Insurance tax professionals discuss the current tax and regulatory landscape of the captive industry, including the OECD’s BEPS plan and IRS scrutiny of micro captives
Captive insurance is regarded as a beneficial approach to alternative risk financing owing to its provision of bespoke coverage, flexibility for emerging risks and reduced premiums — more controversially, the structures also offer opportunities for tax deduction and wealth accumulation.
General tax avoidance vehicles have been an increasing area of focus for organisations such as the Internal Revenue Service (IRS) and the Organisation for Economic Co-operation and Development (OECD).
The Inclusive Framework of the OECD aims to prohibit the specific tax avoidance strategy of base erosion and profit shifting (BEPS). This refers to a practice commonly implemented by large multinational enterprises (MNEs) to shift their profits to jurisdictions with low or zero tax rates. This process is harmful because it distorts competition and investment decisions, as well as creating an issue of fairness, particularly for developing countries that have a heavier reliance on corporate income tax and therefore suffer disproportionately.
Greg Buteyn, international tax partner at Crowe, explains: “The BEPS plan was aimed primarily at intercompany transactions related to transfer pricing, treaty abuses, intercompany debt and the use of harmful tax regimes.”
The OECD estimates that BEPS practices costs countries between US$100-240 billion in lost revenue annually, which is equivalent to between 4 and 10 per cent of the global corporate income tax revenue.
Following the initial release of its 15 action plans in October 2015, the OECD has since developed the second framework, with Buteyn noting that “action one of the BEPS 1.0 report addressed the digitalisation of the economy, but also stressed the need for continuing work in this area. This has resulted in an expanded BEPS initiative, now referred to as BEPS 2.0”.
“Significant political momentum is now driving the BEPS 2.0 taxation project forward — in individual countries, and in the G20 and G7 countries too. There is broad participation in the BEPS 2.0 project as 139 jurisdictions are actively participating through the Inclusive Framework.”
The two-pillar plan will devise a framework for international tax reform that accommodates the evolving globalised and digitalised economy, allowing governments to generate the revenue required to repair their budgets and balance sheets, as well as make needed investments in public services, infrastructure and COVID-related recovery.
The first pillar re-allocates certain taxing rights over MNEs from their home countries to the market jurisdictions in which they operate and earn profit (even if they do not have a physical presence there) to ensure fairer distribution of profits.
The second pillar of the plan intends to control competition over corporate income tax and protect national tax bases by establishing a global minimum corporate tax rate of at least 15 per cent, which the OECD predicts will produce an additional $150 billion in annual global tax revenue. Daniel Kusaila, tax partner at Crowe, adds that the Biden administration is also proposing to tie-in a minimum tax increase on non-US subsidiary proposals to the BEPS 2.0 rate.
This twofold plan is intended to address the complaints raised against MNEs, to ensure that organisations separate their taxable profits from the jurisdictions in which they generate them. Some of the legal entities identified in the BEPS papers as tax avoidance vehicles include captives as subsidiaries of MNEs.
Despite this, the OECD’s plan was adopted by several leading captive domiciles, including the Bahamas, Bermuda, British Virgin Islands, Cayman Islands, Gibraltar, Guernsey, Hong Kong, Jersey, Luxembourg and the US.
Captives and BEPS
A US-based redomesticated captive can be a potential solution to tax concerns over BEPS, as Teresa Jones, senior tax manager at RH CPAs, comments: “In regards to the US, a redomesticated captive structure essentially removes the concern over BEPS, since a captive that has been redomesticated to an onshore jurisdiction or filed a 953(d) election to be classified as a US corporation has no possibility of profit shifting.”
Incentives for redomesticating a captive are not limited to tax rates, and can include jurisdictional neutrality, merger and acquisition activity, regulatory changes, and commercial privacy.
Buteyn adds that “redomesticated captives into the US which are owned by US or foreign parent companies should not see any effect from BEPS 2.0 as long as their effective income tax rate is above the proposed 15 per cent rate in pillar two”. According to Buteyn, this should be the case for redomesticated US-based captives owing to the current tax rate of 21 per cent.
Kusaila notes that in the case of US parent companies with non-US based captives, the current US tax rules will continue to apply to controlled non-US corporation subsidiaries.
Therefore, the captive structures most affected by the second pillar of the OECD’s plan will be non-US based captives owned by non-US parent companies with a group revenue over the minimum threshold of around $850 million.
“To the extent that their effective tax rate is below the OECD’s pillar rate, and its income was not otherwise currently taxed to its parent, the parent company of the captive would be required to ‘top up’ its tax in its home jurisdiction to reach the 15 per cent rate on the captive income,” Kusaila explains.
Following the announcement of the BEPS papers, many captive owners recognised that the business plans and structures of captives as a risk management tool had not been fully understood in terms of complexity or detail.
However, the majority of the structures were able to explain their business model and purpose to aid the pre-financing of potential future losses and claims rather than to collect untaxed profit income.
