US tax issues get a lot more complex when a captive is based offshore, writes Nicholas Polo.
While US taxes should not stop anyone from forming a captive, they can definitely influence the choice of domicile. Tax planning is critical regardless of domicile, but takes on added importance with foreign domiciles due to numerous additional regulations that apply. This article will concentrate mainly on those rules that apply to offshore domiciles of US companies.
A foreign company is considered a Controlled Foreign Corporation (CFC) if 50% or more of its stock votes or value is owned by “US shareholders.” For an insurance company this ownership minimum drops to just 25%.
A US shareholder is defined as any US person (including corporations, partnerships, trusts, etc) that owns 10% or more of the combined voting power of stock in a foreign corporation. Conversely, an owner of less than 10% of the stock is not a US shareholder under the law. CFC status is only needed for 30 consecutive days during a year for it to be considered a CFC for the entire year.
A CFC is taxed on its effectively connected US income calculated under Subpart F of the Internal Revenue Code. This treatment differs from US domestic companies who are taxed on their worldwide income. However, as effectively connected Subpart F income is generally calculated in the same way as a US insurance company's worldwide income, most captive owners should see no significant difference in income tax liability between either a foreign or domestically-domiciled captive.
US shareholders must include the CFC's Subpart F income as a deemed dividend on their federal income tax return. The US shareholders include this as income whether or not any cash dividend is actually paid by the offshore company.
There are, however, a number of other tax items that apply only to foreign companies that have not filed a “domestic election” (as defined later). These include, but are not limited to, the following:
• Federal excise tax.
• Engaged in US trade or business.
• Branch profits tax.
• Withholding tax on interest.
• Passive Foreign Investment Company (PFIC).
• Related Person Insurance Income (RPII).
Insurance premiums sent by a US insured to an offshore insurer are subject to US federal excise tax (FET). For direct premiums the rate is 4% and for reinsurance it is 1% of the premium. The IRS also has a cascading view of the excise tax. That is, if the premiums are retroceded from a captive's domicile to another foreign location, an additional 1% excise tax is due on the retroceded amount. Payments for FET may be exempt under a tax treaty depending upon the foreign country. The above FET rates, however, do apply to all the major foreign captive domiciles.
A CFC, or any foreign company, that is found to be engaging in trade or business within the US is subject to a branch profits tax. The branch profits tax is assessed at a 30% rate on a corporation's effectively connected US income earned through its “US branch.” (This 30% rate may be reduced or eliminated under specific tax treaties.) The branch profits tax is in addition to income tax liability, which means that foreign companies try to avoid engaging in US trade or business. Determining this status subjects a company to a murky facts and circumstance test. Most companies conduct as many business activities as possible outside the US to avoid this classification.
A CFC is also penalised on lending funds to its US parent or US affiliates. A 30% withholding tax (unless there is a lower tax treaty rate) is levied on interest paid to the offshore company. If the loan is made at zero interest, or below-market rates, the IRS has the ability to impute a market interest rate.
Passive Foreign Investment Company rules (PFIC) subject certain passive types of income to current US taxation. PFIC concerns have been reduced for new captives since the Taxpayer Relief Act of 1997 which states that entities qualifying as both a CFC and PFIC will not be considered a PFIC with respect to 10% US shareholders. For captives formed before 1998 there is a QEF (Qualified Electing Fund) provision that can provide some relief from PFIC rules. A PFIC is a foreign company where 75% or more of its income is passive or 50% of its assets produce passive income. There is an exception for foreign insurance companies, although the IRS may question the legitimacy of a captive being an insurance company.
US-domiciled insurance companies do not face tax issues like federal excise tax, branch profits tax, the 30% withholding tax and PFIC concerns. To create a more level playing field, a CFC can make a “domestic election”. This domestic election allows the foreign company to be treated to nearly identical tax laws as a US company - which also means it is now taxed on its worldwide income. One area of concern with a domestic election is that it is just for insurance companies. If the IRS decides that your captive does not meet their definition of an insurance company (a concept not defined in the Tax Code), it may revoke the domestic election and retroactively apply the taxes that are due on a CFC.
Another alternative is to have the foreign captive qualify as a non-Controlled Foreign Corporation (NCFC), which can be accomplished by having non-US shareholders (i.e. those having less than 10% of the vote or value of the captive). This can be established by spreading the ownership and value among at least eleven different US companies or persons each with less than 10% of the stock. Another alternative would be to have some foreign ownership of the captive, although constructive ownership rules would apply if one were thinking of having a foreign subsidiary own the captive. The advantage of a NCFC is that earnings and profits would not be subject to US tax until repatriated.
NCFC status and its related benefits are very difficult to obtain, especially since the Related Party Insurance Income (RPII) provisions were added to the Internal Revenue Code. RPII income is defined by the tax code as “any insurance income attributable to a policy of insurance or reinsurance with respect to which the primary insured is a US shareholder in a foreign corporation or related person to such a shareholder.”
For the purposes of this RPII definition, the term “US shareholder” means any US person (or company) that owns any of the stock of the foreign captive. RPII income must be included as taxable income to all the US shareholders of the corporation.
