jun 8 – 10, 2015 us tax update

JUN 8 – 10, 2015

www.bermudacaptive.bm

US Tax UpdateUS Tax Update

Speakers

• Karey Dearden, Executive Director, EY• Scott Slater, Director, PwC• P. Bruce Wright, Partner, Sutherland Asbill &

Brennan LLP

Agenda

I. Modifications to the insurance framework• Rent-A-Center• Securitas • Revenue Ruling 2014-15

II. Validus and the proposed PFIC regulations

III. What’s on the horizon?• Section 831(b) decision• Insurance risk & common notions of insurance

IV. Direct Placement Tax

• Opinion issued by the Tax Court on January 14, 2014

• Majority found all requisite requirements of insurance to be met:– Risk shifting (dissent disagreed – relied on Humana)– Risk distribution (dissent did not comment)– Insurance risk– Common notions of insurance (dissent disagreed on loanback)

• IRS chose not to appeal

Rent-a-Center v. Commissioner

Court applied a facts and circumstances test which considered the following key items:•RAC is a public company in “rent to own” business•Owned a Bermuda-based captive, Legacy Insurance Company, Ltd.

• IRC Section 953(d) election in place•Captive insured 4-12 subsidiaries in years in question•One subsidiary represented approximately 67% of the risk premiums•“Parental Guaranty”

• The parent provided a limited “parental guaranty” relating to a DTA (~$25M) for the BMA “relevant asset test” purposes

•Captive owned treasury shares of the parent worth ~$108M


Key facts (cont’d)

•Parent paid premiums to Legacy on behalf of subs and used its cost accounting formula to allocate premium expense based on each sub’s exposure units

•Standard coverages – WC, AL, GL

•Structured as a deductible buy-back program

•Independent actuary and third party administrator

•Premiums and paid losses were “netted” for settlement purposes


Key Findings

•IRS sham argument rejected

– Legacy formed for valid non-tax business purposes

•Risk clearly shifted to legacy from subs (but not parent)

•“Brother-sister” theory accepted

•‘Limited’ parental guaranty not a “fatal flaw”

– Majority believed guaranty did not prevent risk shifting

– Captive was adequately capitalized

– $25m relatively small compared to premium levels (>$250m)

– Guaranty never used and removed after unnecessary for BMA


Key Findings (cont’d)

•New standard for ‘risk distribution’

– Majority opinion primarily focused on risks rather than entities

– No mention of ‘entity theory’ as set forth in Rev Ruls 2002-90, 2002-91 and 2005-40

•Court addressed ‘loanbacks’ with respect to treasury shares

– Majority - No circular cash flow as shares were not sold

– Dissent – Legacy a ‘holding tank for cash’ and loanback along with parental guaranty negated risk shifting


Key facts

•Ultimate parent was Securitas AB (“AB”), a Swedish public company

•AB owned Securitas USA Holdings, Inc. (“SHI”), a US affiliate

•AB acquired a number of US guard businesses which is consolidated into a few subsidiaries

•SHI owned a between 4-11 US subsidiaries for the years at issue

– One subsidiary represented ~67% of the total risks

– 4 US subsidiaries represented ~ 90% of the total risks

•SHI also owned Protectors Insurance Company (“Protectors”)

– Vermont based captive

– Insureds were ‘brother-sister’

Securitas Holdings, Inc. v Commissioner

Key facts (cont’d)

•Deductible reimbursement policy with SHI affiliates and Protectors

– WC, AL, GL, etc.

•Protectors entered into a 100% assumption reinsurance arrangement with Securitas Global Reinsurance Limited (“SGRL”), an Irish captive.

– Insureds and Protectors were brother-sister to SGRL

•SHI provided a “parental guaranty” to Protectors to negate the “insurance” transaction between the SHI subsidiaries and Protectors

– No amount ever paid under guaranty

– Other stakeholders did not request/require the guaranty


Findings:

•IRS asserted that Protectors was not an insurance company because the parental guaranty and risk was not shifted to SGRL

•IRS asserted the concentration of risk in the SHI affiliate results in a lack of risk distribution

•In a Tax Court Memorandum decision, the court concluded

– the parental guaranty did not negate risk shifting to SGRL from the SHI affiliates

