SOURCE: Foreign Insurance Excise Tax - Audit Technique Guide, April 2008, as found at http://www.irs.gov/businesses/small/art ... 63,00.html NOTE: This document is not an official pronouncement of the law or the position of the Service and can not be used, cited, or relied upon as such. This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.
Chapter 6 - Captive Insurance Companies
In recent years, the use of captives, both domestic and foreign, has increased dramatically. This is due in part to the global economy. It is also due to corporations structuring transactions to utilize more favorable tax rates and capitalization requirements. Use of captives opens numerous issues which have ramifications not only for excise taxes, but for income taxes as well.
A captive insurance company is generally defined as a wholly owned insurance subsidiary. The purpose of a captive insurance company is to insure the risks of the parent and affiliated entities. Captives can either be formed as a domestic captive within the United States, or as a foreign captive in another country. When 100% of the insurance risk accepted by the captive is the risk of the parent entity the captive is called a ‘pure’ captive. Pure captives may not be treated as true insurance companies for purposes of income and excise taxes.
A captive can insure the risks of other entities within the affiliated group (i.e. brother/sister risks) and the risks of unrelated outside third parties. Once brother/sister risks and especially unrelated third party risks are accepted by the insurance subsidiary, there becomes a point where the insurance subsidiary can no longer be called a pure captive. At that point, depending upon the facts and circumstances of the case, namely the percentage of premiums received by the captive from affiliated entities and third party entities, the captive may not be treated as a true insurance company.
Reasons for Captives
The question is often asked why a corporation would go through the start-up costs and the capitalization expense to establish a captive insurance company. The answer depends upon the strategy of the parent corporation, which may include any of the following:
The parent may wish to reduce the amount of money paid for insurance premiums. By establishing a captive, the parent has control over the amount of premiums paid as the captive will establish its own premium rates.
The parent retains the profits made on insuring within its corporate structure instead of paying the premiums and the underlying profits to an unrelated third party.
The parent may want to reduce the amount of risk retained in the affiliated group. By establishing a captive insurance company and acquiring its insurance through the captive, the parent can control the number of outside third party insureds and thereby control the amount of risk involved with its insurance needs.
Establishment of a foreign captive can be used to funnel income to a country with no or a lower income tax rate than the tax rate in the United States. This offers a substantial savings on income tax expense.
A domestic captive can be established to reduce the percentage of foreign insurance excise tax paid on premiums paid to foreign insurers or reinsurers.
Captive Issues in General
The main issue for captives is whether the captive insurance entity is a valid insurance entity. This determination must be coordinated closely with the income and/or international agents assigned to the case. The determination has an effect on the income tax expense deduction for the insurance premiums expense paid from the parent and/or related entities to the captive.
Risk-shift and Risk-distribution
In order for the captive to be treated as a true insurance entity for income tax purposes, the elements of risk-shift and risk-distribution must be present. This is established in Helvering v. Le Gierse, 312 U.S. 531(1941), and is further defined in Clougherty Packing Company v. Commissioner, 811 F.2d 1297 (9th Cir. 1987).
Risk-shift - Defined as the transfer of the impact of a potential loss from the insured to the insurer. If the insured has truly shifted the risk, then a loss incurred on the risk does not affect the insured. Instead, the insurer bears the loss in its payment of proceeds to the insured.
Risk-distribution - The spread of the risk of loss to others beyond the insured. Therefore, if the insured suffers a loss, the cost of the loss is distributed to all parties who have paid a premium to the insurer. The more parties which insure their risks and pay insurance premiums to the insurer, the more distribution of risk.
The concepts of risk-shift and risk-distribution are important in the determination of whether a captive is to be treated as a true insurance company for income and excise tax purposes. When the captive accepts premiums only from the parent entity and does not reinsure the premiums with an unrelated reinsurer, the risk is not shifted or distributed outside the parent-subsidiary relationship. Therefore, the payment for a loss stays within the affiliated group. The net effect to the affiliated group is the loss itself, as the loss has not been shifted outside of the affiliated group. This is self-insurance.
In the case of self-insurance, the insurance premium expenses deducted on the parent’s income tax return would be disallowed as capitalization of the subsidiary. For excise tax purposes, the entity would not be treated as an insurance company and would be treated more as an agent or broker.