There are two de minimus exceptions to the RPII rules. Under one exception, if RPII income in a particular year is less than 20% of the company's total insurance income then RPII rules will not apply for that year. Under the second exemption, if all RPII income is generated by less than 20% of the company's shareholders the RPII rules would not apply.
The effect of these rules is to make group captives subject to US taxation or cause such a dilution of ownership and control that a non-CFC captive is no longer an attractive alternative.
Accelerated tax deduction for premium payments to an insurance subsidiary
Captive taxation is rarely thought about without considering the deductibility of premium payments. Tax deductibility, however, is a timing issue only. This means that the amount of the tax deduction will be the same over time. The real issue is whether the organisation can immediately deduct premium payments, or has to wait until losses are actually paid before claiming the deduction. While the total cost is the same under either scenario, the net present value cost will change.In the US there are no clear rules in the Tax Code that address the issue of whether a company will get a tax deduction for premium payments. Instead, taxpayers must rely on court decisions such as Humana, Inc. where a federal appellate court in the Sixth Circuit held that Humana, Inc. was entitled to a tax deduction for insurance premiums paid by its subsidiaries to Humana's wholly-owned captive insurance company. Premiums paid by Humana (the parent company) to the captive were not accorded the same treatment based on the fact that the parent directly owned the captive, and thus, no risk shifting took place.Since the Humana case, there have been other court cases that mostly decided in favour of captives. However, there are still no clear-cut rules. Instead, the courts seem to be looking at the facts and circumstances surrounding each case for elements of “insurance”.
Some courts have applied a three-pronged test to address the existence of insurance: First, the presence of insurance risk. By insurance risk it is meant that the losses can be substantially different than the premium charged and the liability is solely with the insurer. Next, the courts look for risk shifting and risk distribution among the various entities. Finally, courts examine whether the transaction is insurance in the commonly accepted sense.
These other cases won by taxpayers dealt primarily with their insurance of unrelated risks. In one of these cases (The Harper Group) the Court found that as little as 30% of outside business would qualify all premiums - including premium paid from a parent to its captive - for a deduction under its risk distribution requirement.
One troubling decision issued by the same court that ruled in the Humana case was against Malone & Hyde. The Sixth Circuit reversed an earlier favourable ruling on this company's Bermuda-based captive. The parent company, on behalf of its subsidiaries, paid the insurance premium to an unrelated insurer for risks that were subsequently reinsured by the parent corporation's captive.
First, the court found fault with a “hold harmless” agreement that the parent company entered into with the front company. The agreement stated that Malone & Hyde agreed to reimburse the front company for any losses sustained from its reinsurance agreement with Malone & Hyde's captive. Another item mentioned in the Malone & Hyde opinion was that Humana formed a captive in response to not being able to find insurance coverage, where Malone & Hyde was formed to reduce its insurance expense. In the court's opinion this was not a legitimate business reason. The court also found that the captive was undercapitalised, even though it met the capitalisation requirements of Bermuda law. Part of the court's decision said, “the record does not indicate that Bermuda exercised oversight similar to that which Colorado [Humana's captive domicile] exercised over Humana's captive insurer.” These and the other factors mentioned led the court to decide that the Malone & Hyde captive was a “sham”.
The Malone & Hyde decision was rendered in 1995 and appears to be singular in its opinion that foreign domiciles are not appropriate for legitimate business enterprises.
The IRS view and the future
The Internal Revenue Service will continue to challenge attempts by a parent company to take accelerated tax deductions for premium payments to captive insurers. The IRS argument, simply stated, is that paying premiums to subsidiaries is like taking money from one pocket and putting it into another. In the IRS's view, this is not insurance because the risk has not shifted to a different entity. To continue the analogy, the risk is not in someone else's pocket.
The IRS's negative view of captives will continue to carry over to other areas and companies will do well to consider the effect of having a domestic election nullified and the probable subsequent court fight over the issue. The IRS may also seek legislative changes to negate unfavourable court decisions.The last few years have seen the Clinton administration include proposals on captives in each of its budget proposals. The most significant of the proposals would require that at least 50% of the captive's premium volume be attributable to outside business for it to be considered a valid insurance company. Another aspect of the proposal is that it would authorise the Treasury Department to write regulations defining who may be a related person. Regulations often take years to write so this may leave a great deal of uncertainty for some time with respect to whether third party business from joint ventures and other similar arrangements are viewed as “insurance”.
US tax issues get a lot more complex when basing your captive offshore. Still, many companies find the regulatory environment and capital requirements more favourable offshore and make the required tradeoffs in the operation of the captive to avoid or minimise adverse tax consequences. Regardless of domicile, tax planning must be done in the formative stages of the captive to get the best result. Since individual transactions and circumstances may vary, you should consult your tax and legal advisors with respect to these issues.
Nicholas Polo is a senior vice president at Becher + Carlson Companies, a firm specialising in alternative risk financing. The company is a member of Am-Re Global Services, Inc. Tel: 818 598 4215 Fax: 818 407 5555.