Navigating the different captive insurance domiciles post-tax reform
The US Congress accomplished two things with tax reform. It reduced personal income taxes for millions of Americans. It also increased the burden of tax compliance for captive insurance companies by an order of magnitude.
Unclear rules and new taxes confuse one of the most exciting decisions in the captive insurance feasibility study: domicile selection. Incorporating a captive insurance company is a big decision requiring dozens of documents, discussions with attorneys, accountants, and actuaries.
The decision of where to domicile the company is fun because the insurance industry is centred in some of the most exotic destinations in the world. However, tax reform changes the calculus. This article highlights a few of the new considerations to be explored in the process of developing new captive programs.
Controlled foreign corporation status
If a captive is owned by US shareholders, in whole or in part, then the captive may be considered a controlled foreign corporation (CFC). A CFC is a corporation located outside of the US with 50 percent or greater shareholder ownership, with each shareholder each owning 10 percent or more of the company. Captives located offshore with US shareholders are frequently deemed CFCs.
Tax reform changed the attribution rules for these companies. Under the pre-reform rules, the shareholders had to own 10 percent or more of the captive’s voting power for 30 days to qualify as a CFC; now the CFC status is imposed if US shareholders own 10 percent or more for a single day. Further, the attribution rules look through foreign parents for CFC determination.
Prior to tax reform, it was worth the compliance costs to navigate CFC status. Some US corporations used their captives to park taxable income in offshore domiciles as part of a larger tax deferral/avoidance strategy.
That strategy has largely vanished in the wake of the global low-taxed intangible income tax (GILTI). GILTI is a new tax. The tax imposes a 10 percent minimum tax on offshore CFCs after accounting for an 80 percent tax credit. Tax practitioners are still devising various techniques to avoid this new tax and the existence of GILTI will increase offshore compliance costs.
Passive foreign investment company
Another issue facing offshore captives is the new regulations for passive foreign investment companies (PFICs). PFICs are offshore corporations with greater than 50 percent of passive investment income or corporations that have 75 percent of their assets producing investment income. A captive that triggers PFIC status is not in an ideal situation as PFIC status creates a compliance headache and an increase in taxes.
“It is possible that captive managers may need to challenge PFIC status in court in order to force the government’s hand on interpreting the new regulations.”
Unfortunately, tax reform made tripping PFIC status much easier for CFCs. The PFIC test, which looks at 50 percent of passive investment income, means that all offshore captives may be PFICs. This is because captive reserves are held for the production of passive income. This extreme result is not likely the Congressional intent, but regulations have not been released clarifying this concern.
Thus, it is possible that captive managers may need to challenge PFIC status in court in order to force the government’s hand on interpreting the new regulations. This issue is a clear and present tax issue for all offshore captives operating as CFCs.
Another new effect of US tax reform is the imposition of base erosion anti-abuse taxes (BEATs). BEAT’s goal is to preclude moving profits into offshore jurisdictions to avoid US taxes. This is accomplished by imposing a minimum tax on otherwise deductible payments to foreign affiliated entities.
The aim of BEAT is to address shady fees or royalties paid to offshore affiliated entities, but also applies to insurance premiums paid to captives. BEAT imposes a 5 percent tax (up to 10 percent next year and then up to 12.5 percent after 2025) on corporate US taxpayers.
The tax works by adding to the US corporate taxable income base any “base erosion payments” paid to foreign companies, such as offshore captives. Since BEAT applies on a gross basis, the captive may not be able to take deductions for claims. While this appears onerous, it affects only very large captives as the rule is leveraged against controlled groups with average annual gross revenues of over $500 million for a three-year taxable period.
The 953(d) election
It’s not all bad news. Offshore captives owned by US shareholders can still make the 953(d) election. The 953(d) election permits the CFC to be taxed as a US company. Captives with greater than 50 percent US shareholders qualify as CFCs. Profits from the captive will be taxed at the new post-tax reform rate of 21 percent (previously 35 percent) unless the captive writes less than $2.3 million in gross written premium and the shareholders make the 831(b) election.
The only real issues to navigate with the 953(d) election is to ensure that 10 percent of the captive’s assets are located in the US and to maintain a US office. If the captive fails to do so, then it will need to execute a closing agreement and letter of credit to ensure payment of taxes with the Internal Revenue Service (IRS). While there are always technicalities, the compliance issues related to 953(d) election are significantly less burdensome or complicated than those arising out of CFC status.
Lower cost of doing business
Remember, don’t let the tax tail wag the dog. If a captive was created in order to offshore income in foreign countries as part of a tax scheme, then tax reform is a devastating blow. Expect to see many of those captives redomiciled into the US. However, taxes are not the only reason to consider a captive insurance company. Moreover, there are significant advantages to middle-market companies that incorporate their captives in offshore domiciles.
The capital necessary to incorporate a single parent captive is lower in most offshore domiciles than for US domiciles. Many offshore domiciles require only $100,000 in reserves to start a captive insurance company. Further, there are no income taxes in many of the offshore domiciles. This means that the only taxable event for income tax purposes occurs with the IRS, state departments of revenue, and any procurement tax considerations.
Also, most offshore domiciles permit greater flexibility regarding investment opportunities. Some US domiciles restrict investments of reserves to mirror the investments for an admitted carrier. Almost all offshore domiciles permit greater flexibility with regard to investments of reserves and unencumbered capital.
The only certainty arising out of US tax reform is that captives’ lawyers and accountants are earning larger fees. Congress attempted to simplify the tax code and made a mess of many issues relating to captives. To its credit, the US Congress did not discriminate—there are piles of incoherence scattered throughout several other areas of the new code (see, eg, Section 199A Qualified Business Income headaches).
This is no excuse for such sloppy legislation. Captive insurance companies have been a punching bag for the IRS for years and tax reform does little to streamline compliance issues or ease their operation. This is shortsighted as captive insurance provides middle-market companies with a powerful financial tool to manage risk, turn insurance into a profit centre, and keep up with large companies that already have captives up and running.
The IRS will eventually release regulations and guidance to assist with compliance. This guidance will ease some of the ambiguity surrounding these new rules. However, guidance may take years and there is no guarantee that the IRS will get it right.
Consequently, we can expect law suits arising over interpretations of the code. Selecting a domicile should not require captive practitioners and stakeholders to consult runes or throw bones to divine the government’s interpretation of needlessly complicated rules.