Internal Revenue Service comments on “abusive” tax structures –Recognizes valid captive insurance companies –But criticizes “often times poorly drafted

• Internal Revenue Service comments on “abusive” tax structures– Recognizes valid captive insurance companies– But criticizes “often times poorly drafted ‘insurance’ binders and

policies to cover ordinary business risks or esoteric, implausible risks for exorbitant ‘premiums’ while maintaining their economical commercial coverage with traditional insurers”

– Underwriting or actuarial support for the insurance premiums either “missing or insufficient”

– Characterizes promoters as receiving “hefty” fees for management and for assisting taxpayers unsophisticated in insurance to “continue the charade”

– Also comments on use of trusts

IR 2015-19

• Issued February 9, 2015• Prepared by JT. Committee on taxation for senate

committee on finance• Increases $1,200,000 to $2,200,000• Requirement that no more than 20% of net written premium

(or, if create, direct written premium) can be attributable to any one policyholder was removed

Proposed Legislation – Section 831(b)

• Opinion issued by the Tax Court on January 14, 2014

• The case was reviewed by the full Tax Court (16 judges – 1 recused himself) as the opinion overturned the Tax Court ruling in Humana (1988)

• Four opinions were issued– Majority opinion (7 judges)– Concurring (6 judges)– Two dissenting

• Majority found all requisite requirements of insurance to be met:– Risk shifting (dissent disagreed – relied on Humana)– Risk distribution (dissent did not comment)– Insurance risk– Common notions of insurance (dissent disagreed on loanback)

• IRS chose not to appeal

Rent-a-Center v. Commissioner

• Court applied a facts and circumstances test

• RAC is a public company in “rent to own” business

• Formed Legacy Insuance Company, Ltd. – Bermuda based captive in 2002

• Legacy had made an IRC Section 953(d) election

• 4-12 subsidiaries in years in question

• One subsidiary represented approximately 67% of the risk premiums

• The parent Company provided a limited “parental guarantee” relating to a deferred tax asset (~$25M) for the relevant asset test which received BMA approval

• Captive owned Treasury Shares of the parent (a publically traded company) worth ~$108M


• RAC paid premiums to legacy on behalf of subs and used its cost accounting formula to allocate premium expense based on each sub’s exposure units

• Standard coverages – workers compensation, auto liability and general liability

• Structured as a deductible buy-back program

• Independent actuary and third party administrator

• Premiums and paid losses were “netted”


• IRS sham argument rejected; legacy formed for valid non-tax business purposes

• Risk clearly shifted to legacy from subs (but not parent)

• Majority of judges now accept brother/sister theory (rejected by tax court in Humana in 1987) based on either facts/circumstances or IRS concession of the economic family doctrine in Rev. Rul. 2001-31

• The 6th circuit in Humana appeal held in 1989 that the tax court had erred on this point, so now 15 tax court judges voted on whether to overrule or keep its past brother/sister position (given that this case’s appeal goes to a different (the 5th) circuit

• As stated, a majority of judges now agree that the brother/sister theory works to create risk shifting, making application of the “balance sheet” test the official tax court position


• Parental Guaranty which had historically thought to be fatal to a captive arrangement (see Carnation and Rev. Rul 2001-31) was not a “fatal” factual flaw – “we must look to the substance of that guaranty”

– Majority opinion found RAC’s limited guaranty of legacy did not prevent risk shifting

– Legacy more than adequately capitalized (dissent disagreed)

– Guaranty provided by parent, not by insured subs owning no legacy shares

– Guaranty in favor of captive not fronting carrier (as in prior cases)

– Regulatory purpose for guaranty so BMA would recognize legacy’s deferred tax asset for statutory ratios

– $25M amount relatively small compared with $264m premiums

– Guaranty never used and removed when no longer needed for BMA


• Tax Court established new standard for determining “risk distribution”

– Majority opinion primarily focused on risks, not entities: “RAC’s subs had a sufficient number of statistically independent risks”

– Judge Foley looked at number of stores, employees and vehicles

– Court never mentioned the “entitiy theory” as set forth in Revenue Rulings 2002-90, 2002-91, and 2005-40

