Steering into the Storm: Amplification of Captive Insurance Company Compliance Issues in the Offshore Tax Crackdown
Beckett G. Cantley
Atlanta's John Marshall Law School
Houston Business and Tax Law Journal, Vol. 12, pp. 224-280, 2012
A CIC is a corporation created to offer insurance to companies that are related parties to the CIC, either in a parent (CIC) – subsidiary (insured) relationship or where the CIC owners also own the insured company. The non-tax benefits of a CIC include premium cost stabilization; elimination or reduction of brokerage commissions and marketing expenses; lower administrative costs; the ability to provide niche coverage for a unique or specific risk that would not otherwise be transferable in the commercial insurance market; and the potential to control certain CIC investment decisions and portfolio management. The tax benefit of an IRC § 831(b) CIC are extensive. Premiums paid to a CIC by its shareholder insured are generally deductible, similar to the deduct-ability of premiums paid on commercial insurance. IRC § 162(a) provides that there shall be allowed deductions on necessary and ordinary expenses incurred in carrying on a business, and Treas. Reg.1.162-1(a) states that business expenses include insurance premiums on policies covering certain business losses. IRC § 831(b) provides that certain electing insurance companies may receive tax-free annual premiums up to $1.2 million, although the CIC would still be liable for tax on its investment earnings. As such, the shareholder insured deducts the premium payments, the CIC receives the premium payments tax-free, and will not be taxed on the premiums until the CIC makes a dividend distribution or the CIC stock is sold – either of which would be at long-term capital gains rates (15%) instead of ordinary income rates (35%). However, to achieve these tax benefits, a CIC must be considered an “insurance company” and the arrangement must be considered an “insurance contract”.
To meet the above-referenced “insurance” requirements, each CIC with U.S. shareholders must use IRS safe harbors or otherwise to both show: (i) that it has properly shifted the risk of economic loss (“risk shifting”) from the insured to the insurer; and (ii) that the insurer has adequately distributed the risk among several insurance companies (or other unrelated entities) so that no particular insurance company (or entity) has all the risk for an economic loss. The IRS is also aware of certain less-prevalent IRC § 831(b) CIC tax-motivated compliance problems, that include: (i) the use of life insurance on the CIC owner’s life as a major investment of the CIC; (ii) engaging in tax motivated loan back arrangements between the CIC and its owners; and (iii) structuring the CIC ownership in the name of a children’s trust (or other entity) to avoid Federal Estate and Gift Taxes. A CIC engaging in any of these compliance issues are likely to eventually come under significant scrutiny by the IRS and face serious consequences if done non-compliantly.
An important decision when forming an IRC § 831(b) CIC is whether to be governed by the laws of a U.S. state or a foreign jurisdiction. The factors that CIC shareholder must review several factors before making this decision, including: (1) exposure to the U.S. tax system; (2) the capitalization burden at formation; (3) the investment flexibility afforded the CIC; and (4) the asset protection afforded the U.S. shareholders of the CIC. As discussed below, these factors do not weigh in a significant way for U.S. taxpayers to choose to form in a foreign jurisdiction. However, any IRC § 831(b) CIC choosing to form offshore may end up compounding all the above-described potential compliance risks by virtue of ending up eventually in the middle of the ongoing IRS offshore tax crackdown.
The IRS and DOJ have used various investigatory and compliance devices to gather significant information on offshore tax activities of U.S. taxpayers, including but not limited to: holding Congressional hearings; the VDI programs; the Qualified Intermediary regime; increased offshore audits; and international tax treaties. The DOJ has used the information to launch civil and criminal tax cases against U.S. domestic and offshore clients, advisors, and banks – warning that U.S. tax avoidance overseas will receive serious scrutiny. Negative consequences for non-compliance offshore may include large civil and criminal tax penalties, including indictments for tax evasion, conspiracy to defraud, money laundering, wire fraud, and violations of the RICO Act. This IRS and DOJ offshore tax crackdown appears as if it will continue to increase in size and scope for the foreseeable future. As the offshore tax enforcement push expands, compliance and audit costs for even a fully compliant foreign CIC may rise significantly. The fact that a tax beneficial entity (like a CIC) is formed and maintained in a foreign jurisdiction may end up making it a more attractive target for an IRS audit, and the scrutiny received in such an IRS audit may be significantly heightened by virtue of the anti-offshore bias derived from the current international enforcement push. Thus, the choice to be an offshore CIC may result in its compliance costs being prohibitive (if compliant) at best, or it may find itself the target of serious penalties (if non-compliant) at worst.
This article provides: (i) an overview of the benefits and requirements of an IRC § 831(b) CIC; (ii) the compliance issues surrounding such a CIC; (iii) a detailed discussion of the progression of the IRS offshore crackdown; (iv) an analysis of the rationales for choosing an offshore jurisdiction for forming a CIC; and (v) a discussion of the IRS crackdown’s potential negative effect on the choice to utilize an offshore IRC § 831(b) CIC.
Number of Pages in PDF File: 57
Date posted: August 26, 2013
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