioned that offshore captives that have made the election to be taxed domestically are equally subject to the proposed regulation. The proposed regulation does not, however, apply to captives that retain their controlled foreign corporation (CFC) status. (Making the 953(d) election voids CFC status). While a CFC's earnings are taxed at the shareholder level, it is free to employ insurance accounting as long as it satisfies the various insurance company tests. Now, the decision to retain CFC status, post the 1986 tax changes, never made much sense for a captive owned in the majority by U.S. taxpayers. The main benefit derived from making the 953(d) election is that the captive obtains its own tax rate, which is generally lower, at least in the early years, than its parent's tax rate. Controlled foreign corporations have no such individual tax rate; their earnings are taxed at their shareholders' rate.
Another significant drawback to remaining a CFC is that it is prohibited from conducting any business whatsoever in the United States. While this might require the captive's shareholders to travel to Bermuda or Cayman to do captive business, it also means that they cannot conduct even the most rudimentary captive transaction within the boundaries of the United States. A CFC captive doing business in the United States has a special name: Engaged in Trade or Business (ETB).
CFCs found to be running afoul of the ETB prohibition are subject to what the Service calls a "branch profits tax," because if a foreign company conducts business in the United States it must, by definition, have a U.S. "branch." And since this fictitious branch doesn't pay income taxes, the Service can collect as much as 30 percent of the foreign company's earnings. Controlled foreign corporation captives also must pay federal excise tax (FET) on their U.S. premiums; 4 percent for direct-writing captives and 1 percent for fronted captives. Making the 953(d) election eliminates the FET.
Conclusion
As you can see, forming your captive onshore or making the domestic election if it's offshore makes perfect business sense—unless the IRS succeeds in turning this onerous and ill-conceived proposal into law. If this happens, the question for existing domestic captives will be whether the costs and risks associated with moving to an offshore domicile and assuming CFC status would be worth it given the fact that they would lose their ability to use insurance accounting if they did nothing. Thankfully, the captive industry is mounting a formidable lobbying effort to help the Service see the error of its ways. The Captive Insurance Companies Association (CICA) has partnered with the Vermont Captive Insurance Association (VCIA) to defeat this proposed regulation.
Nothing in this article should be construed to be tax or legal advice and cannot be used to avoid tax penalties. Readers should consult their own tax counsel relative to the application and consequences of the proposed regulation to their own unique factual circumstances.
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