State and international tax aspects of "captives".

Besides addressing significant U.S. tax issues when forming and operating a captive insurance company (captive), significant state and international tax issues must also be discussed. (For background on the key U.S. tax aspects of captives, see McGrath, Tax Clinic, "Using Captives to Manage Risk," TTA, July 2004, p. 419.)

State Tax Aspects

Nexus: For a state to have taxing authority over a captive, the latter must have sufficient nexus with the state such that taxation does not violate the U.S. Constitution. This determination depends on the facts and circumstances; see, e.g., State Bd. of Ins. v. Todd Shipyards Corp., 370 US 451 (1962); Dow Chemical Co. v. Carol Keeton Rylander, Comptroller of Pub. Accts. of the State of TX, 38 SW3d 741 (TX Ct. Apps. 2001); and Quill Corp. v. North Dakota, 504 US 298 (1992).

In this context, an unsettled issue involves a state's claim of taxing authority over a captive neither located nor licensed to do business in that state. The question is whether the captive is to be taxed as an insurance company, although not regulated as such in that state, or as an out-of-state corporation. Resolution depends on the state's laws, as well as on an analysis of the company's facts and circumstances.

Premium taxes: Generally, states may subject insurance companies to the following taxes: real and personal property, franchise, income, license and capital-based. However, the most significant (and common) tax imposed by states on insurance companies, often in lieu of all other taxes except real property taxes, are premium taxes.

In general, premium taxes are based on an insurer's gross written premiums, as reflected in its annual statement (net of allowable deductions such as return premiums, reinsurance premiums and policyholder dividends). Although the premium tax rate varies by state, the average rate is slightly less than 2% (e.g., CA-2.35%; HI-4.265%; IL-5%; NE-1%; and NYC (life)-0.8%).

Although captives are insurance companies, they typically are licensed to do business in only one state, because they typically insure very specific risks or insureds. As states generally provide for much lower premium tax rates on captives (typically, 0%-0.4%, such as DE-0.1%-0.7% and VT-0.075%-0.6%) than on ordinary insurance companies, the premium tax burden on captives generally will be relatively insignificant in the state tax context.

Income taxes: Currently, seven states (FL, IL, MS, NE, NH, NY (only life) and OR) presently impose an income tax on insurance companies. The income tax is generally imposed on an insurer's state-apportioned net income, as is typically the case for noninsurance corporate taxpayers. Some, but not all of these states, provide a credit mechanism between the income tax and the premium taxes paid to the taxing jurisdiction.

Procurement taxes: Thirty-four states impose procurement taxes. These taxes are not generally directed at insurance companies but, rather, at insureds. Procurement taxes are imposed (absent an exemption) on self-procured insurance when a licensed insurer is not involved in the placement of the insurance coverage, resulting in the complete avoidance of payment of state premium taxes. Procurement tax rates are often higher than premium tax rates, to discourage insure& from securing insurance coverage from unauthorized insurers.

International Tax Aspects of Foreign Captives

Domestic captives are taxed as any other domestic insurance company in the U.S., ignoring special rules and limits associated with foreign ownership. However, once it has been determined that it makes good business sense to form and operate a foreign captive, significant U.S. international tax aspects need to be addressed.

Taxation of foreign-controlled insurance operations: In the case of a foreign insurer having U.S. investments in investment-related assets (e.g., bonds and stocks) and conducting a U.S. trade or business (e.g., a U.S. insurance branch), three layers of tax potentially apply. First, Sec. 881 imposes a 30% withholding tax on all U.S.-source fixed or determinable, annual or periodical income earned by the foreign insurer (unless reduced or eliminated by a treaty) that is not effectively connected with the conduct of a U.S. trade or business (e.g., interest or dividend income). Second, Sec. 882 subjects income effectively connected with the conduct of a U.S. trade or business to a net income tax at the same rate applicable to U.S. corporations. Thus, a foreign insurer conducting a U.S. trade or business (e.g., a U.S. branch) is subject to U.S. corporate tax on the branch's net taxable income. Third, Sec. 884 levies a 30% branch-profits tax on a foreign insurer's effectively connected after-tax earnings (unless reduced or eliminated by a treaty) not reinvested in a U.S. trade or business by the close of the tax year.

Taxation of foreign captives controlled by U.S. shareholders: In the case of a foreign captive significantly U.S.-owned, Federal tax rules focus on anti-deferral (by the U.S. investors, not the foreign captive). Although a detailed discussion of the anti-deferral rules is beyond this item's scope, a basic understanding of subpart F as it applies to foreign captives is necessary (ignoring, for this item's purposes, the foreign personal holding company provisions).

Generally under Sec. 951, U.S. shareholders who own the requisite voting control of a foreign corporation for the requisite period must include in their U.S. taxable income a deemed dividend of subpart F income, whether or not such income is distributed. For controlled foreign corporation (CFC) captives, all insurance income that is not same-country insurance income (SCII) is deemed to be subpart F income subject to current inclusion. SCII is not taxable in the U.S. and generally relates to insured risks located in the same country in which the foreign captive is organized.

Subpart F insurance income must be further bifurcated into related-party insurance income (RPII) and non-related-party insurance income (non-RPII). The RPII rules apply a broader definition of U.S. shareholders and CFCs. Under the general CFC rules, non-RPII income is included in "U.S. shareholders'" taxable income as subpart F income for U.S. shareholders meeting Sec. 951(b)'s ownership thresholds (e.g., 10% of voting stock). In contrast, a pro-rata share of RPII generally is included in the income of U.S. shareholders owning any stock of the foreign insurer. In either case, Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, must be filed to report each U.S. shareholder's share of such income.

See. 953(d) election: Foreign insurance companies that are CFCs, however, may elect to be treated as domestic insurance companies for U.S. tax purposes. This election allows foreign insurers to avoid exposure to the branch-profits tax. In addition, it eliminates a foreign insurer's exposure to the Sec. 4371 excise tax (discussed below). However, one disadvantage associated with this election is that the foreign insurer will be subject to U.S. tax on its worldwide income; see Rev. Proc. 2003-47.

Sec. 953(c)(3)(C) election: A foreign insurance company that has RPII income but does not meet the general CFC definition may help its U.S. shareholders avoid current tax on their pro-rata shares of RPII subpart F income by making a Sec. 953(c)(3)(C) election. This permits the foreign insurer to treat its RPII as effectively connected with a U.S. trade or business, such that it (rather than the U.S. shareholders) will be subject to U.S. tax on the RPII income. A foreign insurer that makes this election also will avoid the branch-profits tax, as well as the Sec. 4371 excise tax imposed on related-person premium payments made to the foreign insurer.

Excise tax on premiums paid to foreign insurers: Unless exempted by treaty, special election or otherwise, Sec. 4371 imposes an excise tax on gross premiums paid to foreign insurers for insuring U.S. risks, without reduction for underwriting expenses. The Sec. 4371(1)-(3) excise tax rates are 4% of gross premiums paid for property/casualty insurance; 1% of gross premiums paid for life, health or accident insurance; and 1% of gross premiums paid for reinsurance. Payment of the excise tax generally is the responsibility of the premium payer, although Sec. 4374 indicates that payment may be sought from the insured, the insurer or the policyholder. The excise tax is reported on Form 720, Quarterly Federal Excise Tax Return.

FROM CLINTON N. MCGRATH, JR., CPA, J.D., LL.M., WASHINGTON, DC