Hospital Captive Legalities: Update on Regulatory, Tax & Corporate Governance Developments Affecting Health Care Pr

1. Hospital Captive Legalities: Update on Regulatory, Tax & Corporate Governance Developments Affecting Health Care Provider CaptivesJune 17, 2008 Thomas M. Jones McDermott Will & Emery LLPtjones@mwe.com 312-984-7536

2. XYZ Bermuda Indemnity, Ltd. Sample Captive Board Presentation: ABC Health Care System [Operates Hospitals in Illinois and Iowa]Elbow Beach ResortBermuda Educational Session – March _, 2008 Thomas M. Jones McDermott Will & Emery LLP Chicago, Illinois

3. Captive Structural/Regulatory Issues • State insurance laws and regulations • Federal and state tax considerations • Securities registration exemption/antifraud disclosure (applicable to group captives) • Other legal considerations (e.g., Medicare fraud and abuse) • Management/governance (directors and committees) • Coverage and policy questions • Choice of form (stock/mutual/reciprocal) (onshore vs. offshore)

4. The Bermuda Regulatory Environment • Judicious discretion with limited statutory rules • Bermuda’s Insurance Act provides the basic framework • The Bermuda Monetary Authority sets financial parameters using a holistic approach and “rules of thumb” rather than rigid rules – meritorious exceptions are granted by the BMA granting a “Sec. 56 Directive” • The captive’s filed business plan, as amended from time to time, establishes its responsibilities and undertakings • Local insurance managers play a contingent but important regulatory role

5. Directors’ Duties Under Bermuda Law • Duty of skill, care and diligence • Oversight role - duty to adequately supervise competent service providers • Fiduciary duties - directors must act in the best interests of the captive and must disclose to other directors any material conflict of interest • Director indemnification - except for dishonesty, willful default or gross negligence

6. Illinois Insurance Regulatory Issues • Prohibition against conducting an unauthorized business of insurance in IL • Two potential bases for the position that there is no unauthorized insurance in Illinois: • Industrial insured exception • No insurance

7. Illinois Insurance Regulatory Issues • Exception for IL “industrial insureds” (each of these three requirements must be met): • At least $100,000 in annual premiums; • Access to employed risk manager or contracted insurance consultant; and • Gross assets over $3 million or gross revenues over $5 million or at least 25 full-time employees

8. Iowa Insurance Regulatory Issues • Prohibition against conducting an unauthorized business of insurance in IA • Two potential bases for the position that there is no unauthorized insurance in IA: • Policy solicited, written & delivered outside IA • No insurance • IA has no industrial insured exception

9. IL & IA Insurance Regulatory Issues • No insurance position: • The “business of insurance” requires risk spreading and risk shifting • Arguably, there is no shifting or spreading of risk within an economically integrated group of entities • Typically, entities within a corporate system that are under common ownership and control of the First Named Insured are covered under a single policy issued to the First Named Insured

10. IL & IA Insurance Regulatory Issues • In order to cover affiliates under the same policy and take the position that the single policy does not represent “insurance”, the covered entities must be under common control, i.e., the policyholder must have more than 50% control, through ownership or ability to elect the governing body • Independent non-employee medical staff physicians constitute third party risk

11. Taxation of Healthcare Captives The key tax question: Is it treated as insurance?

12. Tax Definition of “Insurance” • No clear-cut definition in tax law • Must analyze case law and IRS rulings • Captive’s preference is to avoid “insurance company” tax status for itself and for its parent • But voluntary physicians need premium deductibility

13. Two Basic Requirements For insurance treatment, both risk shifting and risk distribution must be present: • Risk shifting must be to a separate legal entity • Risk distribution connotes enough independent risks pooled to invoke the “actuarial law of large numbers”

14. Advantages of Non-Insurance Status for Tax Exempt Owner of Offshore Captive • Premiums paid not subject to a federal excise tax (4% of the premium for direct insurance and 1% for reinsurance or life) • Can avoid attribution of any “unrelated business taxable income” to captive’s tax-exempt parent • State premium tax (known as “direct placement” tax or “self-procurement” tax) would apply – e.g., IA rate of 2% of premium; none in IL

