There are several tax pitfalls prospective parent companies must be aware of when setting up a captive insurance company, according to a new guide by Ernst & Young (EY).
The guide, ‘Captive formation and tax pitfalls’, outlines five key tax misconceptions and perils to consider when setting up a captive insurance company and choosing a suitable domicile.
Firstly, EY outlines the error in assuming that a captive can be formed chiefly for tax purposes rather than for legitimate business, capital and risk management objectives. Forming a US entity that is not considered an insurance company for US federal income tax reasons may in some cases remove application of state self-procurement tax, EY warns.
This links to the second tax pitfall, described by EY as “one of the biggest and most understandable pitfalls a prospective captive insurance company can encounter”, in assuming that the Internal Revenue Service (IRS) will consider a captive to be an insurance company.
EY notes that although a captive effectively operates as an insurance company (registered and approved by a state or foreign insurance department, filing financial statements with the domicile, adhering to insurance accounting rules, writing insurance contracts, and so on), the IRS takes a more independent view of the transactions being made and tends to not make the same classification.
The professional services firm identifies four requirements to be considered an insurance company for federal income tax purposes: risk distribution; risk shifting; commonly accepted notions of insurance; and the presence of insurance risks.
Therefore, EY says it is essential for parent companies to receive professional advice to avoid any potential legal, tax and reputational problems arising from being set up and structured incorrectly.
This advice could range from accounting, actuarial, investment, legal, risk management and tax professionals to ensure appropriate structure, insurable risks, premium pricing, investment strategy and overall longevity of the captive.
In addition, EY notes the importance of understanding state taxation of a captive. The majority of US states assess premium tax instead of income tax — it is fundamental for a captive to know which states assess income tax on insurance income to ensure compliance.
EY adds: “Depending on the ownership structure of the captive and state law, the captive could be required to file income tax returns on a separate company, combined or unitary method. Proper state tax planning can help avoid pitfalls.”
Captives must also be mindful of direct placement (self-procurement) taxes, as a state can impose these taxes when insurance coverage is purchased from an insurer that is not licensed to do business in that state.
Finally, EY advises that parent companies do not assume that income generated by an offshore captive will be tax-deferred.
The Tax Cuts and Jobs Act means that the tax implications of an offshore captive’s income have become more complex, as it added provisions to the Internal Revenue Code relating to related party insurance income (RPII), passive foreign investment company, and global intangible low-taxed income.
EY notes: “Structuring an offshore captive as a non-controlled foreign corporation may produce a positive effect on the timing of tax, but other structural areas need to be considered.”
“This is challenging to do in a captive structure, because often the risk being insured is related-party coverage, which means the RPII provisions are likely to kick in, or there is 25 per cent US shareholder ownership, either of which will likely make the captive insurance company subject to anti-deferral provisions.”
The guide was written by Paul Phillips, tax partner in the financial services organisation sector, and Mikhail Raybshteyn, tax partner in the financial services organisation and co-leader of EY Americas captive insurance services.