– followed the Rent-a-Center decision with respect to risk distribution in commenting who owns the risk is not the critical question; rather the number of risks resulting from thousands of locations, employees and vehicles are key

•The option to appeal the case to the 9th Circuit expired January 28, 2015


PASS-THROUGH ENTITIES

• BROTHER/SISTER TEST– HUMANA INC. v. COMMISSIONER, 881 F.2d 241 (6TH Cir. 1989)– REV. RUL. 2002-90, 2002-2 C.B. 985

• 12 SUBSIDIARIES EACH WITH 5%-15% OF RISK

– REV. RUL 2005-40, 2005-2 C.B. 4• DEALT WITH SINGLE MEMBER LLC DISREGARDED FOR TAX PURPOSES

• POSITION TAKEN THAT IN DETERMINING RISK DISTRIBUTION SINGLE MEMBER IS THE OWNER OF ASSETS IN THE LLC


XNUMBER

LLC1

LLC2

LLC3

LLC4

LLC5

LLC6

LLC7

LLC8

LLC9

LLC10

LLC11

LLC12

YINSURER

1 INSURED

• REV. RUL 2005-40


• STATUS OF SINGLE MEMBER LLC’S REGARDED– ILM 1999-30-013 – TAXPAYER PERFORMED SERVICES AND DIRECTED

PAYMENT BE MADE TO LLC. IRS WANTED TO FILE A LIEN ON ASSETS OF LLC FOR TAXES OWED BY TAXPAYER. IRS DETERMINED IT COULD NOT BECAUSE UNDER STATE LAW TAXPAYER HAD NO RIGHT TO PROPERTY OWNED BY LLC

– T.D. 9356 NOTED EMPLOYEES SHOULD BE TREATED AS EMPLOYEES OF AN LLC FOR EMPLOYMENT TAX PURPOSES PARTICULARLY AS A RESULT OF STATE EMPLOYMENT TAX ISSUES

– TECH. ADV. MEMO 200816029 – IRS DID NOT LOOK THROUGH MULTI-OWNER LLC BASED ON STATE LAW ANALYSIS

– SUZANNE J. PIERRE v. COMMISSIONER, 133 T.C. 24 (2009), TAX COURT TOOK THE POSITION THAT TRANSFERS OF INTERESTS IN AN LLC TREATED AS A DISREGARDED ENTITY TREATED AS SUCH RATHER THAN TRANSFER OF UNDERLYING ASSETS FOR GIFT TAX PURPOSES. SEE ALSO ReRI HOLDINGS INC. v. COMMISSIONER, T.C. MEMO 2014-99 (2014)


• STATUS OF SINGLE MEMBER LLC’S REGARDED– HEALTHMARK GROUP LTD., GREGORY LENTZ A PARTNER OTHER THAN

TAX MATTERS PARTNER v. COMMISSIONER, DOCKET NO. 8269-14, IRS HAD DISREGARDED 8 SUBSIDIARIES FORMED AS SINGLE MEMBER LLC’S AND DENIED DEDUCTION FOR PAYMENT TO SISTER CAPTIVE. MARCH 27, 2015 DECISION ENTERED STIPULATING ENTRY OF JUDGMENT PURSUANT TO WHICH ALL DEDUCTIONS ALLOWED

MEDICAL STOP LOSS

• BACKGROUND– PROGRAMS GENERALLY DESIGNED TO REIMBURSE EMPLOYERS WITH

REGARD TO LOSS ASSOCIATED WITH SELF-INSURED PROGRAMS– STATE MINIMUM PER INDIVIDUAL AND AGGREGATE ATTACHMENT POINTS– STRUCTURED GENERALLY TO AVOID “PLAN” STATUS UNDER ERISA PER

