Tax Update Impact of Latest IRS Captive Rulings

1. Tax Update &Impact of Latest IRS Captive Rulings Thomas M. Jones, Partner McDermott Will & Emery LLP 312 984 7536tjones@mwe.com Catherine Sheridan Moore, Partner KPMG 441 294 2606 csheridan@kpmg.bm

2. 2 Overview Recap Why “insurance” matters Tax definition of “insurance” Recent IRS rulings Offshore Federal Tax Consideration Federal Excise Tax – Basics Captives with Tax Exempt Shareholder(s) Cell Company Structure – Tax Analysis Emerging Issues for 2005 and beyond

3. 3 Taxation of Captives The key tax question: Will it be treated as “insurance for tax purposes?”

4. 4 Why “Insurance” Matters ? Tax deduction for premiums paid to captive by policyholder Favorable insurance tax treatment of captive (deduction for discounted insurance reserves, unearned premiums) Offshore CFC captives - Subpart F income Domestic captives - direct federal income tax Offshore captives Possible IRC Sec. 953(d) onshore tax election

5. 5 Tax Definition of “Insurance Company” New Section 831(c) codified definition of P&C “insurance company” Only prior statutory definition was for life insurance companies Section 816(a) “any company, more than half of the business of which during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies” New Section 831(c) incorporates the Section 816(a) definition by reference Effect of New Section 831(c) Codifies existing law Similar definition was provided in case law and Treas. Reg. sec. 1.801-3(a)(1) More than half of the captive’s business activities must be related to insurance Net income derived from insurance activities

6. 6 Tax Definition of “Insurance Company” For tax years beginning after December 31, 2003 Gross receipts cannot exceed $600,000 (on a controlled group basis) >50% of gross receipts consist of premiums

7. 7 Rev. Proc. 2002-75 IRS “PLR OK” For many years, the IRS has included rulings on tax status of captives as an issue on which it does not ordinarily rule. “The Service will now consider ruling requests regarding the proper tax treatment of a captive insurance company.”

8. 8 Tax Definition of “Insurance” To find insurance, the IRS and the courts have historically required the presence of both risk shifting and risk distribution The first criterion connotes the transfer of the risk to a separate party The second mandates that enough independent risks are being pooled to invoke the “actuarial law of large numbers”

9. 9 Tax Definition of “Insurance” No statutory or regulatory definition of “insurance” - only cases and rulings A gray area existed between 1 and 31 insureds, but a rule of thumb is that “more than several” unrelated insureds pooling risk should create insurance Case law has further liberalized the tax definition of insurance Unrelated Risk Brother-Sister Theory

10. 10 IRS’s Historical Position –The Economic Family Doctrine In Rev. Rul. 77-316, the IRS first announced its position that risk shifting and distribution do not exist in the context of a single economic family Exception: In Rev. Rul. 78-338, the IRS conceded that sufficient risk shifting and distribution are present where 31 unrelated parties pool risks

11. 11 Revenue Ruling 2002-91 – Group Captive Ruling Industry group liability captive; exact number of participants not specified No member owns over 15%; has over 15% of vote; or accounts for over 15% of risk/premium; implies 7 equal owners OK No assessments or refunds Valid non-tax business purpose was a key factor IRS reinforces prior rulings on group captive insurance arrangements

12. 12 Revenue Ruling 2002-91

13. 13 The “Unrelated Risk” Approach Computation of Allstate’s income using favorable insurance company provisions Tax deductibility of Sears’ premiums paid to Allstate

14. 14 The “Unrelated Risk” Approach

15. 15 Revenue Ruling 2002-89 –Unrelated Risk Ruling Single parent captive otherwise properly formed and operated (adequate capital, no parent guarantees, loan backs, etc.) Not “insurance” if 90% of risks/premiums come from the parent “Insurance” if less than 50% come from the parent and the remainder are from unrelated parties

16. 16 Revenue Ruling 2002-89

17. 17 Taxpayer’s Theory –The “Balance Sheet” Approach Risk shifting and risk distribution may exist within an economic family Risk shifting exists where the risk of loss is transferred off the policyholder’s balance sheet  Risk distribution exists where the risk of loss is distributed among independent policyholders (even within a family)

18. 18 The Brother / Sister Approach No tax deduction for payments from parent to subsidiary Tax deductibility of subsidiaries’ premiums paid to captive (brother - sister premiums)

19. 19 The Brother / Sister Approach Established a 3 Part Test: “Insurance risk” / Not a sham corporation Commonly accepted notion of insurance Risk shifting & risk distribution present Parent guaranty caused denial of premium deduction for period it was in existence Bermuda regulatory regime accepted Brother-sister approach applies to subsidiaries, but not to divisions

20. 20 IRS Ruling Concedes “Economic Family” Theory in June 2001 In Rev. Rul. 2001-31, the IRS abandoned its position that risk shifting and distribution do not exist in the context of a single economic family It now appears arm’s length premium and loss reserve deductions attributable to brother-sister risk (i.e., other affiliates of the parent) will be accepted by the IRS But premium and loss reserve deductions attributable to parent risk will not be allowed without presence of significant (30%?)(50%?) unrelated party risk measured by premiums

21. 21 Revenue Ruling 2002-90 – IRS Sibling Ruling Single parent captive otherwise properly formed and operated (adequate capital, no parent guarantees, loan backs, etc.) Insures 12 domestic subs - parent a holding company; no sub accounts for less than 5% or over 15% of total risk/premium “Insurance” under brother/sister doctrine Note - captive had an insurance license in all states in which it provided subsidiary coverage!

