The tax implications should be carefully considered before forming a captive. Paul Dougherty, David Macall and Barbara Pena from accountancy firm EisnerAmper, an independent member of PKF North America, explore some of the complex challenges and implications for potential captive owners.
While the non-tax business purpose for establishing the captive must be thoroughly examined before considering the formation of a captive insurance entity, the purpose of this article is to summarise some of the US tax rules that may be implicated.
A wide variety of common fact patterns can trigger applicability of the either the US subpart F rules or the US passive foreign investment companies (PFICs) rules, so a detailed understanding of each is important. Thus, it is also important that investments by captives be considered carefully to avoid triggering PFIC treatment.
By addressing some of the detailed US tax rules that apply to investments by US persons in non-US companies and/or activities, this article helps to illustrate the technical issues and exposures that may favour the making of such investments through US-based fund structures.
PFIC treatment and captive-controlled foreign corporation (CFC) treatment can be costly from a US tax compliance perspective, and experience has shown that US investors may be better off investing in non-US companies and/or non-US activities through US-based funds instead of through captives and/or PFICs.
US subpart F issues
Subpart F of the Internal Revenue Code (IRC), section 951, et seq, requires every person (and entity) that is a “US shareholder” of a CFC, and owns stock in the corporation on the last day of the CFC’s tax year, to include in gross income a deemed dividend equal to the shareholder’s pro rata share of the CFC’s “tainted earnings”, which include certain kinds of “insurance income.”
A foreign corporation is a CFC if, on any day during its tax year, US shareholders own more than 50 percent of the combined voting power of all classes of stock, or more than 50 percent of the total value of the corporation. For these purposes, a US shareholder is any person owning at least 10 percent of the total combined voting power of all classes of stock of the foreign corporation. A special CFC definition, discussed below, applies only for purposes of taking into account related person insurance income (ie, from captives).
A CFC’s US shareholders must include in their taxable income a pro rata share of any subpart F insurance income and foreign personal holding company income (FPHCI) of the CFC. A CFC earns subpart F income under IRC section 953 from insurance, unless it is “exempt insurance income” under section 953(e), if such expired provision is retroactively re-enacted by the US Congress. To the extent that a CFC directly earns investment income, such income can be subpart F FPHCI, unless it is “qualified insurance income” under IRC section 954(i), if such expired provision is retroactively re-enacted by the US Congress.
The US shareholders generally will be required to include such investment income as ordinary income along with the section 953 income. Such income is not eligible to be treated as qualified dividends, and therefore will not qualify for the preferential tax rate for long-term capital gains and qualified dividends.
Captive insurance CFCs
Traps for the unwary reside in the special rules under subpart F for purposes of allocating related-person insurance income of an offshore captive arrangement to its US owners. A company is a captive-insurance CFC if its US owners own more than 25 percent of the vote or value of the offshore captive. Section 953(c)(1) does not require 10 percent ownership to be a US shareholder for this purpose. If a foreign captive is a CFC under such 25 percent-test, then its US owners must include in taxable income their pro rata shares of the captive CFC’s related-person insurance income, thereby negating any deferral of such income, whether or not repatriated to the US owners.
Penalties for failing to file form 5471
US shareholders of CFCs are required to file Form 5471. The penalty for failure to file a Form 5471 is $10,000 for each annual accounting period with respect to which such failure occurs and $10,000 for each 30-day period (or fraction thereof) after the US person has been notified of such failure for more than 90 days. Moreover, failure to file Form 5471 can result in the loss of foreign tax credits.
De minimis and highly taxed exceptions to subpart F
There are two statutory exceptions to the rule that characterises underwriting and premium income as subpart F income. The section 954(b)(3) de minimis rule provides an exclusion for any tax year in which the sum of the gross amount of foreign base company income (which includes FPHCI) and gross insurance income (generally, income of a type treated by section 953 as insurance income) is less than the smaller of 5 percent of gross income or $1 million.
There is also a general exception in section 954(b)(4) for highly taxed foreign income that is subject to an effective foreign tax rate that exceeds 90 percent of the maximum US corporate tax rate (or 31.5 percent). Because CFCs must use US tax accounting methods, and many foreign jurisdictions do not include in taxable income as much insurance income as does the US, this exception has limited application.
