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The truth behind captives and taxation.

Why are risk managers so reluctant to question the myth that captive insurers reduce a government's tax revenues? Clearly, risk managers have an interest in establishing that captives do not cause revenue loss to tax authorities. Yet perpetuating this myth raises the question of whether President Lincoln was too optimistic in saying "you can't fool all of the people all of the time."

Earlier this year an editorial in Business Insurance rejoiced in the success of captive owners in their tax battles with the Internal Revenue Service, but it went on to say: "While it will be difficult for risk managers to persuade legislators to pass a law that reduces federal revenues amid the current budget crisis, it may be the only way to persuade the IRS to give up the fight."

Business Insurance was not out of line with the thinking of risk managers in North America, the United Kingdom and Europe, and probably the rest of the world. More surprisingly, this thinking is not even out of line with the opinion of most captive tax lawyers. But the theory is nevertheless still wrong in assuming that captives reduce federal tax revenues.

If risk managers were to fund captives by putting into them an amount equal to the sum paid to an insurer each year, what would the tax implications be for the IRS (or the Inland Revenue in the United Kingdom)? The answer is none. As far as the company's tax contribution is concerned, the deductible captive premiums would match the deductible insurance premium.

The insurer's income, however, would be lower by the amount of premium now given to the captive, and therefore, presumably, so would the tax it pays at the end of the year. At first glance it looks as though the IRS would lose tax revenue, wouldn't it?

However, things are not always what they appear to be. Take a closer look. Suppose there were no claims on the captive in its first year, then its profits would be taxable and the revenue raised by the IRS from the captive would balance the revenue loss from the insurer whose premium volume had been reduced.

Yet suppose claims did occur. For simplicity sake, assume the claim payments made on the captive in its first year equal annual premiums, which is the same as the premium previously paid to the insurer. In the case of the captive, there would be a tax deduction given to the owner for the premium transferred to the captive but there would be no tax on profits because on paper there are not any. So far as the insurer is concerned there would be less taxable premium income but this would have been eradicated anyway by a balancing claims payment. So, again the IRS would not be losing out on revenue from the captive operation.

In effect, why should there be a government tax loss because insurance was placed with one insurer rather than with another? The only argument the tax man has in response to this question is that when captives are located offshore, the payment of tax on profit is slowed. However, insurers, through "adjusting" claims reserves, are far more guilty of paying taxes when they--not the tax authorities--decide the time is right.

In any event, this argument is flawed because it is based on the false assumption that if a company is without a captive, it has to buy insurance from a domestic carrier. If a risk manager decides to buy conventional insurance, he is at liberty to pay this premium to a British, German, French or any other overseas company. If he does that, the U.S. tax authority clearly loses out. In fact, it loses by a larger margin than if the risk manager had placed insurance premium with, say, a Bermuda-based captive.

Chris F. Best is editor of Foresight, a London-based insurance and risk management journal published by Risk and Insurance Group Ltd.
COPYRIGHT 1991 Risk Management Society Publishing, Inc.
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Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Title Annotation:London Perspective
Author:Best, Chris F.
Publication:Risk Management
Date:May 1, 1991
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