Tax Update

1
Tax Update Impact of Latest IRS Captive Rulings
September 13, 2005

• Thomas M. Jones, Partner
• McDermott Will Emery LLP
• 312 984 7536tjones_at_mwe.com
• Catherine Sheridan Moore, Partner
• KPMG
• 441 294 2606
• csheridan_at_kpmg.bm

2
Overview

• Recap
• Why insurance matters
• Tax definition of insurance
• Recent IRS rulings
• Offshore Federal Tax Consideration
• Federal Excise Tax Basics
• Captives with Tax Exempt Shareholder(s)
• Cell Company Structure Tax Analysis
• Emerging Issues for 2005 and beyond

3
Taxation of Captives

• The key tax question
• Will it be treated as insurance for tax
  purposes?

4
Why Insurance Matters ?

• Tax deduction for premiums paid to captive by
  policyholder
• Favorable insurance tax treatment of captive
  (deduction for discounted insurance reserves,
  unearned premiums)
• Offshore CFC captives - Subpart F income
• Domestic captives - direct federal income tax
• Offshore captives
• Possible IRC Sec. 953(d) onshore tax election

5
Tax Definition of Insurance Company
Pension Funding Equity Act of 2004

• New Section 831(c) codified definition of PC
  insurance company
• Only prior statutory definition was for life
  insurance companies
• Section 816(a) any 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
• New Section 831(c) incorporates the Section
  816(a) definition by reference
• Effect of New Section 831(c)
• Codifies existing law
• Similar definition was provided in case law and
  Treas. Reg. sec. 1.801-3(a)(1)
• More than half of the captives business
  activities must be related to insurance
• Net income derived from insurance activities

6
Tax Definition of Insurance Company
IRC Section 501(c)(15) Pension Funding Equity Act
of 2004 (continued)
For Exempt Non-Life Insurance Company
Qualification

• For tax years beginning after December 31, 2003
• Gross receipts cannot exceed 600,000 (on a
  controlled group basis)
• gt50 of gross receipts consist of premiums

7
Rev. Proc. 2002-75

• IRS PLR OK
• For many years, the IRS has included rulings on
  tax status of captives as an issue on which it
  does not ordinarily rule.
• The Service will now consider ruling requests
  regarding the proper tax treatment of a captive
  insurance company.

8
Tax Definition of Insurance

• To find insurance, the IRS and the courts have
  historically required the presence of both risk
  shifting and risk distribution
• The first criterion connotes the transfer of the
  risk to a separate party
• The second mandates that enough independent risks
  are being pooled to invoke the actuarial law of
  large numbers

9
Tax Definition of Insurance

• No statutory or regulatory definition of
  insurance - only cases and rulings
• A gray area existed between 1 and 31 insureds,
  but a rule of thumb is that more than several
  unrelated insureds pooling risk should create
  insurance
• Case law has further liberalized the tax
  definition of insurance
• Unrelated Risk
• Brother-Sister Theory

10
IRSs Historical Position The Economic Family
Doctrine

• In Rev. Rul. 77-316, the IRS first announced its
  position that risk shifting and distribution do
  not exist in the context of a single economic
  family
• Exception In Rev. Rul. 78-338, the IRS conceded
  that sufficient risk shifting and distribution
  are present where 31 unrelated parties pool risks

11
Revenue Ruling 2002-91 Group Captive Ruling
Captive constitutes an insurance company and
premiums paid by participants are deductible

• Industry group liability captive exact number of
  participants not specified
• No member owns over 15 has over 15 of vote or
  accounts for over 15 of risk/premium implies 7
  equal owners OK
• No assessments or refunds
• Valid non-tax business purpose was a key factor
• IRS reinforces prior rulings on group captive
  insurance arrangements

12
Revenue Ruling 2002-91
UNRELATED
MEMBERS
no Member ownsgt15 of Captive
Premiums
GroupCaptive
Ruling Arrangement, based on facts, held as
insurance
13
The Unrelated Risk Approach
Sears, Roebuck and Co. v. Commr

• Computation of Allstates income using favorable
  insurance company provisions
• Tax deductibility of Sears premiums paid to
  Allstate

NYSE Shareholders
Sears
100 Stock Owned
Allstate
lt1 Sears Risk gt99 Unrelated Risk
14
The Unrelated Risk Approach
AMERCO Program
Pure Third-Party Risk
Parent Company Risk
Captive
30
Customer/ Investor Risk
Brother/ Sister Risk
The Tax Court and Ninth Circuit aggregated
customer/investor risk and pure third party risk
to test whether AMERCOs captive qualified as an
insurance company. The courts did not reach the
issue of whether the brother/sister risk was
insurance risk because 30 outside risk was
enough to find insurance.
15
Revenue Ruling 2002-89 Unrelated Risk Ruling