ADVISORY OPINION 92-02A, REIMBURSEMENT SOLELY TO THE EMPLOYER

• RELATED OR UNRELATED BUSINESS– REV. RUL 92-93– REV. RUL 92-94– REV. RUL 2014-15

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MEDICAL STOP LOSS

• BACKGROUND– IRS HAS TAKEN THE POSITION THAT SUCH INSURED BENEFITS ARE

EMPLOYEE NOT EMPLOYER RISKS, SEE REV. RUL. 92-93

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EMPLOYERINSURER CAPTIVE

PREMIUM REINSURES

EMPLOYEES

PAY BENEFITS

MEDICAL STOP LOSS

• REV. RUL. 2014-15– FACTS

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RETIREES

EMPLOYER VEBA INSURER CAPTIVECONTRIBUTION REINSURES

RETIREE MEDICALBENEFITS

MEDICAL STOP LOSS

• RELATED OR UNRELATED BUSINESS– IS IRS POSITION TO LOOK THROUGH TO EMPLOYEES/RETIREES BASED

ON CONTRACTUAL RELATIONSHIP BETWEEN INSURED AND ISSUER OF CERTIFICATE

• CONSEQUENCES– ANALYZE YOUR PROGRAM AND DETERMINE WHETHER IT WILL BE

ADVERSELY AFFECTED IF MEDICAL STOP LOSS ADDED AND IT IS TREATED AS RELATED BUSINESS

• PREMIUMS PAID TO CAPTIVE DEDUCTIBLE BASED ON HUMANA ANALYSIS, SIMILAR SPREAD ON MEDICAL STOP LOSS

• PREMIUMS PAID TO CAPTIVE NOT DEDUCTIBLE BASED ON HUMANA UNLESS RENT-A-CENTER/SECURITAS ANALYSIS APPLIES

• PREMIUMS PAID, e.g., ONLY FOR PARENT RISK, AND DEDUCTION BASED ON UNRELATED BUSINESS

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Validus

Facts

•Validus is a foreign reinsurer that sells reinsurance policies to direct writers of insurance contracts, including contracts which reinsure US risks.

•The policies with US risks are subject to 1 percent US federal excise tax (“FET”).

•In 2006, Validus entered into and paid premiums on nine retrocession policies to protect itself against the risks assumed under the initial reinsurance policies that had already been subject to the FET.

•The Service asserted that the retrocession premiums were also subject to the FET under section 4371(3). This is the Services’ cascading theory.

•Validus paid the FET and sued for a refund in the US District Court for the District of Columbia.

•The US District Court for the District of Columbia granted summary judgment for Validus and held that the plain language of section 4371(3) taxes only reinsurance transactions and does not impose an excise tax on retrocession insurance transactions.

•The Service appealed.

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Validus

Appellate Court Decision

•The US Court of Appeals for the District of Columbia (“Appellate Court”) reviewed the District Court opinion de novo.

•The Appellate Court

– (i) found both parties’ interpretation of the statute plausible, and concluded the statute “is ambiguous with respect to its application to wholly foreign retrocessions;”

– (ii) found nothing to clearly indicate Congress intended the FET to apply to wholly foreign retrocessions’;

– (ii) applied the presumption against extraterritoriality to clarify the meaning of the ambiguous statute; and

– (iii) stated that applying the FET retrocession at issue “would extend the extraterritorial reach of section 4371 by allowing the tax to compound into perpetuity.”

•The Appellate Court affirmed the District Court’s decision, though on narrower grounds, limiting its holding to retrocessions between two foreign entities, rather than to all retrocessions. 21

Proposed PFIC Regulations

Background•Proposed regulations were issued on April 23, 2015 pertaining to the insurance exception to the passive foreign investment company (“PFIC”) rules.

•A foreign corporation is a PFIC if either 75 percent or more of its gross income for the taxable year is passive income (“passive income test”), or on average 50 percent or more of its assets produce passive income or are held for the production of passive income (“passive asset test.”)

• Passive income is generally defined as income of a kind that would be “foreign personal holding company income” which includes dividends, interest, royalties, rents, annuities, certain property transactions, etc.

•An asset is characterized as passive if the asset generates (or is reasonably expected to generate in the foreseeable future) passive income.

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Background

•The statute provides an exception to the passive income definition for “income derived in the active conduct of an insurance business by a corporation which is predominately engaged in an insurance business and which would be subject to tax as an insurance company if such company were a domestic company.”

•The proposed regulations do provide a definition for “active conduct” and “insurance business.”

•“Predominately engaged” was not defined given the stricter and more precise definition of a domestic insurance company included in the statute.

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Summary of Proposed Regulations

•The proposed regulations provide that (i) passive income does not include income earned by a foreign company that would qualify as a domestic insurance company, if such company were a domestic company, and (ii) the income is derived in an active conduct of an insurance business.

•The term “active conduct” means the company’s officers and employees carry out substantial managerial and operational activities.