Some of the other BEPS rules that would apply to captives in many jurisdictions include: alignment of transfer pricing policy with value creation in the captive; economic substance requirements; compliance with limitation on benefits provisions to prevent treaty abuses; and disclosure of “aggressive” tax planning strategies, says Buteyn.
US legislation
While US-based captives may not be directly or significantly affected by the BEPS plan, Jones notes several other significant compliance concerns for US captives, commenting: “The new controlled foreign corporation rules and the global intangible low-taxed income rules proposed in Biden’s tax plan (assuming they are passed into law) will remove some of the benefits of having offshore insurance companies that do not make a 953(d) election.”
“However, there still may be regulatory reasons for having an offshore captive, such as the ability to write more third-party business,” she adds.
The Biden administration is also currently proposing to replace the 2018 Base Erosion and Anti-Abuse Tax (BEAT) rules — designed to increase the US tax liabilities on certain related party insurance payments from US subsidiaries to non-US related parties in MNEs — with the Stopping Harmful Inversions and Ending Low-Tax Developments (SHIELD) provision to increase these tax payments further.
Recent tax legislation and regulations are also “putting pressure on US-owned, non-US captives by threatening to eliminate the passive foreign investment company insurance tax exception to defer US tax on captive income that has been available,” Kusaila adds. “This proposal will require more employee management substance in non-US captives, a role which has historically been provided by a third-party captive manager.”
Jones highlights the specific domicile of the State of Washington as presenting some compliance concerns, with MNEs such as Microsoft and Costco paying substantial premiums and back taxes relating to premiums sourced out of the state to captives domiciled in other jurisdictions.
The State of Washington has since passed legislation requiring captives operating and writing premium in the state to pay a registration fee of $2,500 and a 2 per cent premium tax.
“The concern for the industry is that this type of legislation could be a slippery slope, leading to companies redomiciling where they are doing business, which could potentially cause more premium tax to be paid,” Jones explains.
Internal Revenue Scrutiny
The other significant regulatory and compliance issue facing captives in terms of tax is the IRS’ pursuit of micro captives. The Service’s annual ‘Dirty Dozen’ list of tax scams for 2021 marked micro captives as abusive arrangements, having previously escaped the 2020 list for the first time in five years.
The IRS’ list accused offshore micro captive structures of “lack[ing] the attributes of insurance” by insuring implausible risks or duplicating commercial coverage in order to avoid paying tax on underwriting income under section 831(b) of the US Tax Code.
Commenting on how the IRS’ scrutiny of micro captives has affected perceptions of captive insurance, Jones says that Notice 2016-66 and litigation against micro captives “has had a substantial effect on the market as a whole.For all of the captive managers we deal with, they desire to play by the rules. The concern is that no one knows what the rules are, as every situation has different risk management characteristics,” she explains.
“We have seen a remarkable uptick in larger captive formations, as well as formations of smaller captives who are scared to make the 831(b) election, even when they believe they fully comply with the IRS code. Congress created the section, yet the IRS essentially used a blanket approach to indicate that anyone making the election is doing it solely for tax reasons,” Jones adds.
For insureds seeking a robust risk management programme in which they are able to meet the commonly accepted definition of insurance, as well as risk distribution and risk transfer, the attack on captives making an election contained in the US Tax Code may be perceived as a significant deterrent.
Kusaila expects that micro captives will continue to see increased scrutiny by the IRS over the next several years. However, Jones is optimistic that the Supreme Court ruling in IRS v CIC Services, which indicated that the IRS had violated the Anti-Injunction Act in its issuance of Notice 2016-66, will “bode well” for the future of the captive industry.
Looking to the future, Jones is also confident that, from a state standpoint, the regulatory landscape for captives is “very good” as major domiciles are beginning to engage in competition to attract well-run captives.
However, she recognises that from a tax perspective, the position of Washington State and the IRS requires some case law so that the industry is able to play by the rules set forth.
“Hopefully, we will see the Reserve Mechanical case appeal results soon, which should provide further guidance to the industry,” Jones adds.
Meanwhile, Kusaila predicts that “if the current administration’s tax plan is enacted, it is likely audit activity will be increased, not only for captives but in general as well. The Biden administration has proposed additional funding of approximately $80 billion for the IRS over 10 years.”
“Thus, we believe there will be a significant increase to the number of audits performed. Due to the impact COVID-19 has had on everyone’s budget, we expect an increased scrutiny in non-US tax authorities as well,” Kusaila explains.
Elsewhere, Buteyn expects an increase in the number of states scrutinising captives’ long standing tax positions; whether self-procurement or income taxes, he expects states to regard captives as an area in which they can generate revenue.
“While the tax landscape might be rocky over the next several years, it is important to note that the insurance benefits far exceed those of tax. Organisations must look at the insurance benefits provided to determine if a captive is right for them,” Buteyn concludes.