Note: Per Revenue Ruling 2001-31, I.R.B. 2001-26, (June 04, 2001), the IRS cannot rely on the economic family theory in challenging a captive. Therefore, a captive will not be challenged based solely on the fact that transactions within the economic family occur. Other factors to consider in challenging a captive will be discussed later in this lesson under Government’s Position.
Effect of Pure Captive Reinsurance
If the captive reinsures premiums on United States risks with an unrelated reinsurer, the portion of the premiums reinsured create risk-shift and risk-distribution. This is due to the fact that an outside third party has now accepted a portion or all of the risk initially “insured” with the captive. Should a loss occur, an entity outside of the affiliated group is now responsible for covering all or a portion of the loss incurred. Therefore, the pure captive will be treated as a true insurance company for the amount of premiums reinsured. Cite: FSA 1992-1123-2, Misc-doc, 98ARD 155-4.
Example: Domestic Parent Company A pays $ 2,000,000 in premiums for casualty insurance on buildings located in Los Angeles to Captive B located in Barbados. This premium income is the only premiums received by Captive B. Captive B reinsures 40% of the risk with Foreign Insurer C, an unrelated entity located in the Cayman Islands. Neither Captive B nor Foreign Insurer C holds a section 953(d) election.
The effect of the reinsurance with Foreign Insurer C is to create risk-shift and risk-distribution for the $800,000 in premiums reinsured and Captive B is treated as an insurance company for this portion of the premiums. Therefore, the 4% casualty insurance rate is imposed on the $800,000 in insurance premiums paid from Domestic Parent Company A to Captive B creating $32,000 in tax liability. In addition, the 1% reinsurance tax rate is imposed on the reinsurance premiums paid from Captive B to Foreign Insurer C creating $8,000 in tax liability under the cascading principle. The issue of cascading is discussed further in Chapter 7.
The $1,200,000 (60% times $2,000,000) of premiums paid by Domestic Parent Company A to Captive B is self-insurance and no foreign insurance excise tax is imposed as Captive B is not treated as a true insurance company for this portion of the premiums. The $1,200,000 becomes a capital contribution to Captive B and is to be coordinated with income tax to ensure the income tax adjustments are made to the case.
Effect of Unrelated Third Party Premiums
If the captive subsidiary accepts a significant portion of its premium income from unrelated third parties, risk is determined to be shifted and distributed outside the affiliated group. True insurance would exist and the income tax expense for the premiums paid would be allowable as an income tax deduction. The excise agent would then recognize the insurance captive as a true insurance company and determine any adjustment accordingly.
The amount of unrelated third party insurance needed to transform a captive into a true insurance company has not been fully established. A summary of the court cases surrounding this issue is presented at the end of this lesson. As always, the facts and circumstances of each case must be taken into consideration in making this determination.
Domestic Captive Issues
Recently, many corporations have established on-shore, or domestic captives. A state must have captive laws which allow for the formation of a captive insurance company. States such as Vermont, Colorado, Arizona, and Hawaii have very favorable captive laws. In fact, the State of Vermont actually markets the establishment of a captive insurance company as an industry.
Use as Intermediaries
Issues concerning domestic captives center around the determination of whether or not the captive is a true insurance company. This determination becomes significant if the captive reinsures with a taxable foreign insurer. By using the domestic captive as an intermediary, the taxpayer can reduce the federal excise tax rate from 4%, for direct insurance, to 1%, for reinsurance. Since the amount of insurance premiums can reach the tens of millions of dollars for large taxpayers, this can be a significant savings.
Multiple Transactions within the United States
A transaction stream must be analyzed before a determination is made. Many transactions within the United States may occur before the premiums are ceded to a taxable offshore insurance company. For example, the parent may pay premiums to an unrelated insurance company who cedes the premiums directly, per contract, to the parent's wholly owned captive in the United States. The captive may then cede the premium to a related or unrelated offshore insurance company. The transactions prior to the cession of the premiums offshore need to be looked at in depth to determine if the unrelated insurance company is merely acting as a conduit to get the premiums to the domestic captive to shield the movement of the premiums off-shore.
Note: Diagramming the flow of premiums often puts the case into perspective when multiple entities are involved.