• A company can be engaged in an active trade or business if incidental activities are carried out by independent contractors; however, in determining whether the officers or employees carry out substantial managerial and operational activities, the activities of the independent contractors are disregarded.

•The term “insurance business” means the business of issuing insurance and annuity contracts and the reinsuring of risks underwritten by insurance companies together with investment activities and administrative services required to support the insurance business. The investment activities are to produce income to meet the insurance obligations.

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THE IRC §831(b) ARENA

• LEGISLATION– INITIAL DRAFT BY JOINT COMMITTEE

• INCREASED IRC §831(b) LIMIT FROM $1,200,000 TO $2,200,000

• REQUIRED NO MORE THAN 20% OF NET WRITTEN PREMIUM ATTRIBUTABLE TO ANY ONE POLICYHOLDER AND PRECLUDED REINSURANCE

– NEXT DRAFT• INCREASE ONLY

– NEXT DRAFT• INCREASE

• STUDY TO BE COMPLETED EARLY 2016


• IR 2015-19– IRS COMMENT ON ABUSIVE TAX STRUCTURES

• RECOGNIZES VALID CAPTIVES• CRITICIZES POORLY DRAFTED BINDERS AND POLICIES, IMPLAUSIBLE

RISKS, EXORBITANT PREMIUMS– WHILE MAINTAINING COMMERCIAL COVERAGES WITH TRADITIONAL

INSURERS

– UNDERWRITING AND ACTUARIAL SUPPORT “MISSING OR INSUFFICIENT”

– HEFTY FEES FOR PROMOTORS

– USE OF TRUSTS/ESTATE PLANNING


• AVRAHAMI v. COMMISSIONER, FEEDBACK INS. CO. v. COMMISSIONER

– PREMIUM PAID BY 4 COMPANIES OWNED BY BENYAMIN AND ORNA AVRAHAMI TO FEEDBACK INSURANCE CO. LTD. (FICL), A ST. KITTS/NEVIS ENTITY OWNED BY ORNA, IRC §953(d) ELECTION, PREMIUM WITHIN IRC §831(b) LIMITS

– FOR 2009/2010 YEARS AT ISSUE, FICL OFFERED COVERAGES TO THE 4 COMPANIES THAT IRS DESCRIBED AS “BUSINES SINCOME,” “LITIGATION EXPENSE,” “EMPLOYEE FIDELITY,” “LOSS OF KEY EMPLOYEE,” “TAX INDEMNITY,” “BUSINESS RISK,” AND “ADMINISTRATIVE ACTIONS”

– NO PAYMENTS/CLAIMS 2009/2010– NO REINSURANCE OUTWARD


• AVRAHAMI v. COMMISSIONER, FEEDBACK INS. CO. v. COMMISSIONER

– PARTICIPATED IN A TERRORISM POOL IN EACH OF 2009/2010 ADMINISTERED BY PAN-AMERICAN REINSURANCE CO. PREMIUM CEDED ON FUNDS WITHHELD BASIS. PREMIUM 33% IN 2009 AND 31% IN 2010

– ALL BUT ABOUT $6,000 LOANED TO COMPANY BELLY BUTTON CENTER LLC OWNED BY 3 CHILDREN OF AVRAHAMI. NO PRINCIPAL OR INTEREST PAID ON LOANS

– IRS ARGUES• NO ECONOMIC SUBSTANCE AND AS SUCH ALL TRANSACTIONS SHOULD BE

DISREGARDED

• TRANSACTIONS WITH 4 COMPANIES IS NOT INSURANCE

– TRIAL HELD

Insurance Risk & Common Notions of InsuranceTAM 201149021

Facts

•Taxpayer filed as a domestic property and casualty insurance company.

•Taxpayer entered into contracts with unrelated parties (“protected parties”).

•Taxpayer was obligated to pay the excess of (i) the predicted residual value of the protected asset over (ii) the fair market value of the asset at the end of the lease term. The payment was referred to as the “residual value payment.”

•A protected party could elect to have the contracts apply to a group of assets.

•The contracts covered multiple classes of assets including passenger vehicles, commercial equipment, and commercial real estate that the protected parties leased to third parties.


Facts (continued)

•The length of the contracts differed, and some contracts pertaining to commercial assets could have a length of 10 to 25 years.