22. 22 Revenue Ruling 2002-90

23. 23 Post Ruling Caveats The captive must still establish: Presence of risk distribution That the captive should be respected as a separate and distinct taxable entity, i.e., it is not a sham

24. 24 Non-Sham Status Insurance status continues to require respect for the captive as an entity separate and distinct from its economic family: Valid non-tax business purpose Adequate capitalization (maximum 5:1 premium/surplus ratio recommended) No parental support agreements Limited loan backs of captive assets to parent or affiliates (“circularity of cash flow”) Formation of captive in other than a weakly or non-regulated offshore domicile

25. 25 Revenue Ruling 2005-40 The IRS analyzed 4 hypothetical captive arrangements and concluded that 3 of the 4 lacked risk distribution, a hallmark of “insurance” status. Prior to Rev. Rul. 2005-40, the IRS’s position regarding risk distribution was unclear, primarily because published IRS (and judicial) guidance focused on risk shifting, the other hallmark for insurance status. Rev. Rul. 2005-40 is a clear articulation of the IRS’s current position that risk distribution entails two elements. First, a significant number of independent, homogeneous risk exposures must be transferred to the captive, such that the law of large numbers takes effect. And second, the risk exposures transferred to the captive must derive from at least several “independent” entities from a Federal income tax perspective.

26. 26 Revenue Ruling 2005-40 Situation 1 X owns and operates a large fleet of vehicles Vehicles represent a significant volume of independent, “homogeneous” risk X enters into an arrangement with unrelated Y where in exchange for “premiums”, Y agrees to “insure” X against risk of loss with respect to X’s vehicle fleet Y does not “insure” any entity other than X

27. 27 Revenue Ruling 2005-40 Situation 2 Same as Situation 1, except that Y also “insures” unrelated Z in exchange for “premiums against risk of loss with respect to Z’s vehicle fleet in the conduct of a business substantially similar to that of X Y’s earnings from its arrangement with Z constitute 10% of Y’s total amount earned (both gross and net) during the year and the risk exposure attributable to Z comprise 10% of the total risk borne by Y

28. 28 Revenue Ruling 2005-40 Situation 3 X conducts a courier business through 12 LLCs that are disregarded entities for Federal Income tax purposes The LLCs own a fleet of vehicles that represent a significant volume of independent, homogeneous risk Each of the LLCs enters into an arrangement with Y where unrelated Y agrees to “insure” the LLC against risk of loss with respect to its vehicle fleet Y does not “insure” any entity other than the LLCs None of the LLCs account for less than 5%, or more than 15% of the total risk assumed by Y

29. 29 Revenue Ruling 2005-40 Situation 4 Same as Situation 3, except that the 12 LLCs elect to be treated as corporations for Federal income tax purposes

30. 30 Revenue Ruling 2005-40Holding The IRS concluded that, although each of the arrangements satisfied the risk shifting requirement for insurance status, risk distribution was lacking in Situations 1, 2 and 3. Accordingly, only Situation 4 constituted “insurance” from a Federal income tax perspective. The IRS did not, however, provide a clear indication of the manner in which Situations 1, 2 and 3 should be treated for Federal income tax purposes. Rather, the IRS stated that a range of “non-insurance” characterizations could apply, i.e., a deposit arrangement, a loan, a contribution to capital (to the extent of the net value, if any), an indemnity arrangement that is not an insurance contract, or otherwise. The potential non-insurance characterizations can have dramatically different consequences from a Federal income tax perspective.

31. 31 Revenue Ruling 2005-40Risk Shifting Risk shifting, which looks to whether the insureds transferred the financial consequences of a potential loss to the insurer, was found to exist in all four Situations. The rationale, although unstated, was that the purported insurer, Y, was unrelated to the insureds. This conclusion is consistent with existing authority. See Humana v. Com’r, 881 F.2d 247 (6th Cir. 1989); Kidde Industries v. U.S., 40 Fed. Cl. 42, 54 (Fed. Cl. 1997); Rev. Rul. 2001-31; Rev. Rul. 2002-89; Rev. Rul. 2002-90.

