Captive Insurance Company Tax Update

1. Captive Insurance Company Tax Update 19 June 2008

2. Agenda • Panelists • History of the Federal Taxation of Captives • Recent Developments

3. Panelists • Mary Gillmarten, Director • Deloitte & Touche LLP, Washington, D.C. • P. Bruce Wright, Partner • Dewey & LeBoeuff, LLP, New York • Richard E. Irvine, Partner • PricewaterhouseCoopers, Hamilton, Bermuda

4. Captive Insurance Companies – History of Federal Taxation of Captives FAS 5 Standard for accruing liabilities • “Estimable and Probable” Standard US Tax Standard for deducting accrued liabilities under IRC §461 “Economic Performance Standard” • Liability must be “fixed and determinable • Economic performance occurs w/in 8 ½ months (i.e., payment) restrict deductibility to ‘cash method US Insurance Company Taxation (Subchapter L): • May establish (i.e., deduct) a reserve which is ‘fair and reasonable’ • May earn certain revenues over period of obligation (Extended Service Contracts) • The contractual shifting of risks to a qualified captive establishes US GAAP/Tax parity Result Balance Sheet Monetization

5. Captive Insurance Companies – History of Federal Taxation of Captives 1941 – No statutory or regulatory definition of “insurance,” but U.S. Supreme Court said, for tax purposes, “insurance” must include: • Insurance Risk • Risk Shifting • Risk Distribution • Common notions of insurance • Helvering v. LeGierse, 312 U.S. 531 (1941) 1977 – IRS issues Revenue Ruling 77-316, which establishes “economic family” doctrine, e.g., no insurance between related parties 1978-1990 – Series of court cases denying captive benefits • Carnation v. Commissioner, 71 T.C. 400 (1978), 640 F .2d 1010; 1981 • Parental Guaranty • Clougherty Packing v. Commissioner, 84 T.C. No. 61 (1985), 811 F.2d 1297; 1987 • First application of the “Balance Sheet Theory”

6. Captive Insurance Companies – History of Federal Taxation of Captives 1978-1990 – Series of court cases denying captive benefits (Continued) • Gulf Oil Corporation v. Commissioner, 89 T.C. 1010 (1987), 914 F.2d 396; 1990 • 2% unrelated risk insufficient • Mobil Oil, Stearns-Rogers, Beech Aircraft 1989 – Revenue Ruling 89-72 • No amount of “unrelated risks” will enable risk shifting

7. Captive Insurance Companies – History of Federal Taxation of Captives 1989 – Taxpayer wins in Humana in the 6th Circuit Court of Appeals • Balance Sheet Theory applied (Brother/Sister distinguished from Parent/Subsidiary) 1991-1993 – Taxpayer wins in AMERCO, Harper, Sears and ODECO based upon significant levels of ‘unrelated risk’ • Technical risk shifting • Risk shifting in substance 1993 – IRS issues Revenue Rulings 92-93 and Ruling 92-94 which conclude that employee benefit risks are “unrelated risks” 1997 – Taxpayer wins in HCA and Kidde open brother/sister captive to all Circuits 1999 – Tax Analyst files FOIA request to have access to Field Service Advices. Review of FSA’s indicate IRS has been conceding captive cases since 1993

8. Captive Insurance Companies – History of Federal Taxation of Captives 2001 – IRS issues Revenue Ruling 2001-31 and ‘obsoletes’ all prior captive rulings dealing with economic family • will still pursue captive issue on “facts and circumstances” • will look for “thinly capitalized” captives and presence of “parental guarantees and hold harmless agreements” 2002 – Revenue Procedure 2002-75 IRS will now rule on captive insurance transactions (formerly a no rule area) and IRS Issues Revenue Rulings affirming insurance tax treatment

9. Captive Insurance Companies – History of Federal Taxation of Captives 2002 – Revenue Ruling 2002-89 – Premium payments from parent and from subsidiaries are deductible provided: • Third party premium constitutes 50% or more of total premium, • Risks are homogeneous • Common notions of insurance are satisfied • No loanbacks • Premium payments from parent are not deductible when: • Third party premium constitutes 10% or less of the total premium • Revenue Ruling 2002-90 – brother/sister subsidiaries insure professional liability risks with captive • 12 or more insured subsidiaries • No insured accounts for less than 5% or more than 15% of total risk insured by captive • Homogeneous risks • Captive licensed in each state it does business • No loanbacks