– Introduced the requirement for a pool of “statistically independent risks”

• Tax Court addressed “loanbacks” with respect to $108M of RAC Treasury Shares held by Legacy

– Judge Foley said no circular cash flow because shares not sold

– Dissent said treasury shares were a factor in characterizing legacy as “a mere holding tank for cash”

– Dissent viewed parental guaranty and Treasury Shares to negate risk Shifting


• Securitas Holdings, Inc. & Subsidiaries v. Commissioner

• Ultimate parent Company was Securitas AB, a Swedish publically traded company

• AB owned Securitas USA Holdings, Inc. a US affiliate

• AB had been very acquisitive prior to the transaction and had acquired a number of US guard businesses which is consolidated into a few subsidiaries

• SHI owned a between 4-11 subsidiaries for the years at issue

– One subsidiary represented

– 4 US subsidiaries represented ~ 90% of the total risks

• SHI also owned Protectors Insurance Company (a Vermont based captive)

Securitas Holdings, Inc. v Commissioner

• Protectors entered into a deductible reimbursement policy with the SHI affiliates

• Protectors entered into a 100% assumption reinsurance arrangement with Securitas Global Reinsurance Limited, (“SGRL”).

• SHI also owned another US based insurance company – Centaur Insurance Company which was under supervision by the State of Illinois

• SHI provided a “parental guaranty” to Protectors to negate the “insurance” transaction between the SHI subsidiaries and Protectors

• Premiums from one SHI affiliate represented ~67% of the total premiums of Protectors

• Premiums from the SHI affiliates represented ~90% of the risks of SGRL

• SGRL assumed risks from a number of non US affiliates through XL


• IRS asserted that Protectors was not an insurance company because the parental guaranty and risk was not shifted to SGRL

• IRS asserted the concentration of risk in the SHI affiliate results in a lack of risk distribution

• In a Tax Court Memorandum decision, the court concluded the parental guaranty did not negate risk shifting to SGRL from the SHI affiliates and the court followed the Rent-a-Center decision with respect to risk distribution in commenting who owns the risk is not the critical question; rather the number of risks resulting from thousands of locations, employees and vehicles are key

• The option to appeal the case to the 9th Circuit expired January 28, 2015


• A number of companies have insured medical stop loss programs with their captives.

– The Department of Labor (who enforces ERISA) has concluded a Medical Stop Loss policy is not an ERISA benefit – see Advisory Opinion 92-02A

– Is a Medical Stop Loss a “related” or “unrelated” risk as it applies to risk shifting and risk distribution in a captive insurance company?

• Revenue Rulings 92-93 and 92-94 concluded that certain insured employee benefits are “employee” (e.g., unrelated) and not “employer” (e.g., related) risks

• Private letter ruling sought on transaction which IRS placed on its priority guidance plan several years ago as proposed revenue ruling

• Proposed revenue ruling was thought to address medical stop loss issue when published

Revenue Ruling 2014-15

• The employer maintains health programs for retirees

• The employer established a Voluntary Employee Benefit Association (“VEBA”) and funded the employer’s outstanding employee benefit obligation for both retired and future retirees.

• Employer may cancel the benefit at any time.

• Employer made tax deductible contributions to the VEBA

• The VEBA purchased a non cancellable accident and health insurance policy from an unrelated insurance company (Fronting Insurer)

• The Fronting Insurer reinsured the risks with a captive insurance company affiliate of the employer

• Premiums are arm’s length

• No loanbacks from the captive


• In the Ruling, the IRS held

– The risks are the risks of the employee and not the employer

– Risks are adequately distributed among a large group (see Rev. Rul’s 2002-89 and 2005-40)

– Risks are “insurance” risks

– In the analysis, the IRS cites Rev. Rul. 92-93.

– IRS does not address the result if no VEBA is used


• There have been persistent concerns that hedge funds have been establishing foreign reinsurance companies as a means of avoiding the passive foreign investment company (PFIC) rules.

• A PFIC is generally any foreign corporation that is not a CFC if 75% or more of its gross income is passive income or at least 50% of its assets produce passive income.

