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IRS issues long-awaited regulations.

Shareholders of many offshore captive insurers were dramatically affected by revisions in [sections of] of the Internal Revenue Code of 1986. Since that time, publication of regulations interpreting the statute were eagerly anticipated. The proposed regulations were published April 16.

Mostly, the regulations provide rules for allocating different types of income a foreign insurer can receive, such as underwriting income from the same country risk, which is not taxable under Subpart F rules; underwriting income derived from out-of-country risks, which is generally taxable only if the insurer is a controlled foreign corporation under conventional tests; and related person insurance income (RPII). Much of this has greater application to alien insurers operating in the commercial marketplace outside the United States.

For most captives formed offshore writing business only of their shareholder insureds, the proposed regulations do not provide much new insight. There are, however, a few points that generally apply to those captives. * Under [sections of]1.953-3(b)(2)(iii), a U.S. citizen that is not insured or reinsured, directly or indirectly, by the captive will not be considered a U.S. shareholder of the captive for purposes of the RPII rules if it owns shares of a foreign corporation which owns stock, directly or indirectly, in the captive if the stock of the other foreign corporation is publicly traded; the U.S. person owns less than 5 percent of the voting power and value of the stock of the foreign corporation; and the stock of the captive constitutes less than 5 percent of the gross value of all assets of the foreign corporation. * [sections of]1.953-3(b)(3) indicates that if several U.S. insurers form a foreign captive to reinsure risks, the premiums will constitute RPII whether the arrangement is a conventional contract or an assumption reinsurance contract pursuant to which the ceding company will no longer retain any rights or obligations. * Under [sections of]953-3(b)(5), cross-insurance arrangements are discussed, whereby the captive cedes business to another unrelated insurer in return for a cession of other business. It is provided that the business ceded to the captive under the circumstances will be treated as RPII. (The rule seems stringent because it does not reach the conclusion based on a form of conduct relating to the assumed business; for example, trying to equate profitability and volume.) * [sections of]1.953-3(b)(6)(iv) contains an anti-abuse rule, which provides that if premiums charged on an insurance or reinsurance contract are below those charged on comparable contracts issued to unrelated persons, the district director can recast capital contributions or other deposits made by shareholders as premium. An example provided in the regulations indicates that the comparability test only applies if the captive is charging different rates to shareholders/equity owners and non-shareholders/non-equityowners. The ability to recharacterize payments, however, seems at odds with the position the Internal Revenue Service has traditionally taken which limits current deductions to all possible extents. By recharacterizing capital or deposits, deductions to member/shareholders would be presumably increased. Any increased RPII might then be offset by such increased deductions. * [sections of]1.953-6(a) (1) requires that captives that are controlled foreign corporations that do not file NAIC blanks may be required to complete those portions necessary to make the determinations and computations required under the code. * [sections of]1.953-6(h)(7) deals with captives that are mutuals. Shareholders of such captives must include its pro rata share of RPII in gross income. The regulations provide rules for allocating RPII. The first of the following rules that will result in the appropriate allocations is to be used: The amount that would be distributed under the policy or by-laws; the amount that would be distributed if the company were liquidated; and the proportion of each member's premiums paid over the five-year period ending on the last day of the captive's year bears to the total or premiums paid by all policyholders "who hold ownership interests on the last day of the taxable year and have held their interest over the five-year period." * [sections of1.953-7(b) deals with the exception contained in [section of]953 (c)(3)(B) of the code, which generally provides that no income shall be RPII if less than 20 percent of gross premium is RPII. The proposed regulation permits the district director to exclude premium income attributable to a contract if the primary purpose for entering into the contract is to qualify for the exception. * Finally, [secttion].953-7(c) discusses the election under [section]953(c)(3)(C) of the code to treat RPII as effectively connected with a trade or business conducted in the United States. In connection with such an election, the electing foreign corporation must post a letter of credit equal to 10 percent of gross premiums. The proposed regulation provides that no change in the amount of the letter of credit is required unless, in a subsequent taxable year, there is an increase in gross premiums to more than 120 percent of the amount of gross premium used to complete the letter of credit. P. Bruce Wright is a member of the New York Bar. He is also a member of the law firm LeBoeuf, Lamb, Leiby and MacRae.
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Title Annotation:Legal Considerations; Internal Revenue Service
Author:Wright, P. Bruce
Publication:Risk Management
Date:Sep 1, 1991
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