10. Captive Insurance Companies – History of Federal Taxation of Captives • Revenue Ruling 2002-91 - group captive insures professional liability risks of its shareholders • Number of insureds is not disclosed; however, no insured accounts for less than 5% or more than 15% of total risk insured by captive (implies 7 or more owners) • Homogeneous risks • Captive licensed in each state it does business • No loanbacks

11. Captive Insurance Companies – History of Federal Taxation of Captives 2004 – Pension Funding Equity Act of 2004 • Clarifies definition of “insurance company” for non-life insurance company purposes • More than half of the business during the year is the issuance of insurance, reinsurance or annuity contracts • Changes qualification standard for “tax exempt” status under IRC Section 501(c)(15) • $600,000 gross receipts limitation • 50% or more must be (re)insurance premiums • Changes the qualification standard for “small insurance companies” under IRC Section 831(b) • $0 - $1,200,000 premium limitation

12. Captive Insurance Companies – History of Federal Taxation of Captives 2005 – Revenue Ruling 2005-40 • IRS sets forth its position on “risk distribution” • Examined 4 Situations • Single Unrelated Insured = not sufficient risk distribution • Two Unrelated Insureds (90/10 concentration) = not sufficient risk distribution • 12 LLC’s (disregarded entities) = SMLLC’s are not viewed as separate entities so a single insured, no risk distribution • 12 LLC’s elect to be treated as associations (check the box) = multiple insureds, adequate risk distribution

13. Captive Insurance Companies – History of Federal Taxation of Captives 2005 – IRS Notice 2005-49 • IRS requested comments to develop additional guidance in the captive taxation area • Specifically, the Service requested input regarding • What factors should be taken into account in determining whether a cell captive arrangement constitutes insurance and if so, the mechanics of federal elections (i.e., IRC Sections 953(d) and 953(c)(3)(C)) • Affect of loanbacks of premiums on a related party insurance arrangement • Relevance of “homogeneity” on whether risks are adequately distributed • Issues raised by finite risk transactions

14. Captive Insurance Companies – Recent Activity PLR 200644047 • The IRS ruled that an organization did not qualify for tax-exempt status under section 501(c)(15) because its insurance arrangement had no risk distribution. • Taxpayer's sole shareholder is X, a corporation that contracts with physicians and other medical service providers, as independent contractors. • Taxpayer has no employees and issued one purported insurance contract each in 2002 and 2003, identifying X as the "Name Insured" and several other parties as "Insureds." • The other “Insureds” included approximately 30 physicians. • For each relevant policy year, the premium was paid by X on behalf of all the insureds. • The IRS reasoned that even though there were purportedly multiple insureds under the policy, the only risks insured were those that arose in connection with providing medical services to Named Insureds' own clients. As such, it appeared likely that a claim against any Insured would necessarily entail a claim against the Named Insured as well.

15. Captive Insurance Companies – Recent Activity 2006 – Proposed Regulations under 1.1502-13(e)(2) • Involved the treatment of insurance transactions involving obligations between members of a consolidated group • Under current regulations (1.1502-13(e)(2)(ii)(A)), if a member provides insurance to another member in an intercompany transaction, the transaction is taken into account on a separate entity basis • Under the proposed regulations, where a significant portion (5% or more) of the business of the insuring member arises from insuring other members, the Service deemed it appropriate to take the items in the transaction into account on a single entity basis • The proposed regulations had the effect of eliminating the tax benefits associated with captive insurance transactions in a consolidated group, which have been provided for by the courts in a number of captive insurance cases arguing against the Service’s “economic family” theory. • On February 20, 2008, the IRS withdrew the portion of the proposed regulations relating to the treatment of transactions involving the provision of insurance between members of a consolidated group, in response to the comments received • According to the IRS, it will “continue to study whether revisions to the rules of intercompany transactions are necessary to clearly reflect the taxable income of consolidated groups.”