• Single parent captive otherwise properly formed
  and operated (adequate capital, no parent
  guarantees, loan backs, etc.)
• Not insurance if 90 of risks/premiums come
  from the parent
• Insurance if less than 50 come from the parent
  and the remainder are from unrelated parties

16
Revenue Ruling 2002-89
Scenario 1
Scenario 2


P
P
lt50 premium lt50 of risks
90 premium 90 of risks
Captive
S
Risks of P pooled with risks of unrelated insureds
Not insurance lacks requisite risk
shifting/risk distribution
Is insurance premiums paid by P are
deductible
17
Taxpayers Theory The Balance Sheet Approach

• Risk shifting and risk distribution may exist
  within an economic family
• Risk shifting exists where the risk of loss is
  transferred off the policyholders balance sheet
  
• Risk distribution exists where the risk of loss
  is distributed among independent policyholders
  (even within a family)

18
The Brother / Sister Approach
Humana, Inc. v. Commr

• No tax deduction for payments from parent to
  subsidiary
• Tax deductibility of subsidiaries premiums paid
  to captive (brother - sister premiums)

NYSE Shareholders
Humana
Foreign Holding Co.
100 Subs
Colorado Captive
19
The Brother / Sister Approach
Kidde Industries, Inc. v. Commr

• Established a 3 Part Test
• Insurance risk / Not a sham corporation
• Commonly accepted notion of insurance
• Risk shifting risk distribution present
• Parent guaranty caused denial of premium
  deduction for period it was in existence
• Bermuda regulatory regime accepted
• Brother-sister approach applies to subsidiaries,
  but not to divisions

20
IRS Ruling Concedes Economic Family Theory in
June 2001

• In Rev. Rul. 2001-31, the IRS abandoned its
  position that risk shifting and distribution do
  not exist in the context of a single economic
  family
• It now appears arms length premium and loss
  reserve deductions attributable to brother-sister
  risk (i.e., other affiliates of the parent) will
  be accepted by the IRS
• But premium and loss reserve deductions
  attributable to parent risk will not be allowed
  without presence of significant (30?)(50?)
  unrelated party risk measured by premiums

21
Revenue Ruling 2002-90 IRS Sibling Ruling

• Single parent captive otherwise properly formed
  and operated (adequate capital, no parent
  guarantees, loan backs, etc.)
• Insures 12 domestic subs - parent a holding
  company no sub accounts for less than 5 or over
  15 of total risk/premium
• Insurance under brother/sister doctrine
• Note - captive had an insurance license in all
  states in which it provided subsidiary coverage!

22
Revenue Ruling 2002-90
P
12 subsidiaries
Insurance
Solely insures professional liability risk of
each of the 12 subsidiaries
Ruling Arrangement between Insurance and 12
subsidiaries of Insurances parent constitutes
insurance
23
Post Ruling Caveats

• The captive must still establish
• Presence of risk distribution
• That the captive should be respected as a
  separate and distinct taxable entity, i.e., it is
  not a sham

24
Non-Sham Status

• Insurance status continues to require respect for
  the captive as an entity separate and distinct
  from its economic family
• Valid non-tax business purpose
• Adequate capitalization (maximum 51
  premium/surplus ratio recommended)
• No parental support agreements
• Limited loan backs of captive assets to parent or
  affiliates (circularity of cash flow)
• Formation of captive in other than a weakly or
  non-regulated offshore domicile

25
Revenue Ruling 2005-40

• The IRS analyzed 4 hypothetical captive
  arrangements and concluded that 3 of the 4 lacked
  risk distribution, a hallmark of insurance
  status.
• Prior to Rev. Rul. 2005-40, the IRSs position
  regarding risk distribution was unclear,
  primarily because published IRS (and judicial)
  guidance focused on risk shifting, the other
  hallmark for insurance status.
• Rev. Rul. 2005-40 is a clear articulation of the
  IRSs current position that risk distribution
  entails two elements.
• First, a significant number of independent,
  homogeneous risk exposures must be transferred to
  the captive, such that the law of large numbers
  takes effect.
• And second, the risk exposures transferred to the
  captive must derive from at least several
  independent entities from a Federal income tax
  perspective.

