Careful planning can help reduce the risk of exposure to premium taxes outside a captive’s domicile, says Joseph Holahan of Morris, Manning and Martin.
Events over the last year have highlighted the potential for captive insurance to be subject to premium taxes in states outside the captive’s domicile. These developments include a New Jersey Tax Court decision in June 2018 requiring Johnson & Johnson to pay self-procurement taxes to New Jersey on all of the US risks written by its Vermont captive, and an enforcement action brought by the Washington State Insurance Commissioner against an Arizona captive owned by Microsoft. Microsoft paid $876,820 in premium taxes, interest and penalties to settle that action in August 2018.
It is too early to tell whether these events indicate a trend towards more aggressive state enforcement in this area. In this regard, it is worth noting that Johnson & Johnson paid the taxes voluntarily and then sought a refund for the portion attributable to risks outside New Jersey. Nevertheless, they illustrate the value of evaluating the potential for premium tax liability when structuring a captive programme and taking sensible steps to reduce the exposure.
Whether a captive or its insureds may be subject to premium taxes outside the captive’s domicile is not a new issue. Under the law of most states, an insured may self-procure coverage from an insurer that is not licensed in the state, but must report the transaction to the state and pay a tax on the premium. This practice is referred to as “self-procurement” or sometimes “direct” or “independent” procurement.
Tax rates for self-procured insurance vary from 1.5 percent to 6.0 percent, depending on the state.
Many states also allow “industrial insureds”—companies that meet certain criteria for size and sophistication—to obtain insurance from unlicensed insurers. Industrial insureds pay a tax on premiums at the same rate as insureds who self-procure.
The authority of states
Federal law places certain limitations on the authority of states to tax and regulate insurance transactions involving an out-of-state insurer. In its 1962 decision, State Board of Insurance v Todd Shipyards, the Supreme Court held that due to limits on state authority established by the McCarran-Ferguson Act, Texas could not assess a premium tax on an insurance transaction where the only contacts with the state were the fact that the insured property was located in the state and the insured did business there.
In reaching this conclusion, the court noted that the insurance transaction at issue took place entirely outside Texas: the insurance was negotiated and paid for outside the state; the policies were issued outside the state; all losses were adjusted and paid outside the state; and the insurers had no office or place of business in the state and did not solicit insurance there.
Todd Shipyards remains good precedent, but lower courts deciding cases in more recent years generally have sought to limit the ruling to the narrow facts of the case. Under these decisions, almost any contact by a captive with a state other than the fact that insured property or operations are present there could be enough for the state to assess a premium tax.
The Nonadmitted and Reinsurance Reform Act of 2010 (NRRA) places additional limitations on the authority of states to impose premium taxes on insurance written by an out-of-state insurer. The NRRA provides that no state other than the “home state” of the insured may require any premium tax payment for “nonadmitted” insurance. There is some uncertainty whether “nonadmitted” insurance includes captive insurance, but many states have taken the position that it does.
The NRRA defines the home state of an insured as the state in which the insured has its principal place of business. Generally speaking, this is the state where the insured has its corporate headquarters. If more than one insured from a group of insureds affiliated by common control are named insureds under a single policy, the home state for the policy is the home state of the insured to which the greatest percentage of the premium is attributed.
Reducing the exposure
By analysing and adjusting their operations in light of applicable federal and state laws, captive owners may be able to reduce their exposure to extra-domicile premium taxes. Applying these laws to a captive programme can be complicated and is highly fact-specific, but general considerations include the following:
If the home state of the insured licenses captives, consider forming (or for existing programmes, re-domiciling) the captive in that state. The captive will owe captive premium taxes in the domicile (at a low rate), but other states will probably have no authority to collect premium taxes on the insurance due to the NRRA’s prohibition against any state other than the home state requiring any premium tax payment for nonadmitted insurance.
For existing captive programmes, an alternative strategy is to form a captive in the owner’s home state and reinsure the business to the existing captive. This approach may require paying a reinsurance premium tax to the existing captive domicile in addition to the tax on direct premiums owed to the home state, but these tax rates typically are very low, so that even when taken together, they are likely to be far less than any self-procurement tax.
Limit operations of the captive outside its domicile. This can be difficult to do, especially with respect to the state where the owner has its principal place of business, where personnel who manage the captive programme may be located. Nevertheless, limiting contacts outside the domicile will help strengthen the position that states other than the domicile have no authority to tax the captive’s transactions.
Adjust policies insuring affiliated companies to reduce self-procurement taxes. The NRRA makes the home state for a policy insuring affiliated named insureds the home state of the insured to which the greatest percentage of premium is allocated.
This rule gives rise to certain strategies that may help reduce any self-procurement taxes owed. For example, by adjusting deductibles and therefore the allocated premium for each affiliate, it may be possible to move the home state for the policy to a lower-tax jurisdiction.
Alternatively, a single policy may be split into two or more policies covering different affiliates, which may reduce the total amount of self-procurement tax owed. Other approaches also are possible. The best strategy depends on where each affiliate has its home state, applicable tax rates, and other factors.
Switch to reinsurance. For example, many captives write deductible reimbursement coverage for their owners. If the commercial carrier writing the underlying policy is amenable, a deductible reimbursement policy can easily be recrafted as reinsurance. The total tax liability for this arrangement, which would include the premium tax the commercial carrier pays for coverage within the deductible plus any premium tax the captive pays for the reinsurance, is likely to be lower than any self-procurement tax payable on the deductible reimbursement coverage.
Consider whether captive insurance is “insurance” in any state where it appears self-procurement taxes may be owed. Because captive insurance is a form a self-insurance, there may be precedents in any particular state to support the position that it is not “insurance” subject to regulation and taxation there.
Whether captive insurance may be subject to premium taxes outside the captive’s domicile has always been a consideration for captive programmes. A close analysis of the programme and applicable law can help captive owners better understand the exposure and take effective steps to manage and reduce this risk.
Joseph Holahan is of counsel in the insurance and reinsurance practice of Morris, Manning and Martin. He can be contacted at: email@example.com
Manning and Martin, Captives Insurance, Premium Taxes, Tax rates, Joseph Holahan, North America