32. 32 Revenue Ruling 2005-40Risk Distribution Risk distribution, on the other hand, was found to be lacking. In reaching that conclusion, the IRS ruled that risk distribution has two elements. First, the insurer must assume a significant number of independent, homogenous risk exposures for the law of large numbers to apply. This allows the insurer to smooth out losses to match more closely its receipt of premiums.  And second, the insurer must pool the premiums (and risk) from a particular insured with the premiums (and risk) of other insureds, such that the insured is not “in significant part paying for its own risks.”

33. 33 Revenue Ruling 2005-40Risk Distribution (Continued) The first requirement for risk distribution was satisfied because a significant number of independent, homogenous risk exposures were transferred to Y, the purported insurer. The second requirement was not satisfied in Situations 1, 2 and 3. Situation 1 involved a single insured, so there was no pooling of premiums by Y. 90% of the risk (and premiums) transferred to Y in Situation 2 derived from a single insured, X. Thus, there was not a sufficient pooling of X’s premiums. It is possible, however, that there was a sufficient pooling of Z’s (the 10% insured’s) premiums to create risk distribution for Z (potentially resulting in characterization of Z’s payments as deductible “insurance premiums”). Situation 3 involved multiple insureds for state law purposes, but the insureds were treated as a single entity for Federal income tax purposes. The IRS concluded that, as a result, Situation 3 should be treated the same as Situation 1. In contrast, Situation 4 created risk distribution because numerous (albeit related) entities that were “regarded” for Federal income tax purposes transferred risk and premiums to Y.

34. 34 Revenue Ruling 2005-40Comments No attempt was made to reconcile Rev. Rul. 2005-40 with prior judicial and IRS guidance indicating that a single insured can create sufficient risk distribution. Gulf Oil v. Comm’r, 89 T.C. 1010, 1025-1026 (1987) (“a single insured can have sufficient unrelated risks to achieve adequate risk distribution”). 1998 FSA Lexis 167 (“a single taxpayer may transfer an amount of homogenous and statistically independent risks which would be sufficient to satisfy the risk distribution requirement”). Other authority interpreting the risk distribution requirement is arguably ambiguous. Accordingly, some taxpayers may continue to take the position that multiple insureds are not needed to satisfy the risk distribution requirement. Given the lack of authority and the IRS’s contrary position, there is a material possibility that in those situations, risk distribution (and, therefore, insurance status) will ultimately be found to be lacking.

35. 35 General Offshore Federal Tax Considerations Offshore captive tax issues include: Imputed federal income tax on controlled foreign corporations (Subpart F/CFCs) Related party insurance income (“RPII”) Branch profits tax Federal withholding tax Federal excise tax

36. 36 Federal Excise Tax – The Basics Applies to premiums paid to foreign insurers/reinsurers covering U.S. risks 4 percent on “direct” property & casualty policies 1 percent on life policies and all reinsurance Generally withheld and remitted (quarterly on IRS Form 720) by payer of premium If not a deductible “insurance” premium, then FET N/A – Rev. Rul. 78-277 Also N/A if onshore tax election is made or tax treaty applies (Bermuda and Barbados N/A)

37. 37 Taxation of Captives with aTax-Exempt Owner Goal to avoid “insurance company” status for captive If not insurance, then can avoid federal excise tax and state “self-procurement” tax on premiums If not insurance, then can avoid “unrelated business taxable income” to tax-exempt parent

38. 38 1996 Federal Income Tax Legislation Applicable to Offshore Captives Owned by Tax Exempt Organizations Insurance (e.g. underwriting and investment) income generally creates “unrelated business taxable income” to tax exempt owners Sec. 512(b)(17) imposes “look through” rule invoking Sec. 501(m) “commercial type insurance” UBTI Special rule exempts hospitals, colleges and universities exclusively using policyholder (not shareholder) dividends Certain tax exempt affiliates are considered within the economic family if “significant common purposes and substantial common ownership” exist Sec. 512(b)(17) is inapplicable if no “insurance” is present (e.g., most single parent captives are unaffected)

39. 39 Cell Company Structure

40. 40 Will Cells’ Separateness Be Respected in Court ? Segregation concept seems valid, but not yet judicially tested Two key factors to enhance success: Governing law/venue must be the domicile Cell assets should be located in the domicile Reason: contrary to insolvency principle of horizontal “equitable distribution” of assets to creditors; cell structure is a vertical distribution only within the cell

41. 41 U.S. Tax Analysis of Cell Companies Single Company ? Multiple “mini-corporations” ? Is Risk Sharing determined on a Cell-by-Cell or on a Company-Wide basis ?

42. 42 More Emerging Issues for 2005 and Beyond Notice 2005-49, IRS requests Taxpayer comments on 4 subjects: Finite risk policies (in captive arrangements) Proper characterization of cell captive structures as “insurance” and mechanics of making elections Tax consequences of loan-backs from a captive to its owner(s) Homogeneity of risk as a key element of risk distribution

43. 43 28 Years of Captive Taxation QUESTIONS