16. Captive Insurance Companies – Recent Activity Revenue Ruling 2007-47 • X, a domestic accrual method corporation, was engaged in a business process that was inherently harmful to people and property. As a result, government regulations required X to remediate the harm, requiring X to incur future costs in order to restore X’s business location to its condition before X’s business began. • The exact amount and timing of the future costs were a function of many unknown factors; however, there was no uncertainty that the future costs would be incurred. • X estimated the present value of the future costs ($150x) and entered into an arrangement with an unrelated insurance company (IC) to reimburse X for its future costs, up to a limit of $300x. • The IRS concluded that the arrangement lacked the requisite insurance risk to constitute insurance. There was certainty that IC would have to perform under the arrangement, so the arrangement was pre-funding by X of its future obligations. • The central theme is that an arrangement that lacks fortuity fails to qualify as insurance for tax purposes.

17. Captive Insurance Companies – Recent Activity PLR 200746003 • Group captive ruling where an undisclosed number of companies in a group captive insure homogeneous risks. • The Taxpayer requests a ruling not to be taxed as an insurance company under IRC Section 831(c) • Service applies Revenue Ruling 2002-91 • IRS notes that each participating entity is in significant part paying for its own risks • Notes that several members constitute > 15% of the risks insured by the captive • There is not adequate risk distribution because there are too few members (less than the number implied in Revenue Ruling 2002-91) because several members constitute > 15% of the risks. • Service concludes a lack of risk distribution and no insurance.

18. Captive Insurance Companies – Recent Activity Final Regulations under 1.6012-2 • 1.6012-2(c)(2)--Domestic nonlife insurance companies. • Every domestic insurance company other than a life insurance company shall make a return on Form 1120-PC, "U.S. Property and Casualty Insurance Company Income Tax Return." This includes organizations described in section 501(m)(1) that provide commercial-type insurance and organizations described in section 833. Except as provided in paragraph (c)(4) of this section, such company shall file with its return a copy of its annual statement (or a pro forma annual statement), including the underwriting and investment exhibit (or any successor thereto) for the year covered by such return. • 1.6012-2(c)(4)--Exception for insurance companies filing their Federal income tax returns electronically. • If an insurance company described in paragraph (c)(1), (c)(2), or (c)(3) of this section files its Federal income tax return electronically, it should not include on or with such return its annual statement (or pro forma annual statement), or any portion thereof. Such statement must be available at all times for inspection by authorized Internal Revenue Service officers or employees and retained for so long as such statements may be material in the administration of any internal revenue law. See 1.6001-1(e).

19. Captive Insurance Companies – Recent Activity Final Regulations under 1.6012-2 • 1.6012-2(c)(5) -- Definition. • For purposes of this section, the term annual statement means the annual statement, the form of which is approved by the National Association of Insurance Commissioners (NAIC), which is filed by an insurance company for the year with the insurance departments of States, Territories, and the District of Columbia. The term annual statement also includes a pro forma annual statement if the insurance company is not required to file the NAIC annual statement. • 1.6012-2(k) – Effective/applicability date. • Paragraph (c) of this section applies to any taxable year beginning on or after May 30, 2006. However, taxpayers may apply paragraph (c) of this section to any original Federal income tax return (including any amended return filed on or before the due date (including extensions) of such original return) timely filed on or after May 30, 2006. For taxable years beginning before May 30, 2006, see 1.6012-2 as contained in 26 CFR part 1 in effect on April 1, 2006. • IRS acknowledges that "pro forma" is not defined, and advises to prepare financial statements that provide sufficient information for the Service to understand a company's activities. For example: • Vintaging of loss reserves • Schedule F type reinsurance detail

20. Captive Insurance Companies – Recent Activity FAA 20072502F • Example of the IRS applying FAS 113 criteria • IRS Counsel gave advice to revenue agent that transaction did not meet tax criteria for “insurance risk” where A (the ceding company) and B (the assuming company) entered into a retroactive insurance contract in Year 1. • The contract ceded 90% of A's losses to multiple assuming companies. • B assumed 30%, • A retained 10%, • Remaining 60% was assumed by other insurers. • Losses subject to the contract included loss and loss adjustment expenses paid by A on or after Year 1 for accident years prior to Year 1. • Transaction met “risk transfer” criteria for both GAAP (FAS 113) and Stat (SSAP 62) • IRS counsel ultimately found that no insurance risk had transferred when the tax savings were included in the analysis, and therefore sufficient insurance risk was not present.