15. Onshore Hospital Captives – Tax Status • If captive funds risk of only its tax exempt parent and employees, then captive can obtain an IRS “determination letter” granting IRC Sec. 501(c)(3) tax exempt status • Must file IRS Form 1023 with a description of intended activities – can cover non-employed physicians or other third parties only if “insubstantial” in amount (<5% of premiums) • Thus limited scope of captive activities if onshore – covering any substantial ineligible party causes all income of the domestic captive to become fully taxable

16. Offshore Hospital Captives - Tax Issues • No corporate income taxes in Bermuda • Offshore captives are not tax-exempt – so they can accommodate addition of non-employed physicians, but there may be tax ramifications • Federal excise tax on premiums • Unrelated business taxable income to captive’s U.S. shareholder – on net income from covering VAPs or non-controlled entities • But unlike onshore captives, covering third parties may generate some tax but it does nottaint the entire captive – this is the principal reason most captives owned by tax exempt hospitals are domiciled offshore

17. Hospital Captive with Independent Physician Coverage 501(c)(3)Parent Insurance HospitalOwned Medical Practice Non-Employed Medical Staff Physicians 501(c)(3)Hospital Insurance Insurance Captive Insurance Company Insurance (Regulatory Issues)

18. Avoiding a U.S. Trade or Business Why? If offshore captive is found to be engaging in a U.S. business, it will become subject to U.S. corporate income tax on its income effectively connected with the U.S. How to avoid: • Conduct day-to-day activities outside of U.S. • Do not qualify to do business in any state • Utilize offshore management company • Never sign contracts in U.S. • Never hold meetings or make official decisions in U.S.

19. Avoiding a U.S. Trade or Business • Critical for offshore captives not electing onshore tax treatment, but also relevant for compliance with state insurance “unauthorized business of insurance” laws • Potential double taxation - mainstream 35% corporate income tax plus additional 30% “branch profits” tax on profit repatriations from the U.S. • Goal - make captive a passive reimburser of already paid claims

20. Avoiding a U.S. Trade or Business • A factual determination • Determined anew each tax year • Main factors are continuity, regularity and substantiality of captive’s U.S. activities • Management situs test - where is captive’s “mind and management?” • Activity of employees and dependent agents attributed to captive; not independent agents

21. Avoiding a U.S. Trade or Business Suggested actions to avoid a U.S. business: • Prohibit U.S. meetings and contract signing in offshore captive’s corporate bylaws (called bye-laws in Bermuda) • Policy language should allow indemnitee to adjust claims with optional participation by captive • Parent’s risk manager should not be an officer or director of the captive; he/she should present claims report, etc. in capacity of consultant to the board

22. Bermuda Captive Investments A 30% non-recoverable federal “withholding” tax is imposed on certain U.S. investments: • All dividends paid on equities (common and preferred shares, ETFs) of U.S. issuers (except American Depository Receipts) • U.S. bond funds (3 year exception enacted in 2004 expired 1/1/08) (but no tax on portfolios comprised of individual bonds) • “Clone” bond funds formed in Ireland (UCITS) or Luxembourg (SICAVs) avoid this tax under applicable U.S. tax treaties • Avoid funds formed in the U.S. as trusts or partnerships

23. U.S. Tax Compliance The captive’s U.S. shareholder must file annually the following forms: • IRS Form 5471: show captive as an investment company • IRS Form 926: report all transfers to captive as capital contributions • Treasury Form TD F 90-22.1: all U.S. persons must disclose signatory authority over foreign bank accounts

24. U.S. Tax Compliance (Continued) • Making a Protective IRS Form 1120-F Filing • A foreign corporation that is engaged in a U.S. trade or business is subject to U.S. tax on its net income, not its gross income, but ONLY if it files a U.S. return in that year • If a foreign corporation is found to be engaged in a trade or business on audit and has not filed a U.S. return for the year in question, it will generally be taxed in the U.S. on its gross income (i.e., no deductions or credits allowed) • A foreign corporation can make a “protective” filing in any year even if it does not believe it has a U.S. trade or business by filing a Form 1120-F and indicating that the form is being filed for protective purposes • No need to show numbers; just name, address & FEIN