• Passive income does not include income derived in the active conduct of an insurance business by a corporation which is “primarily engaged in the insurance business” and would be taxed under subchapter L if it were domestic.

• It has been asserted that hedge funds have established foreign reinsurers which have been over-capitalized and which invested their capital and reserves in the hedge fund.

• This would permit the hedge fund to obtain an inappropriate deferral and rate benefit

• It is claimed that these reinsurers have justified their large capitalizations on the grounds that they are writing catastrophe risk.

PFIC Proposed Regulations

• The IRS initially sought to combat this potential abuse through Notice 2003-34.

– This Notice stated that the critical issue was whether the character of all of the business actually done by the company indicates that it uses its capital primarily in investing rather than primarily in the insurance business.

• Chairman Camp’s Tax Reform Discussion Draft would have replaced the current subjective test for determining whether a foreign corporation is predominately engaged in an insurance business with an objective test under which a foreign insurer would not be a PFIC if:

– More than 50% of annual gross receipts consist of premiums that would be subject to tax under subchapter L if the corporation were domestic, and

– Applicable insurance liabilities constitute more than 35% of total assets.

• Senator Baucus’s tax reform proposal included a similar provision.

• These objective tests would have treated a number of foreign reinsurers that were clearly “legitimate” as being PFICs (in addition to a number of domestic insurance companies who would have been PFIC’s if they were offshore.


• Senator Wyden has taken up this issue and has pressured Treasury to issue further guidance in this area.

• On April 23, the IRS released proposed regulations under section 1297 relating to the definition of passive income for purposes of the insurance company exception.

• The Proposed Regulations would further define the terms “active conduct” and “insurance business”.

• Comments are specifically requested regarding how to determine the portion of a foreign insurance company’s assets that are held to meet obligations under insurance contracts and have asked for comments regarding what is an adequate level of capitalization.

• Comments are due by July 23, 2015.

• Defines an “insurance business” to mean

– the business activity of issuing insurance and annuity contracts and the reinsuring of risks underwritten by insurance companies,

– investment activities and administrative services that are required to support or are substantially related to insurance contracts issued by or reinsured by the foreign company


• “Active conduct” would have the same meaning as in Treas. Reg. §1.367(a)-2T(b)(3) except that officers and employees are not considered to include the officers or employees of related entities.

• This is a facts and circumstances test that generally requires that the officers and employees of the corporation carry out “substantial managerial and operational activities.” Although Treas. Reg. §1.367(a)-2T(b)(3) includes officers and employees of related entities for this purpose, the proposed section 1297 regulations do not.

• In determining whether the officers and employees of the corporation carry out substantial managerial and operational activities, however, the activities of independent contractors shall be disregarded.

• Significant “push back” is expected given the legal structure of a number of the Bermuda based insurers and reinsurers

• Potential consequences in the captive insurance space with relies heavily on both independent contractors and related parties


• Validus, a Bermuda reinsurance company, retroceded U.S. risks to foreign reinsurers. In accordance with Rev. Rul. 2008-15, the IRS applied the ‘cascading’ FET rule to these retrocessions and collected a 1% FET

• Validus challenged the IRS and won in the District Court which ruled on the theory that the statue does not impose an excise tax on retrocessions.

• The U.S. appealed the decision of the District Court to the United States Court of Appeals for the District of Columbia Circuit.

• The U.S. argues that retrocessions are a type of reinsurance and the District Court erred in determining that under the plain meaning of the statute FET does not apply to retrocessions.

Validus Insurance, Ltd. v U.S.

• On May 26, 2015, the Appealate Court held for the taxpayer

• The Court cited ambiguity in the statute on whether Congress had intended to tax a “extra-territorial” retrocession transaction between foreign parties

• The ruling addresses “extraterritorial retrocessions” but did not address a foreign to foreign reinsurance transaction

Validus Insurance, Ltd. v U.S.

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Documents

Internal Revenue Service comments on “abusive” tax structures –Recognizes valid captive insurance companies –But criticizes “often times poorly drafted