•The contracts were issued in the commonly accepted form of an insurance contract and had insurance standard policy provisions.

•Taxpayer’s obligation to make a residual value payment matured only at the end of the contract term. Fluctuations in the protected asset’s value during the term of the contract did not create a liability unless the decline was permanent.


Service’s Position

The Service’s overall conclusion was that the substance of the arrangement did not satisfy three of the factors to have an insurance arrangement: (i) lacked insurance risk, (ii) was not insurance in the commonly accepted sense, and (iii) lacked risk distribution.

•Insurance risk - The Service concluded the risk was more akin to an investment risk than to an insurance risk.

•Common notions of insurance - The Service noted that while the contract may ensure the projected income from market forces, the event which triggers the contract is made at contract termination and such a measurement is not a casualty event.

•Risk distribution - The Service took the view all the risks were interdependent; as such, risk distribution was not present.

Insurance Risk & Common Notions of InsuranceCCA 201511021

Facts

•Taxpayer is a multinational enterprise.

•Taxpayer has a domestic captive that writes a wide variety of insurance business, e.g., automobile liability, credit guarantee, earthquake damage, retiree medical cost, etc.

•Captive began insuring “loss of earnings” arising from foreign currency (“FX”) transactions.

•“Loss of earnings” was defined as the percentage increase or decrease in the rate of exchange of the US dollar against the specified foreign currency between the effective and expiration dates multiplied by the coverage limit.


Facts (continued)

•Contracts were issued for 12 months, and each contract started at a different month, e.g., January, February, March, etc.

•Contracts were retrospectively rated contracts.

•Policy premium was determined using a specific formula and option market data was used in calculating the premium.

•The contracts had many features commonly found in insurance policies.

•No one insured had more than 15 percent of the premium paid to the captive.

•No mention of any parental guarantee, premium loan back, or other aspect that would be inconsistent with a bona fide insurance arrangement.



•The Service concluded the arrangement was not insurance because the contracts lacked insurance risk, are not insurance in the commonly accepted sense, and lacked risk distribution.

•Insurance risk– The Service stated one should take into account such things as– (i) the ordinary activities of a business enterprise,– (ii) the typical activities and obligations of running a business,– (iii) whether an action that might be covered by a policy is in control of the

insured within a business context,– (iv) whether the economic risk involved is a market risk that is part of the

business environment, – (v) whether the insured is required by law or regulation to pay for the covered

claim, and– (vi) whether the action in question is willful or inevitable.



•Common notions of insuranceThe Service used similar arguments as were used in the residual value ruling to conclude the contracts were not insurance in the commonly accepted sense. Namely, (i) all products sold by insurance companies are not insurance contracts for US federal income tax purposes, (ii) a “casualty event” is required to damage or impair an asset or income to have an insurance contract, and (iii) that a contract termination date does not provide the type of event that gives rise to a casualty event.

•Risk Distribution

The Service noted a number of contracts were sold, but under the principles of Revenue Ruling 2005-40, risk distribution did not occur.

• Direct placement tax is imposed on an insured when directly procuring coverage from a non-admitted insurer (i.e. captive)

• Payable based on rates, varying by states, on the net written premiums paid to the captive

• Note, some states do not impose any direct placement tax

Direct Placement Tax

• Effective January 1, 2015, S.B. 3324 imposes direct placement tax of up to 4.6% on insurance contracts independently procured from a non-admitted insurer by industrial insureds.

– Industrial insureds are defined as those who,• Procure the insurance of Class 2 (casualty, fidelity, surety), or

Class 3 (fire and marine) risks by use of services of a full-time employee who is a qualified risk manager’

• Procures insurance from an unauthorized insurer without services of an intermediary insurance producer, and;

• Is an exempt commercial purchaser whose home state (generally the principal place of business) is Illinois.

Direct Placement Tax - Illinois

• Legislatively amended its direct placement tax on non-admitted insurance

• Previously Tennessee had only imposed direct placement taxes on limited lines of business such as marine insurance

• Section 56-2-411 of the Tennessee Code Annotated expands its direct placement tax beyond marine insurance to industrial insureds, as similarly defined.

Direct Placement Tax - Tennessee

Questions

Questions?

jun 8 – 10, 2015 us tax update

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