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Tax Issues… Now and Later Southampton Princess June 24, 2009

Tax Issues… Now and Later Southampton Princess June 24, 2009. Tax Issues… Now and Later. Thomas M. Jones, Partner McDermott Will & Emery LLP 312 984 7536 tjones@mwe.com Catherine Sheridan Moore, Partner KPMG 441 294 2606 csheridan@kpmg.bm. Overview. Recap Why “insurance” matters

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Tax Issues… Now and Later Southampton Princess June 24, 2009

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  1. Tax Issues… Now and LaterSouthampton PrincessJune 24, 2009

  2. Tax Issues… Now and Later Thomas M. Jones, Partner McDermott Will & Emery LLP 312 984 7536tjones@mwe.com Catherine Sheridan Moore, Partner KPMG 441 294 2606 csheridan@kpmg.bm

  3. Overview • Recap • Why “insurance” matters • Tax definition of “insurance” • Recent IRS Pronouncements • Emerging Issues for 2009 and Beyond

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

  5. 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 captives • CFC – Subpart F • Possible IRC § 953(d) tax election

  6. 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 separate party • The second mandates that enough independent risks are being pooled to invoke the “actuarial law of large numbers”

  7. Tax Definition of “Insurance” • Case law has liberalized the tax definition of insurance by espousing two alternative approaches to achieving insurance tax treatment • Unrelated Risk • Brother-Sister Theory

  8. Revenue Ruling 2002-89: Unrelated Risk • 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

  9. Revenue Ruling 2002-89: Unrelated Risk Scenario 1 Scenario 2 * * P P <50% premium <50% of risks 90% premium 90% of risks Captive S Risks of P pooled with risks of unrelated insureds * Not insurance – lacks requisite risk shifting/risk distribution * Is insurance – premiums paid by P are deductible

  10. Revenue Ruling 2002-90: 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!

  11. Revenue Ruling 2002-90: Sibling Ruling Ruling: Arrangement between Captive and 12 subsidiaries of Captive’s parent constitutes insurance P 12 subsidiaries Insurance Solely insures professional liability risk of each of the 12 subsidiaries

  12. The Brother/Sister ApproachHumana, Inc. v. Comm’r. • 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 • Brother-sister approach applies to subsidiaries, but not to either parent or divisions

  13. Revenue Ruling 2002-91: Group Captives • Captive constitutes an “insurance company” and premiums paid by participants are deductible • 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

  14. Revenue Ruling 2002-91: Group Captives Ruling: Arrangement, based on facts, held as insurance UNRELATEDMEMBERS no Member owns>15% of Captive Premiums GroupCaptive

  15. Post Rulings 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 • IRS refers to its new approach as a “facts and circumstances” test

  16. 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 • Captive operates on an arm’s length basis in a manner similar to that of commercial insurers

  17. Tax Classification of Insurance Companies All entities eligible for “insurance company” federal tax treatment are per se corporations under § 7701(a)(3) Thus, there is no such thing as pass-through tax treatment for an “insurance company” even if it’s formed as a LLC, LLP or trust under state/local law 17

  18. U.S. Taxation of Offshore Captives • Offshore captive tax issues include: • Imputed federal income tax on U.S. share-holders of controlled foreign corporations (Subpart F income) • Related party insurance income (“RPII”) • Direct “mainstream” income tax plus potential branch profits tax if engaged in a U.S. trade or business • Federal 30% withholding tax (discourages loan backs) • Federal excise tax on premiums of 4% or 1%

  19. U.S. Taxation of Offshore Captives • IRC 953(d) election: • Taxed as if a domestic (“U.S.”) insurance company • Direct taxation • No Federal withholding tax • No FET

  20. Emerging Issues for 2009 and Beyond • Notice 2005-49, IRS requested taxpayer comments on 4 captive related subjects: • Finite risk policies as “insurance” (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

  21. Future Tax Challenges for Captives • In short term, cash stress = more loan backs • Mid-term, more captive IRS audits • Longer term, parent’s tax losses will mean insurance tax status of captive less important • In long term, likely future tax rate reversal with corporate rates < individual rates means fewer S corp, LLC, etc. pass-thru structures and more “C corp” families eligible for tax benefits based on brother/sister risk 21

  22. Recent IRS Cell Captive Guidance 22

  23. IRS 2009-10 Priority Guidance Plan • Released 9/10/08 – Captive related matters listed: • “Guidance on the classification of certain cell captive insurance arrangements. Previous guidance was published in Notice 2008-19.” • “Revenue ruling providing guidance on reinsurance arrangements entered into with a single ceding company.” • “Guidance concerning the classification of series LLCs and cell companies under §7701.”