21. Captive Insurance Companies – Recent Activity Revenue Ruling 2008-08 • The IRS provided guidance through examples of when a cell of a protected cell company can enter into a transaction which is treated as insurance for federal income tax purposes, and when amounts paid to these cells is deductible as “insurance premiums” under Section 162. • Example 1: X, a corporation that owns Cell X, enters into a contract whereby Cell X insures professional liability risks of X. Cell X does not enter into any arrangements with entities other than X. • IRS finds the arrangement between X and Cell X is akin to a parent and its wholly owned subsidiary, and in the absence of unrelated risk, lacks the requisite risk shifting and risk distribution to constitute insurance. • Example 2: Y, a corporation, owns all stock of Cell Y, as well as all the stock of 12 subsidiaries. (Mirrors facts of Rev. Rul. 2002-90). The 12 subs have a significant volume of independent, homogenous risks, insured into Cell Y. No sub has coverage for less than 5% nor more than 15% of the total risk insured by Cell Y. • IRS finds the subsidiaries have shifted the liability risks to Cell Y. The premiums are pooled such that a loss by one sub is not in substantial part paid from its own premiums. Had the subs of Y entered into identical arrangements with a sibling corporation that was regulated as an insurance company, the arrangements would constitute insurance and the premiums would be deductible under Section 162.

22. Captive Insurance Companies – Recent Activity IRS Notice 2008-19 • In conjunction with Revenue Ruling 2008-8, the IRS issued the Notice to request comments on further guidance to address issues that arise if those arrangements do constitute insurance, specifically, the status of such a cell as an insurance company within the meaning of §§ 816(a) and 831(c), and some of the consequences of a cell’s status as an insurance company. • The Notice puts forth proposed guidance that would address (a) when a cell of a Protected Cell Company is treated as an insurance company for federal income tax purposes, and (b) some of the consequences of the treatment of a cell as an insurance company. • The proposed guidance would include a rule to the effect that a cell of a Protected Cell Company would be treated as an insurance company separate from any other entity if: • the assets and liabilities of the cell are segregated from the assets and liabilities of any other cells and from the assets and liabilities of the Protected Cell Company • based on all the facts and circumstances, the arrangements and other activities of the cell, if conducted by a corporation, would result in its being classified as an insurance company within the meaning of §§ 816(a) or 831(c).

23. Captive Insurance Companies – Recent Activity IRS Notice 2008-19 • Effect of insurance company treatment at the cell level under the proposed rule: • Any tax elections that are available by reason of a cell’s status as an insurance company would be made by the cell; • The cell would be required to receive an employer identification number (EIN) if it is subject to U.S. tax jurisdiction; • The activities of the cell would be disregarded for purposes of determining the status of the Protected Cell Company as an insurance company for federal income tax purposes; • The cell would be required to file all applicable federal income tax returns and pay all required taxes with respect to its income; and • A Protected Cell Company would not take into account any items of income, deduction, reserve or credit with respect to any cell that is treated as an insurance company under the proposed rule making

24. Captive Insurance Companies – Recent Activity PLR 200803022 • IRS revoked the tax-exempt status of a Section 501(c)(15) because it was overcapitalized and did not meet the operational requirements of an insurance company. • Corporation was formed to write mortgage guarantee reinsurance and other classes of insurance and reinsurance to its parent and affiliates. • When corporation was created, it generated minimal investment income; however, as a result of reorganization, corporation was the recipient of additional paid in capital in the form of shares of stock. • Stock had a significant FMV and generated dividend and interest income • Corp received 88.6% of the gross income from interest and dividends and only earned 11.4% of its combined total revenue from insurance premiums. • In revoking the entity's tax-exempt status the IRS raised the following questions about the organizations' status as an insurance company: • Whether the organization is an insurance company exempt from tax pursuant to Section 501(c)(15) for the relevant taxable years?, • Whether the organization continues to qualify for exemption from federal income tax as an organization described in Section 501(c)(15)?, • Can the organization Rely on the Determination Letter Granted by the IRS Pursuant to IRC Section 501(c)(15)?, and • Is the entity entitled to relief pursuant to IRC Section 7805(b)?

