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Taxation and the future of offshore insurers.

Prior to 1987, U.S. businesses garnered substantial tax advantages when establishing captive insurers in Bermuda, the Bahamas and the Cayman Islands. Typically, a U.S. multinational would organize a foreign corporation to insure its business property and activities. The underwriting income of the foreign entity would be accumulated indefinitely on a tax-deferred basis. As long as the arrangement was not viewed as self insurance, premiums paid to the offshore entity would be deductible by the parent.

Today, the tax incentives to establish offshore insurance companies have been eliminated for the majority of U.S. multinationals that own captives. Rather than a deferral of underwriting income, most offshore profits are now taxed under Subpart F of the Internal Revenue Code. Furthermore, underwriting premiums paid to captives can be deducted only in narrow, well-defined situations. Nonetheless, some tax benefits can still be gleaned by captive insurers.

Controlled Foreign Corporations

Sections 951 through 964 of the code, known as Subpart F, are intended to tax offshore profits during the taxable year they are earned. In so doing, this portion of the code substantially increases, on a present value basis, the U.S. tax liabilities of many U.S. individuals and companies with foreign business interests.

The focus of Subpart F is on controlled foreign corporations, which are defined as having more than 50 percent of their voting power or stock value owned by U.S. shareholders. By definition, U.S. shareholders include only U.S. citizens and residents or entities that own at least 10 percent of the foreign corporation's voting power. For example, a wholly owned foreign subsidiary of a U.S. multinational corporation is considered a controlled foreign corporation. But a foreign corporation owned equally by 11 unrelated U.S. persons is not a controlled foreign corporation since there are no U.S. shareholders.

Controlled foreign corporations are not subject to U.S. taxation unless they earn U.S. source income or income that is effectively connected with a U.S. trade or business. Nonetheless, the U.S. shareholders of such a corporation are taxable via a constructive dividend when the controlled foreign corporation earns "tainted income" derived, for example, from issuing or reissuing certain insurance or annuity contracts or when it invests in certain U.S. property. As a result, the income earned by many offshore insurers is taxable to the U.S. owners, even though the profits are not currently remitted and may remain offshore for several years.

The proliferation of foreign captives has resulted in congressional scrutiny and an obstacle course of Draconian barriers that corporations in other industries are not required to run. For example, a foreign corporation that receives more than 75 percent of its gross premiums from insuring risks outside the country where it is organized is likely to be a controlled foreign corporation. Specifically, it is a controlled foreign corporation if more than 25 percent, rather than 50 percent, of the voting power or value of shares is owned by U.S. shareholders.

Tax Reform Impact

Despite this obstacle, captive insurers organized abroad easily escaped U.S. taxation before the Tax Reform Act of 1986. For instance, share ownership could be dispersed so that no U.S. person owned the 10 percent minimum needed to be considered a U.S. shareholder. Without a shareholder, the captive was not a controlled foreign corporation. But even when the captive was considered to be one, U.S. taxes were often deferred by insuring persons residing, property located or activities occurring outside the United States. Prior to the act, only the insurance of U.S. risks generated Subpart F income.

The act changed the game considerably. Most so-called related party insurance income is now treated as Subpart F income. Related party insurance income is the insurance and reinsurance income from policies issued to U.S. persons who own stock in the captive and parties related to these U.S. stockholders. Any U.S. person who owns stock in an offshore captive, even if it is less than 10 percent, is considered to be a U.S. shareholder in determining whether related party insurance income is Subpart F income.

In addition, the act dropped the "more than 50 percent" threshold to 25 percent or more," even when 75 percent of gross premiums are not derived from risks outside the country of incorporation. Any insurer, including a mutual insurer, that surpasses the 25 percent threshold is considered a controlled foreign corporation but only regarding its related party insurance income. Under this exacting standard, dispersion of ownership among unrelated U.S. persons is no longer a viable planning technique.

However, related party insurance income does escape Subpart F if more than 75 percent of the voting power and stock value is owned by foreign parties unrelated to U.S. shareholders. Thus, a U.S. multinational willing to accept no more than a 25 percent interest can become part of a pool with multiple foreign businesses in need of insurance and still circumvent Subpart E Due to legislation in other countries similar to Subpart F, a tax incentive to pool interests exists among many foreign insurers.

Tax Planning

There are only three ways for an offshore insurer with related party insurance income to avoid the more stringent definition of "U.S. shareholder" and the lower 25 percent threshold of controlled foreign corporation status. First, these modifications are inapplicable if at least 80 percent of voting power and stock value are owned by persons who are neither insured by the company nor related to those who are insured. In other words, the insured must be willing to relinquish effective control over the offshore captive.

Second, the special rules do not apply if at least 80 percent of total insurance income is received from parties other than U.S. owners and persons related to these owners. In effect, the gross related party insurance income must be less than 20 percent of total gross insurance income. This means that the parent corporation must be willing to insure the property and activities of unrelated parties.

The third way an offshore insurer can avoid these restrictions is by electing to treat all of its related party insurance income as if it is connected with a U.S. trade or business and by waiving any treaty benefits that pertain to this income. Once made, the election is effective for all subsequent years and cannot be revoked without Internal Revenue Service consent. The effect of the election is that the related party insurance income is taxed at U.S. regular income tax rates; that is, all potential deferral benefits related to the related party insurance income are forfeited.

No U.S. excise tax applies, however, to any insurance or reinsurance premium that is taxed as "effectively connected income." Furthermore, the so-called branch profit tax does not apply to related party insurance income that is treated as effectively connected under this election. Some nominal tax benefits may be derived as well to the extent the foreign insurer is in a lower marginal tax bracket than its shareholders.