25. Summary of Hospital Captive Status • Not an “insurance company” for tax purposes • No federal excise tax imposed on premiums • No “unrelated business taxable income” to sole S/H • “Premiums” are not deductible for taxable affiliates • No violation of Illinois or Iowa insurance law • No captive activity in Illinois or Iowa • Self-funding, not true insurance • Policyholders representing most of the premium also qualify as “industrial insureds” • Foregoing not changed with coverage of controlled affiliates • But some major changes if non-employed physician practices are covered in the future

26. Goals of Corporate Governance Presentation • To provide an overview of ten key 2007-2008 corporate governance developments • To list underlying factors causing the subtle and ongoing shift in board focus from “guidance” to “compliance” • To alert attendees of important corporate governance developments so they can position themselves to anticipate upcoming changes

27. Development One: Environment of Skepticism • Healthcare providers are operating within an increasingly skeptical environment • Governmental (federal, state and local) • Media (biased?) • Patients, residents, families and service recipients • Standard setting associations, consumer advocacy groups, corporate payer alliances, etc.

28. Development Two: Best Practices 2.0 • Governance “best practices” continued to evolve in 2007-08, both through actions taken by leading nonprofit organizations and by report released by the Panel on the Nonprofit Sector’s “Principles for Good Governance and Ethical Practice”

29. Development Three: Conflict Avoidance • Closer emphasis on proper board and key committee (compensation, audit, compliance) composition generated by legislatures, regulators, media and public interest groups • Elimination of incestuous financial relationships created difficult decisions in the nominating process and narrowed the field of eligible independent candidates knowledgeable about the industry

30. Development Four: Conflicts Management • Issues associated with proper handling of existing director conflicts of interest and lack of independence continued to surface in 2008, placing boards under increasing pressure to address legislative/regulatory concerns with the integrity of the board’s decision-making process

31. Development Five: Executive Compensation • Matters relating to executive compensation paid by nonprofit, tax-exempt organizations, and the board’s role in approving such compensation, continued to be the source of close regulatory attention in 2008

32. Development Six: IRS and Governance • The IRS has dramatically increased its level of attention to the corporate governance practices of tax-exempt organizations, as manifested in multiple different ways • 2007-08 witnessed several important developments relating to the ability of nonprofit hospitals and health systems to qualify for both local (property tax) and federal (income) tax exemptions

33. Development Seven: Legal Controls • 2007 was particularly notable for a series of events which emphasize the importance of legal controls, and of a strong internal/general counsel function, within the organization

34. Development Eight: Quality of Care Oversight • A growing expectation of the board to exercise an increasing degree of oversight regarding quality as it relates to service performance, measurement tools and reporting requirements emerged during 2007

35. Development Nine: Financial Irregularities • An important 2007 development which “flew under the radar” is the dramatic increase in reported cases/allegations of financial impropriety involving corporate management of nonprofits

36. Development Ten: Proper Role of Board • The foregoing developments collectively contribute to a particularly significant shift in the role of the board from “guidance” to “compliance”

37. The Guidance Board • Traditional approach • Focused principally on providing management with strategic guidance • Advice and support versus direct oversight • Supportive of entrepreneurial spirit

38. The Compliance Board • Focused principally on organizational compliance with laws and regulations • Responsive to increasing legal/public opinions scrutiny • Mentality of “constructive skepticism” • Appreciation of enhanced oversight obligation • “Vigorous oversight” of corporate affairs

39. Emerging Governance Concerns • How far should corporate accountability extend? Cost/benefit analysis? • Do executives suffer from less direct expression of vision from the board? • Decline in “informed risk taking”? • Are boards becoming too reactive; too focused on regulation, compliance, whistle-blowing risks?

40. Questions

41. Thank You