Life insurance companies often fund investment-oriented contracts by acquiring shares in mutual funds. In the domestic context, earnings derived from a mutual fund may be offset by deductions for reserves maintained by the insurance company. In the case of a CFC, however, the holding of stock in a foreign mutual fund could create subpart F income—without benefit of reserve deductions—or could implicate the PFIC rules. These technical problems restrict a CFC’s flexibility to invest reserves by virtue of the resulting discontinuity between the treatment of direct holdings in foreign operating companies and indirect holdings via mutual fund investments.
Indirectly owned PFICs
Any non-US corporation with 50 percent or more of its assets being passive and/or more than 75 percent of its income being passive is classified as a PFIC. For this purpose, passive income is of a kind which would be FPHCI under subpart F, section 954(c), such as certain interest, dividends, capital gains, etc. Passive assets are assets that generate passive income, as defined above (ie, FPHCI under section 954[c]).
The PFIC rules, IRC section 1291, et seq, which apply without regard to ownership percentages, extract either a current tax or an interest charge from US investors in foreign corporations with proportionally substantial passive assets, or earning proportionally substantial amounts of passive income, as defined above. Fortunately, IRC section 1297(b)(2)(B) makes clear that the income derived by a corporation predominantly engaged in the active conduct of an insurance business is not treated as passive income for purposes of the PFIC rules; however, in 2003, the IRS promulgated administrative guidance indicating that certain insurance activities not deemed substantial by the Internal Revenue Service (IRS) would be disregarded with the effect of expanding applicability of the PFIC rules to investments held by such insurance companies, Notice 2003-34, 2003-1 C.B. 990.
On the other hand, where a CFC owns shares in a foreign mutual fund, the constructive ownership rules of IRC section 1298(a) treat the CFC’s US parent as the owner of the fund. Section 1298(b)(5) provides regulatory authority to treat PFIC distributions as direct distributions to a constructive US owner. Proposed Reg. §1.1291-1 would confirm the application of the PFIC rules to indirect ownership through a “non-PFIC”.
The detailed PFIC rules are notoriously complicated and often overlooked in situations involving investments in non-US entities by US investors, and thus are beyond the scope of this article. Because of the frequency with which PFIC compliance requirements are overlooked, it is very important for any US investor in a foreign activity to promptly consult with a qualified US tax adviser about the potential applicability of the PFIC rules.
In a nutshell, the compliance requirements that can apply to US owners of PFICs may make it worthwhile to avoid PFIC treatment. This reality also needs to be considered any time a non-US captive insurance company branches out into investment fund activities, because of the risk that the increased investment assets and income can trigger PFIC treatment to the captive, thereby triggering additional compliance burdens for the US owners of such PFIC.
Section 953(d) election
This election allows a non-US captive to be treated for tax purposes as if it were a US captive. The election is made with the US tax return and is irrevocable without IRS consent. The election can be a useful way of avoiding PFIC treatment, since the election results in treatment of the captive as a US corporation.
Cayman Islands has no income tax treaty with the US
Dividends and interest paid from US sources (if not qualifying for the portfolio interest exemption) do not qualify for reduced withholding. Thus they are subject to 30 percent withholding. Dividends and interest from other countries generally can be subjected to foreign withholding taxes as well. Notwithstanding the lack of an income tax treaty between the US and Caymans, the recently effective Foreign Account Tax Compliance Act (FATCA) rules in the US have dramatically raised the stakes for most participants in US-connected commerce to verify that their FATCA compliance procedures have been reviewed by qualified tax advisers.
Federal excise tax
Insurance premiums that are paid to non-US companies are subject to an excise tax, 4 percent for direct insurance or 1 percent for reinsurance or life, accident and health insurance. The tax applies to premiums paid on contracts that qualify as insurance contracts for US Federal tax purposes, regardless whether the foreign payee qualifies as insurance companies for US tax purposes. In other words, premiums paid to a captive insurance company may be subject to the Federal excise tax even though the captive does not qualify as an insurance company.
Paul Dougherty is a tax partner at EisnerAmper. He can be contacted at: firstname.lastname@example.org
David Macall is a senior accountant at EisnerAmper. He can be contacted at: email@example.com
Barbara Pena is a senior manager at EisnerAmper. She can be contacted at: firstname.lastname@example.org
Paul Dougherty, David Macall, Barbara Pena, EisnerAmper, PKF, North America, PFIC, CFC, IRC, FATCA, Insurance