Related and Unrelated Premiums
Tax issues concerning taxability of insurance premiums paid only by a parent to its captive are fairly straightforward. However, the issues become more difficult once related party (brother/sister), and unrelated third party premiums are accepted by the captive. Depending upon the percentage of premiums accepted from these two types of entities, the premiums may be treated as a true insurance premiums.
In the case of unrelated third party premiums, such amounts are treated as true insurance. On the other hand, premiums from a brother/sister corporation paid to the captive may be treated in full or in part as insurance. The facts and circumstances of the case and the percentage of related premiums as well as unrelated premiums received by the captive insurance company must be considered in determining whether and to what extent true insurance exists.
IMPORTANT: Close coordination with the Case Coordinator, the Case Manager, International Agent and/or the Insurance Agent on the case is required. The excise issue determination will be based upon the determination made by the above agents on the deductibility of premiums paid to the captive subsidiary for income tax purposes.
Foreign Captive Issues
There are numerous excise tax issues concerning foreign captives. Each issue is a variation on the basic issue of whether the captive is to be recognized as a true insurance company. Once the question as to the viability of the captive is answered, the excise agent can use this information to determine whether an issue with the foreign captive exists.
Recognized as a True Insurance Company
It is important to ensure that the insurance is true insurance, as discussed above with domestic captives. The parent corporation may set up a number of captive subsidiaries in the United States as well as in foreign countries. When a determination is made to recognize the foreign captive as a true insurance company, the following potential issues may exist:
Premium payments for direct insurance may be taxed at the 4% rate.
Premium payments for reinsurance may be taxed at the 1% rate.
The captive may reinsure with another reinsurer located in a taxable country, thereby causing a 1% tax to be imposed on the foreign captive for cascading tax.
A captive, located in a qualified treaty country with an anti-conduit provision, may reinsure with another reinsurer located in a taxable country. Therefore, the anti-conduit provisions would be violated and the exemption would be lost. The premium payment from the U.S. would then become taxable. In addition, the 1% tax would be imposed on the amount of premiums reinsured.
Not Recognized as a True Insurance Company
If the foreign captive is not recognized as a true insurance company, the potential issues are summarized below:
The foreign captive will be treated as an agent of the parent company for excise tax purposes. Insurance expense for the premiums paid to the captive will not be allowed as a deduction for income tax purposes, and the amount paid to the captive would be treated as a capital contribution to the captive.
If the U.S. parent pays premiums directly to a captive, and the captive cedes premiums to another taxable insurer, the premiums ceded would be subject to the 4 percent excise tax. (Assuming the premiums were paid for casualty insurance).
If the premiums ceded to the foreign captive are for reinsurance, the amount of premiums ceded to a second taxable foreign insurer would be subject to the 1 percent reinsurance excise tax under the principle of cascading. Cascading is discussed in depth in Chapter 7.
Captive Rulings and Court Cases
The concept of risk-shift and risk-distribution as it relates to insurance is discussed in a number of court cases and rulings. Although a majority of the court cases and rulings deal with the disallowance of the income tax deduction for the payment of the insurance premiums between a parent and a captive, the same basic concepts are inherent in making the excise tax determination. Where insurance is not recognized for income tax purposes, an insurance premium payment will not be recognized for excise tax purposes.
The following revenue ruling and cases support the Government’s position that a pure captive is not treated as a true insurance company.
Revenue Ruling 2001-31, IRB 2001-26, (June 04, 2001)
Prior to the issuance of Revenue Ruling 2001-31, the Service relied on the “economic family” theory, the theory that transactions between the parent and the captive stay within the affiliated group. The economic family theory was used for analyzing whether the transactions involved risk-shift and risk-distribution thereby constituting true insurance. With the issuance of Rev. Rul. 2001-31, the Service may no longer rely solely on the economic family theory.
However, the Service may continue to challenge captive insurance transactions based upon the facts and circumstances of the case. In making the determination, the source of premium income to the captive is to be analyzed. Each source has its own tax consequence.
Parent to Captive (Subsidiary) Premiums:
No insurance exists when a captive accepts premiums only from the parent company as risk-shift and risk-distribution have not occurred. (However, if the captive reinsures all or a portion of the premiums received, insurance may exist. Reference: Effect of Pure Captive Reinsurance above.)
