The US Internal Revenue Service has recently been compelled to release to the public its field service advices. Doug Harrell finds them to be full of useful accounting information.
Field service advices (FSAs) are memoranda prepared by various officeswithin the office of chief counsel at the national office of the Internal Revenue Service (IRS). Their purpose is to provide non-binding advice, guidance and analysis to IRS agents, attorneys and appeals officers to help them develop an issue or determine litigation hazards regarding both substantive and procedural issues.
In FSA 1999-15004, an IRS agent sought advice from the national office on a captive arrangement that seemed to satisfy many of the standards enunciated by a number of court cases. The national office advised the agent to gather additional information and to develop more detailed factual circumstances for its analysis of whether to litigate the deductibility of the premiums paid to the captive. The requested information appears to focus on the possible sham or non-commercial aspects of the captive arrangement under review. The instructions given to the agent provide an insight into the way the IRS will evaluate a captive insurance arrangement. The following is a summary of the instructions given to the IRS field agent:
• Parental and/or brother-sister guarantees: The existence of parental and/or brother-sister guarantees, hold harmless agreements, letters of credit, etc. should be determined. The IRS contends that the existence of brother-sister guarantees, hold harmless agreement, letters of credit, etc. would indicate that the requisite risk shifting has not occurred. It has advised agents to review files with the state as a source for such data.
• Capitalisation: Compare the capitalisation of the captive with the amount of risk insured and review the captive insurer's premium to surplus ratio. The agent may also consult an actuary regarding whether the capitalisation is indeed adequate. If (it is) not adequate, perhaps there has not been a real risk transfer.
• Regulatory issues: Examine the regulation of insurance in the jurisdiction to determine if there is a strict regulator or a weak regulator that would permit significant under-capitalisation of the captive, or permit a parent to legally borrow out nearly all of the captive's available cash. If the regulation is minimal, agents should determine if either the parent or the captive takes advantage of the latitude allowed by the regulator.
• Unavailability of reasonably priced insurance in the marketplace:
Information should be gathered with regard to the business reason for the formation of the captive insurer. Facts regarding the insurance coverage for the controlled group prior to the formation of the captive should be developed. What was the parent doing to handle risks prior to the existence of the captive? Is the individual who is managing the captive the same person who was initially the risk manager running the parent's self-insurance reserve? If so, an analogy can be made that nothing has really changed.
The IRS national office also asked the agent to examine contracts, reinsurance, financial ratios, ownership, and business relationships and any documents that would suggest the captive is a sham.
From the foregoing, it is possible to draw the following conclusions:
• FSA 1999-15004 gives taxpayers some insight into additional areas of IRS interest and concern in its analysis of captive insurance arrangements. The IRS has not retreated from its “economic family” position set forth in Revenue Ruling 77-316 and Revenue Ruling 88-72.
The IRS still maintains that the rulings are the guiding authority on the deductibility of captive insurance premiums, despite the reluctance of many courts to accept its analysis. However, the IRS seems to have acknowledged to its agents that its “economic family” theory is not widely applied or supported in the courts and is asking them to develop other lines of attack.
As taxpayers continue to form captive insurance companies as a means to help them manage their risks and to obtain insurance coverage, they should be cognisant of the thinking of the IRS. To reduce the likelihood of having to face a challenge to the deductibility of the premiums paid to the captive, every effort should be made to satisfy or respond to the factors outlined in FSA 1999-15004.
Douglas Harrell is a senior manager with KPMG and heads up its US tax practice in the Cayman Islands. He has been with KPMG for 11 years, and has worked extensively in the area of US taxation of offshore captive insurance companies for the past seven years.