Even when Subpart F is avoided, however, other provisions in the code can thwart any deferral strategy, including those that deal with foreign personal holding companies and passive foreign investment companies. However, these provisions are not the formidable obstacles to the tax planning of offshore insurers as is Subpart F.

Even when the Subpart F provisions cannot be circumvented, the costs of insuring through a captive can be lower than commercial rates, since the premiums can be structured to minimize underwriting profits and overhead expenses. However, the feasibility of using a captive often hinges on the premium deductibility. According to the 1941 Supreme Court case Helvering v. LeGierse, premium deductibility depends on whether there has been a shift of risk and risk distribution. The official position of the IRS in Revenue Ruling 77-316 is that premiums paid to a captive do not involve these essential elements of bona fide insurance and, therefore, are not deductible.

In the 1981 case Carnation v. Commissioner, underwriting premiums were paid to an unrelated insurer, but 90 percent of the risk was reinsured through an offshore captive of the taxpayer. If the captive could not pay any claims filed by the unrelated insurer, the parent agreed to provide its captive with sufficient capitalization on demand. Because of the interdependence of the agreements to insure and capitalize, the 9th Circuit Court of Appeals held that risk shifting was absent. Thus, 90 percent of the premiums were not deductible. Similar decisions were reached by Humana v. Commissioner, a 6th Circuit Court of Appeals case in 1989, and Gulf Oil Corp. v. Commissioner, a 3rd Circuit Court of Appeals case in 1990. In contrast, the Tax Court allowed the deduction in Sears, Roebuck and Co. v. Commissioner in a 1991 decision because the premiums from the parent company were relatively small.

The importance of adequate capitalization was further emphasized in 1986 in Beech Aircraft Corp. v. United States. Although there was no explicit agreement to capitalize the captive subsidiary, the 10th Circuit Court of Appeals found an implied agreement to indemnify. If a sizable claim occurred, the captive would be unable to meet its obligation. In effect, the loss would be borne by the parent in a form of self insurance. The court held that the premium was not deductible.

A deduction for underwriting premiums paid to a captive insurer was allowed in 1985 in Crawford Fitting Co. v. United States. The distinguishing characteristic of this case was that the captive and the insured were brother-sister related, not parent-subsidiary corporations. The U.S. District Court in Ohio noted that, unlike a subsidiary, the profitability of a brother-sister captive does not directly affect the financial position of the insured. Though some commentators have warned against attributing too much weight to this decision, the Tax Court embraced this principle in Harper Group v. Commissioner and AMERCO and subsidiaries v. Commissioner, both decided in 1991.

The Future of Captives

For those willing to walk a narrow path, it is possible to preserve both the tax deferral and the tax deduction for premiums paid by the insured. The key is to form an insurance pool that disperses ownership and risk; for example, an offshore insurer owned by 20 unrelated, equal shareholders. If only four of these shareholders are U.S. residents, the insurer is not a controlled foreign corporation, and the deferral of underwriting income is secure.

Furthermore, if the insured risk of any single shareholder does not exceed 5 percent of total insured risks, the IRS will recognize the arrangement as one that shifts and distributes risk. Some businesses may not find this arrangement palatable because the financial stability of some foreign shareholders is difficult to verify. Further, the dispersion of ownership involves the loss of control, which no longer merits the term "captive."

Despite the Draconian measures taken by Congress to curb captive use, a number of nontax reasons remain for why offshore insurers continue to exist. First, the regulatory environment abroad is often more relaxed, with lower reserve requirements in some countries. However, amendments to the Product Liability Risk Retention Act of 1981 and favorable legislation passed by such states as Colorado and Vermont may cause any difference in the overseas regulatory environment to appear negligible. Second, the unavailability of some forms of insurance at a reasonable cost in the United States will continue to force many companies to establish captives. Third, lenders and security analysts normally accept and recognize insurance policies issued by captives.

Tax Benefits

In addition to the non-tax benefits, the well-advised company still can derive some tax benefits. First, the deductibility of premiums can be preserved by closely adhering to the lessons of Crawford and the recent flurry of Tax Court decisions. Also, some foreign jurisdictions such as Bermuda, do not impose premium excise taxes. Third, U.S. taxation of non-related party insurance investment income still can be deferred (even when related party insurance income is taxed under Subpart F) by employing the pre-act dispersion-of-ownership strategies. Finally, a multiowner captive that meets the 5 percent risk test should be able to reduce its Subpart F income with deductions for future loss reserves under Section 805(b)(2). Thus, the U.S. owner's deduction for premiums paid would exceed its constructive dividend under Subpart F, resulting in a net tax benefit.

Until recently, pending treaties with Barbados and Bermuda exempted insurance or reinsurance payments by U.S. persons from the premium excise tax found in Section 4371 of the code. Section 6139 of the Technical and Miscellaneous Revenue Act of 1988, however, allowed the United States to impose and collect the premium excise tax beginning on Jan. 1, 1990, notwithstanding contrary provisions in the United States-Barbados and the United StatesUnited Kingdom (for Bermuda) income tax treaties. Furthermore, the IRS announced in Notice 89-89 the termination of this excise tax exemption.

Risk managers should not give up on captives. By using their ingenuity and knowledge about the tax laws, they can avoid the pitfalls. Indeed, if handled correctly, captive insurers are still economically sound investments. Ernest R. Larkins is associate professor of the School of Accountancy at Georgia State University in Atlanta.
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Author:Larkins, Ernest R.
Publication:Risk Management
Date:Sep 1, 1991
Previous Article:Dynamic forces driving group captive formation.
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