Brother-sister premiums need to be evaluated to see if normal insurance practices are present:
Pricing of premiums.
Provisions of policy are the same as regular policies.
Captive is properly capitalized.
Is there any capitalization indemnification agreement with the parent?
Does the insurance entity operate as a separate and distinct entity?
Professional insurance staffing.
If factors are present, then brother-sister premiums are likely to be considered to be insurance.
Outside Third Party Premiums:
If outside third party premium income of the captive is greater than 30%, then all of the premiums are likely to be considered insurance. In order for this to happen, all premiums must be pooled (commingled funds). If outside third party premium income of the captive is less than 30%, a close scrutiny of the facts and circumstances of the case as discussed in the prior section on brother-sister premiums. This is due to the fact that outside premiums are not substantial. The percentage of outside third party insurance is determined via the amount of earned premiums of the captive subsidiary.
Helvering v. LeGierse, 312 U.S. 531 (1941)
Case defines insurance in the terms of risk-shift and risk-distribution. The court said that “these elements of risk-shifting and risk distribution are essential to a life insurance contracts is agreed by courts and commentators.”
Carnation Company v. Commissioner, 640 F.2d 1010 (9th Cir. 1981)
In this case, the parent corporation paid premiums to an unrelated entity which acted as a fronting company. The unrelated entity then “reinsured” 90% of the premiums with the parent company's wholly owned captive insurance company. The Court determined that no insurance existed between the parent and its wholly owned captive insurance company as the risk of loss did not shift.
Gulf Oil Corp. v. Commissioner, 914 F.2d 396 (3rd Cir. 1990)
Taxpayer paid premiums to an unrelated fronting company which ceded the premiums to the taxpayer’s captive foreign insurance company, which was undercapitalized. Taxpayer provided a guarantee to the fronting company that it would indemnity the fronting company if the captive ever became unable to meet its obligations with respect to the reinsured risks. Because of the taxpayer’s guarantee, the Third Circuit Court of Appeals upheld the Tax Court’s ruling that no risk-shifting or risk-distribution took place and therefore, the taxpayer was not entitled to an insurance premium deduction. In so holding, the Third Circuit left open the possibility that the existence of unrelated insurance premiums might establish risk-transfer sufficient to justify the deduction of insurance premiums.
Courts have been reluctant to fully embrace the economic family theory. Accordingly, subsequent to the Gulf Oil Corp. v. Commissioner decision in 1990, various courts began to place weight on the amount of unrelated insurance business accepted by a captive in determining whether true insurance exists. A sample of these cases is set forth below.
Important note: If the federal court of appeals for the State in which the taxpayer is located has rendered an opinion on the issue, such decision is controlling (i.e. it will take precedence over the revenue rulings). Thus, it is important to check if there has been any case law on the issue applicable to the State in which the taxpayer is located.
Sears Roebuck and Co. v. Commissioner, 972 F. 2d 858 (7th Cir. 1992)
A captive with outside insurance business of 99.75 percent was considered by the courts to be a legitimate insurance company. Therefore, the .25% of the premiums received from the parent was considered insurance.
AMERCO v. Commissioner, 979 F.2d 162 (9th Cir. 1992)
A third tier wholly owned subsidiary captive insurance company, with outside insurance of at least 52% was considered by the Court to be a legitimate insurance company. The insurance company was also licensed in 45 states and the District of Columbia under the standard state insurance laws.
Ocean Drilling & Exploration Co. v. United States, 988 F.2d 1135 (Fed. Cir. 1993).
Insurance premiums paid by a parent company to a subsidiary insurance company on behalf of the company's other subsidiaries were valid insurance expenses. Risk-shift and risk-distribution between the parent and the insurance subsidiary were present since the insurer provided insurance to unrelated parties in an amount significant enough to reduce the parent's risk. Unrelated party insurance accounted for 44% one year and 66% the next year of the premiums written by the insurance subsidiary.
Harper Group v. Commissioner, 979 F.2d 1341 (9th Cir. 1992)
Wholly owned subsidiary with outside business of 29% which received premium payments from related subsidiaries and outside parties was determined to be a legitimate insurance company. Thus, the premiums paid by related subsidiaries in a brother/sister transaction were deductible for income tax purposes.
