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.
Continued at http://www.irs.gov/businesses/small/art ... 63,00.html