26
Revenue Ruling 2005-40

• Situation 1
• X owns and operates a large fleet of vehicles
• Vehicles represent a significant volume of
  independent, homogeneous risk
• X enters into an arrangement with unrelated Y
  where in exchange for premiums, Y agrees to
  insure X against risk of loss with respect to
  Xs vehicle fleet
• Y does not insure any entity other than X

(only insures Xs risks)
100Premiums
Corp. X (U.S.)
Corp. Y (U.S.)
Risk Funding Contract
27
Revenue Ruling 2005-40

• Situation 2
• Same as Situation 1, except that Y also insures
  unrelated Z in exchange for premiums against
  risk of loss with respect to Zs vehicle fleet in
  the conduct of a business substantially similar
  to that of X
• Ys earnings from its arrangement with Z
  constitute 10 of Ys total amount earned (both
  gross and net) during the year and the risk
  exposure attributable to Z comprise 10 of the
  total risk borne by Y

Corp. X (U.S.)
Corp. Z (U.S.)
90 Premiums(and Risk)
10 Premiums(and Risk)
Corp. Y (U.S.)
RiskFundingContract
RiskFundingContract
28
Revenue Ruling 2005-40

• Situation 3
• X conducts a courier business through 12 LLCs
  that are disregarded entities for Federal Income
  tax purposes
• The LLCs own a fleet of vehicles that represent a
  significant volume of independent, homogeneous
  risk
• Each of the LLCs enters into an arrangement with
  Y where unrelated Y agrees to insure the LLC
  against risk of loss with respect to its vehicle
  fleet
• Y does not insure any entity other than the
  LLCs
• None of the LLCs account for less than 5, or
  more than 15 of the total risk assumed by Y

Corp. X (U.S.)
1
2
3
4
5
6
7
8
9
10
11
12
Risk Funding Contracts
100 of premium from LLCs
Corp. Y (U.S.)
Disregarded entity for Federal income tax
purposes
29
Revenue Ruling 2005-40

• Situation 4
• Same as Situation 3, except that the 12 LLCs
  elect to be treated as corporations for Federal
  income tax purposes

Corp. X (U.S.)
12
1
2
3
4
5
6
7
8
9
10
11
Risk Funding Contracts
Corp. Y (U.S.)
Corporation for Federal income tax purposes
30
Revenue Ruling 2005-40Holding

• The IRS concluded that, although each of the
  arrangements satisfied the risk shifting
  requirement for insurance status, risk
  distribution was lacking in Situations 1, 2 and
  3. Accordingly, only Situation 4 constituted
  insurance from a Federal income tax
  perspective.
• The IRS did not, however, provide a clear
  indication of the manner in which Situations 1, 2
  and 3 should be treated for Federal income tax
  purposes.
• Rather, the IRS stated that a range of
  non-insurance characterizations could apply,
  i.e., a deposit arrangement, a loan, a
  contribution to capital (to the extent of the net
  value, if any), an indemnity arrangement that is
  not an insurance contract, or otherwise.
• The potential non-insurance characterizations can
  have dramatically different consequences from a
  Federal income tax perspective.

31
Revenue Ruling 2005-40Risk Shifting

• Risk shifting, which looks to whether the
  insureds transferred the financial consequences
  of a potential loss to the insurer, was found to
  exist in all four Situations.
• The rationale, although unstated, was that the
  purported insurer, Y, was unrelated to the
  insureds.
• This conclusion is consistent with existing
  authority.
• See Humana v. Comr, 881 F.2d 247 (6th Cir.
  1989) Kidde Industries v. U.S., 40 Fed. Cl. 42,
  54 (Fed. Cl. 1997) Rev. Rul. 2001-31 Rev. Rul.
  2002-89 Rev. Rul. 2002-90.

32
Revenue Ruling 2005-40Risk Distribution

• Risk distribution, on the other hand, was found
  to be lacking. In reaching that conclusion, the
  IRS ruled that risk distribution has two
  elements.
• First, the insurer must assume a significant
  number of independent, homogenous risk exposures
  for the law of large numbers to apply. This
  allows the insurer to smooth out losses to match
  more closely its receipt of premiums.
• And second, the insurer must pool the premiums
  (and risk) from a particular insured with the
  premiums (and risk) of other insureds, such that
  the insured is not in significant part paying
  for its own risks.