The Court also considered the argument that the brother/sister subsidiaries might be considered “outside” business, but did not make a determination on this issue as the pure outside business percentage caused the captive's transactions to be recognized as insurance.
Humana, Inc. v. Commissioner, 881 F.2d 247 (6th Cir. 1989)
A wholly owned subsidiary insurance company received premiums from its parent company and related subsidiaries. Initially, the Tax Court held that the captive was not considered to be an insurance company with respect to the premiums received from both the parent and the brother/sister entities.
The Sixth Circuit Court of Appeals later ruled that premiums received from brother/sister transactions should be considered insurance premiums, but the premiums received from the parent should still be considered as nondeductible. (Remember, the finding of the Court of Appeals applies only to the Sixth Circuit.)
Malone & Hyde, Inc. v. Commissioner, TC Memo, 1991-585.
Corporation established a wholly owned foreign insurance subsidiary (s1) to reinsure itself and its subsidiaries. There were no unrelated third party premiums accepted by s1. After s1 was established, the corporation insured with a domestic unrelated corporation (d1), which then agreed to cede premiums to s1. The court disallowed the full amount of premiums paid by the parent and subsidiaries to d1 which were reinsured with s1.
The above litigation shows that the courts do consider related party and outside third party premiums received by the captive in their decision. Therefore, the amount of related party and outside third party premiums must be well documented in the case file.
Captive with Multiple Owners
The following ruling and court case deal with a captive which has multiple unrelated shareholders.
Revenue Ruling 78-338, 1978-2 C.B. 107
Amounts paid by a domestic corporation to a foreign insurance company with 31 unrelated shareholders, none of which own a controlling interest in the insurance company, are deductible premiums as risk of loss can be shifted and distributed between the members.
NOTE: Revenue Ruling 78-338 is modified by Revenue Ruling 2001-31. Other than the economic family theory, the rationale remains the same.
Black Hills Corp. v. Commissioner, 73 F.3d 799 (8th Cir. 1996)
When each of the owners of the insurance company pay premiums to a separately maintained account for each member, the transaction of premium payment from the owner to the insurance company is not insurance.
Note: It is important that the excise tax examiner coordinate the audit of the foreign insurance excise tax issues with other agents on the case who are responsible for determining the deductibility of premium payments to the captive. Once this determination is made, the applicability of the foreign insurance excise tax is to be considered using the facts and circumstances of the case.
Chart of Cases and Rulings for Captive Issues
The chart below summarizes the revenue rulings and court cases discussed in this chapter.
SCENARIO 1. All premiums paid directly from the parent to a captive. RESULT: Income Tax-No insurance expense Excise Tax-Potential adj. if captive reinsures with a taxable foreign reinsurer. REFERENCE: Rev. Rul. 2001-31 (Facts & circumstances of case to be considered as guided by case law)
SCENARIO 2. All premiums paid from parent to unrelated agent then ceded to captive. RESULT: Income Tax-No insurance expense Excise Tax-Potential adj. if captive reinsures with a taxable foreign reinsurer. REFERENCE: Rev. Rul. 2001-31 (Facts & circumstances of case to be considered as guided by case law) Carnation Co.
SCENARIO 3. Premiums paid from parent to captive along with brother/sister premiums. RESULT: Income Tax- No insurance for parent but may be insurance for relateds. Excise- Potential adj. if captive reinsures. REFERENCE: Humana Harper Group
SCENARIO 4. Premiums paid from parent to captive along with unrelated third party premiums. RESULT: Income Tax- Possible insurance if percentage of third party premium is significant. Excise Tax-Tax due on foreign premiums if determined to be insurance. REFERENCE: Sears Roebuck AMERCO Ocean Drilling Harper Group
SCENARIO 5. Captive is owned by multiple owners. RESULT: Income Tax- Insurance Excise Tax- Tax due on foreign premiums. REFERENCE: Rev. Rul. 78-338 (No economic family theory position)
SCENARIO 6. Captive owned by multiple owners with separate accounts for each owner. RESULT: Income Tax- No Insurance Excise Tax- Potential adj. if captive reinsures. REFERENCE: Black Hills Corp.