On September 28, 2007, the U.S. Treasury Department issued proposed tax accounting regulations that, if adopted, would create a consolidating elimination of deductions for captive insurance reserves. Because the proposed regulations would affect a captive only if it is a member of a U.S. tax consolidated group, some taxpayers have already begun
planning how to exclude their captives from consolidated tax returns prospectively. Planning alternatives include:
- Let a non-consolidated holding company own the captive. For example, a life insurance company is excluded from a consolidated tax return unless its non-life parent elects otherwise.
- Redomicile the captive from the U.S.to offshore and operate it as a controlled foreign corporation (CFC). However, premiums paid to an insurance CFC may incur federal excise tax (4% tax on direct premiums, 1% tax on reinsurance premiums) unless the captive is in a treaty country such as Ireland.
According to one survey, 30% of U.S. captives would be affected by the proposed regulations, particularly captives that belong to publicly traded corporations. In contrast, most group captives and closely-held captives would be untouched. Closely-held captives are typically owned by individual family members or trusts, not by a parent of a consolidated group.
Accelerating the deductibility of unpaid losses via insurance company accounting is one of the most significant tax advantages (though not the only one) of forming a captive insurance company. The proposed regulations would essentially eliminate insurance company tax accounting by treating intercompany insurance as non-insurance, notwithstanding case law and IRS revenue rulings that say intercompany insurance really is insurance.
Commentators (including us) are questioning the validity of the proposed regulations; hence, the mainstream is taking a wait-and-see approach. However, anti-avoidance rules in the consolidated return regulations create a logic for restructuring ownership of a captive before Treasury adopts (if it ever will) the proposed regulations. In an important but unheralded private ruling issued earlier this year, TAM 200729035, the IRS disregarded a purchasing cooperative that was used as a non-consolidated holding company for operating subsidiaries. For similar reasons, if the proposed regulations are adopted the IRS perhaps could disregard the non-consolidated ownership structure of a captive insurer. However, the IRS would have difficulty applying the antiavoidance rules to thwart planning around regulations that are not yet adopted.
Treasury is welcoming public comment about the proposed regulations through December 27, 2007. If the proposed regulations are adopted in 2008, they would go into effect no earlier than 2009 for a calendar year taxpayer. Eventually the courts might invalidate the regulations, but in the meantime the regulations—even in proposed form—will complicate captive insurance planning and make business purpose paramount.
Under an exception tailored for commercial insurance companies, the proposed regulations would not apply where 95% or more of an insurer’s premiums comes from unrelated parties. Where a fronting carrier cedes reinsurance premiums to a captive, the proposed regulations suggest the IRS could treat the reinsurance business as related-party business so as to disallow reserve recognition pursuant to antiavoidance rules. Fortunately, reserves for unrelated risk would continue to be deductible by a captive. The unrelated risk exception may give a boost to captive insurance of employer plans, which constitutes unrelated risk under a look-through rule.
For a fuller discussion, see AKO’s article “Proposed Tax Regulations: A Solution without a Problem” in the December 2007 edition of Anderson Kill’s The Captive Report, which can be found on our website at https://www.andersonkill.com/webpdfext/publications/captive/pdf/captivereport_aut07.pdf.