25. Captive Insurance Companies – Recent Activity Revenue Ruling 2008-15 • Describes the insurance excise tax consequences (under section 4371) of insurance premiums paid by one foreign insurer (foreign insurer) to another (foreign reinsurer). • The ruling describes 4 fact patterns: • Situation 1 --Foreign insurer, incorporated in X, insures U.S. risk. There is no tax treaty between U.S. and X. Foreign insurer reinsures with foreign reinsurer in country Y. There is a tax treaty between U.S. and Y that does not exempt insurance from excise tax. • Premiums paid by U.S. corporation are subject to 4% excise tax • Premiums paid by foreign insurer to foreign reinsurer are subject to 1% excise tax.

26. Captive Insurance Companies – Recent Activity Revenue Ruling 2008-15 • Situation 2 --Foreign reinsurer, incorporated in country W, reinsures U.S. insurer. Foreign reinsurer enters into reinsurance agreement with foreign reinsurer, incorporated in country Y. Both W and Y have tax treaties with U.S. that do not exempt insurance from excise tax. • Premiums paid by U.S. insurer to foreign reinsurer are subject to 1% excise tax. • Premiums paid by Foreign reinsurer to other foreign reinsurer are subject to 1% excise tax. • Situation 3 --Same facts as #1, except that there is a tax treaty between X and U.S that exempts insurance from excise tax as long as it is not reinsured with an entity not entitled to the benefits of the treaty. • Premiums paid by U.S. corporation would be exempt from excise tax; however are subject to 4% excise tax as of the date the reinsurance premiums are paid by foreign insurer to foreign reinsurer. • Premiums paid by foreign insurer to foreign reinsurer are subject to 1% excise tax.

27. Captive Insurance Companies – Recent Activity Revenue Ruling 2008-15 • Situation 4 --Same facts as #1, except that foreign insurer is resident of country Z, and there is a tax treaty between Z and U.S. which exempts insurance from excise tax, as long as the policies are not part of a conduit arrangement. • Premiums paid by U.S. corporation to foreign insurer are exempt from excise tax. • Premiums paid by foreign insurer to foreign reinsurer are subject to 1% excise tax.

28. Captive Insurance Companies – Recent Activity Announcement 2008-18 • Voluntary compliance initiative • Allows foreign insurance companies who have failed to pay excise tax due under section 4371, or failed to disclose that it had claimed a waiver from the taxes pursuant to an income tax treaty, to become compliant with its obligations. • In general, if a taxpayer participates in this initiative in accordance with the terms laid out in this announcement, the IRS will not conduct examinations covering insurance excise tax liabilities arising under the four situations set forth in Rev. Rul. 2008-15, or any similar fact pattern, to the extent that premiums are paid or received by the participating taxpayer during any quarterly tax period prior to October 1, 2008. • Does not cover foreign (re)insurers previously subject to a Closing Agreement with the IRS.

29. Captive Insurance Companies – Recent Activity TAM 200816029 • Addressed whether an entity classified as a partnership for federal income tax purposes should be considered the insured entity under a purported insurance arrangement for purposes of evaluating whether there is sufficient risk distribution to treat the arrangement as insurance for federal income tax purposes • The Service concluded that a “general partnership”, where the general partner(s) are ultimately liable for the liabilities of the entity, it is the general partner whose risk of loss is shifted; as such, it is the general partner who should be considered the insured • The Service concluded that an entity treated as a “partnership” which is of the type that does not have a general partner(s); that is, under applicable law no liability of the entity can in the ordinary course attach to anyone other than the entity, it is the entity that should be considered the insured.

30. Questions?