  24. Key Tax Considerations of the Cell Captive Who is the taxpayer? Entire company Each cell viewed separately The sponsor organization or the participant At what level is the determination of “insurance” status made? Entire company level Cell level The sponsor organization or the participant level 24

  25. Cell Companies: Rev. Rul. 2008-8 General Account Y Preferred Shares Preferred Shares Insurance Policy X Cell X Cell Y Insurance Policy Covering Brother/Sister Group 1 12 • Adequate capital • No subsidiary < 5% nor >15% • No loans • No guarantees by Y or Y1 → Y12 of Cell Y obligations • No other insurance contracts • Homogeneous risk • Annual policy • No Insured except for X • No guarantee of Cell X obligations • Adequate capital • No loans • Annual policy 25

  26. Cell Companies: Rev. Rul. 2008-8 Look to existing rules; apply on cellular basis Risk shifting Risk distribution Arrangement between X and Cell X akin to a parent and wholly-owned subsidiary under Rev. Ruls. 2002-89 & 2005-40 Arrangement between Y and Cell Y characterized as brother/sister insurance under Rev. Rul. 2002-90 Should have been a 3rd situation in which Cell Z owned by Z wrote over 50% unrelated risk with holding of insurance under Rev. Rul. 2002-89 26

  27. Cell Companies: IRS Notice 2008-19 Proposed Guidance Cell of a PCC would be treated as an insurance company separatefrom any other entity if: Assets and liabilities are legally segregated Based on facts and circumstances cell would be classified as an insurance company taxable under IRC § 816(a) or § 831(c) Tax Effect Elections at cell level Cell must apply for FEIN if subject to U.S. tax jurisdiction Cell activities not taken into account in characterizing PCC’s “general account” (core) Cell (or parent, if consolidated) responsible for filing returns and paying tax PCC does not include income items with respect to cell 27

  28. To implement this guidance, taxpayer comment requested by 5/5/08 regarding: Transitional rules Reporting, if any, necessary to ensure PCC has needed information Special rules regarding foreign entities (including CFCs) Treatment of PCCs and cells under consolidated return rules How to handle segregated arrangements not involving insurance Note explicitly states no inference should be inferred as to tax status of PCC core or its non-insurance cells Effective date would be for tax years beginning more than 12 months after this guidance is finalized Cell Companies: IRS Notice 2008-19 28

  29. Chief Counsel Advice 200849013 • Offshore cell captive that made an onshore tax election • Wholly owned by a mutual with numerous unrelated policyholder/member-owners • IRS assumed each cell is a separate taxpayer • Each cell was tied to a specific mutual member via a participation agreement • Held Cell 1 qualifies under the brother-sister test – IRS agent was wrong to aggregate 1st & 2nd tier subs • No IRS conclusion on aggregate analysis versus by lines of business because IRS position on homogeneity issue remains unclear as of the CCA release date (12/5/08)

  30. Recent IRS Federal Excise Tax Guidance 30

  31. U.S. Federal Excise Tax • “Insurance Premiums” received by a non-U.S. Captive from a U.S. (re)insurer are subject to a U.S. excise tax • Exceptions for • 953(d) electing companies • Those engaged in a U.S. trade or business • Treaty provisions • Tax Rates – on gross premiums • Direct P&C insurance – 4% • Reinsurance & Life – 1%

  32. Cascading of Federal Excise Tax • In Rev. Rul. 2008-15, the IRS announced that it will impose a 1% excise tax on every subsequent reinsurance transaction associated with U.S. risks. • Rev. Rul. 2008-15 sets forth four situations to demonstrate this principle with and without applicable tax treaties.

  33. Example – U.S. Federal Excise Tax (“FET”) USFront Premium $ Will FET apply? If so, at what rate? Bermuda Captive Will FET apply to this cession? Premium $ Bermuda Reinsurer

  34. Cascading of Federal Excise Tax Voluntary Compliance Initiative • IRS Announcement 2008-18 states that the IRS will not seek to collect the cascading taxes for periods prior to October 1, 2008, from insurance companies that agree to collect such taxes at all times on or after October 1, 2008 • If an insurance company does not agree to do so, then the IRS can collect those taxes for all prior and future periods

  35. Recent IRS Tax Rulings

  36. PLR 200910066 - Released 3/06/09 • Insurer in run-off qualified as an insurance company since >50% of its business during the year involved (re)insurance • Did not qualify for tax exempt status since it did not meet the 50% gross receipts test (as it had no premiums)

  37. PLR 200907006 - Released 2/13/09 • Offshore captive owned by Individual A with onshore tax election • Direct writes numerous barely related domestic poIicyholders • Also participates (as cedant and reinsurer) in same foreign jurisdiction risk pool with >12 unrelated participants no one of which accounts for >15% of total pooled risk • Mostly in extraction industry so risks mostly are homogeneous • No guarantees by any related party and captive is well capitalized • PLR concludes captive is a bona fide insurance company applying the group captive standards of Rev. Rul. 2002-91 • But seems like the unrelated risk standards of Rev. Rul. 2002-89 would be a more appropriate basis for reaching this taxpayer favorable result