33
Revenue Ruling 2005-40Risk Distribution
(Continued)

• The first requirement for risk distribution was
  satisfied because a significant number of
  independent, homogenous risk exposures were
  transferred to Y, the purported insurer.
• The second requirement was not satisfied in
  Situations 1, 2 and 3.
• Situation 1 involved a single insured, so there
  was no pooling of premiums by Y.
• 90 of the risk (and premiums) transferred to Y
  in Situation 2 derived from a single insured, X.
  Thus, there was not a sufficient pooling of Xs
  premiums. It is possible, however, that there
  was a sufficient pooling of Zs (the 10
  insureds) premiums to create risk distribution
  for Z (potentially resulting in characterization
  of Zs payments as deductible insurance
  premiums).
• Situation 3 involved multiple insureds for state
  law purposes, but the insureds were treated as a
  single entity for Federal income tax purposes.
  The IRS concluded that, as a result, Situation 3
  should be treated the same as Situation 1.
• In contrast, Situation 4 created risk
  distribution because numerous (albeit related)
  entities that were regarded for Federal income
  tax purposes transferred risk and premiums to Y.

34
Revenue Ruling 2005-40Comments

• No attempt was made to reconcile Rev. Rul.
  2005-40 with prior judicial and IRS guidance
  indicating that a single insured can create
  sufficient risk distribution.
• Gulf Oil v. Commr, 89 T.C. 1010, 1025-1026
  (1987) (a single insured can have sufficient
  unrelated risks to achieve adequate risk
  distribution).
• 1998 FSA Lexis 167 (a single taxpayer may
  transfer an amount of homogenous and
  statistically independent risks which would be
  sufficient to satisfy the risk distribution
  requirement).
• Other authority interpreting the risk
  distribution requirement is arguably ambiguous.
• Accordingly, some taxpayers may continue to take
  the position that multiple insureds are not
  needed to satisfy the risk distribution
  requirement.
• Given the lack of authority and the IRSs
  contrary position, there is a material
  possibility that in those situations, risk
  distribution (and, therefore, insurance status)
  will ultimately be found to be lacking.

35
General Offshore Federal Tax Considerations

• Offshore captive tax issues include
• Imputed federal income tax on controlled foreign
  corporations (Subpart F/CFCs)
• Related party insurance income (RPII)
• Branch profits tax
• Federal withholding tax
• Federal excise tax

36
Federal Excise Tax The Basics

• Applies to premiums paid to foreign
  insurers/reinsurers covering U.S. risks
• 4 percent on direct property casualty
  policies
• 1 percent on life policies and all reinsurance
• Generally withheld and remitted (quarterly on IRS
  Form 720) by payer of premium
• If not a deductible insurance premium, then FET
  N/A Rev. Rul. 78-277
• Also N/A if onshore tax election is made or tax
  treaty applies (Bermuda and Barbados N/A)

37
Taxation of Captives with aTax-Exempt Owner

• Goal to avoid insurance company status for
  captive
• If not insurance, then can avoid federal excise
  tax and state self-procurement tax on premiums
• If not insurance, then can avoid unrelated
  business taxable income to tax-exempt parent

38
1996 Federal Income Tax Legislation Applicable to
Offshore Captives Owned by Tax Exempt
Organizations

• Insurance (e.g. underwriting and investment)
  income generally creates unrelated business
  taxable income to tax exempt owners
• Sec. 512(b)(17) imposes look through rule
  invoking Sec. 501(m) commercial type insurance
  UBTI
• Special rule exempts hospitals, colleges and
  universities exclusively using policyholder (not
  shareholder) dividends
• Certain tax exempt affiliates are considered
  within the economic family if significant common
  purposes and substantial common ownership exist
• Sec. 512(b)(17) is inapplicable if no insurance
  is present (e.g., most single parent captives are
  unaffected)

39
Cell Company Structure
POOLED LAYER CORE CAPITAL
Cell A
Cell B
Cell D
Cell C
40
Will Cells Separateness Be Respected in Court ?

• Segregation concept seems valid, but not yet
  judicially tested
• Two key factors to enhance success
• Governing law/venue must be the domicile
• Cell assets should be located in the domicile
• Reason contrary to insolvency principle of
  horizontal equitable distribution of assets to
  creditors cell structure is a vertical
  distribution only within the cell

41
U.S. Tax Analysis of Cell Companies

• Single Company ?
• Multiple mini-corporations ?
• Is Risk Sharing determined on a Cell-by-Cell or
  on a Company-Wide basis ?

42
More Emerging Issues for 2005 and Beyond

• Notice 2005-49, IRS requests Taxpayer comments on
  4 subjects
• Finite risk policies (in captive arrangements)
• Proper characterization of cell captive
  structures as insurance and mechanics of making
  elections
• Tax consequences of loan-backs from a captive to
  its owner(s)
• Homogeneity of risk as a key element of risk
  distribution

43
28 Years of Captive Taxation

• QUESTIONS