  38. FAA 20092101F - Released 2/4/09 • Field Attorney Advice invokes long dormant IRC §845 • Super-§482 transfer pricing adjustment provision applies to reinsurance • Insurer used quota share reinsurance to transfer profitable business into subsidiary reinsurer (offshore with §953(d) election) • Motive: Sub had net operating tax losses isolated under DCL rules • IRS conceded transaction was not a sham and reinsurance was real • IRS viewed surplus relief of ceding company generated by transaction to be unnecessary and wouldn’t have occurred but for tax benefit • IRS applied §845(b) stating business reason for reinsurance transaction is irrelevant if “significant tax avoidance effect” occurs • Note §845 applies to both related party and unrelated party reinsurance • A “wild card” that the IRS can play in many factual situations

  39. CCA 200844011 - Released 10/31/08 • Involves an offshore contractual risk pooling arrangement among wholly owned domestic captives of numerous unrelated U.S. parents • The pool operates through committees meeting offshore and is managed by an offshore captive manager • Holds that notwithstanding non-entity legal status, for tax purposes the pool functions and is taxable as a reinsurance company under § 7701(a)(3) • Thus, the pool is classified as a foreign reinsurer covering U.S. risks of the captives’ policyholders • As a result, federal excise tax is imposed (presumably at a 1% rate) on premiums paid to the pool

  40. PLR 200837041 - Released 9/12/08 • Offshore mutual group captive lost (c)(15) status and 953(d) election revoked due to lack of risk distribution; insufficient insurance activity • Concedes “no court has squarely held that there can be no risk distribution if there is only one, or a few, insureds.” • But indicates “risk distribution in terms of exposure units is computed by line of business” citing FSA 1998-578 for a homogeneity requirement (but compare CCA 200849013, already discussed) • PLR states that too much income derived from investments rather than premiums and that the taxpayer was over-capitalized • PLR says taxpayer “had no employees, no sales staff or clerical staff” and there was “no promoting or selling of insurance services” • Taxpayer apparently failed to conduct level of insurance activity indicated in its tax exemption application

  41. TAM 200827006 - Released 7/4/08 • Embedded warranty, similar to PLR 200628018, but latter deals with manufacturer itself while this ruling deals with retailer assuming and covering manufacturers’ warranty obligations • Non-insurance status of embedded warranty applies to both manufacturer branded products and taxpayer branded products • IRS rationale is lack of fortuity because “insurance does not guarantee the integrity of an item” but rather covers “outside perils” • Here the product likely was defective when shipped and sold, so the problem was under the manufacturer’s control, was not accidental and therefore is a business rather than an insurance risk • IRS asserts shifting the risk to the retailer’s captive does not change the nature of the underlying risk

  42. TAM 200824028 - Released 6/13/08 • Captive allegedly in run-off lost (c)(15) status and 953(d) election revoked • Taxpayer’s argument that more extensive insurance activities in prior years should count in year under audit rejected: “the test is applied on a year to year basis” • IRS concedes insurers in run-off can retain insurance company tax status, but notes taxpayer’s activities not consistent with a run-off company as it “did not undertake any efforts to either expedite closing the run-off business or develop additional [insurance] business” • Also held taxpayer was a member of a controlled group causing it to exceed the then applicable statutory $350,000 premium limitation

  43. TAM 200816029 – Released 4/18/08 Where a partnership is the named insured in a captive insurance arrangement, is the partnership or the partners the insureds for determining adequacy of risk distribution? The IRS determined that the: The partners are the insureds if it is a general partnership The partnership is the insured if there are no general partners and no liability could attach to anyone other than the partnership (i.e., a multi-member LLC choosing partnership taxation)

  44. A Few Problems with TAM 200816029 Fails to discuss the aggregate vs. entity theory surrounding proper tax treatment of partnership items Disregards the partnership as the named insured Does not consider the existence of multiple, independent risks in determining risk distribution Fails to comport with business realities – e.g., most limited partnerships have a single general corporate partner with nominal capital, yet all risks are attributed to it

  45. Questions

  46. Circular 230 • ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING,  MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. • Any advice in this communication is for the sole benefit and use of our client and should not be relied upon by any other person. Any other person who chooses to rely on this advice does so at their own risk. The advice is limited to the conclusions specifically set forth herein and is based on the completeness and accuracy of the stated facts, assumptions and/or representations included.  In rendering our advice, we may consider tax authorities that are subject to change, retroactively and/or prospectively, and any such changes could affect the validity of our advice.  We will not update our advice for subsequent changes or modifications to the law and regulations, or to the judicial and administrative interpretations thereof.

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