Tax reform: the fallout for captives
For large captives, the major effect of HR 1, aka the Tax Cuts and Jobs Act (TCJA), is the shift from a graduated tax rate system, with the top tax rate of 35 percent, to a flat rate of 21 percent.
This change will ultimately decrease the federal tax benefit to captive owners, as the accelerated deduction for losses incurred but not recorded (IBNR) will be worth less at a 21 percent tax rate than at the previous rate.
Another significant change to large captives is the change on the adjustment for loss reserve discounting. Insurance companies compute taxable income by reducing their underwriting income by losses and expenses incurred. Losses incurred includes discounted unpaid losses computed under IRC Section 846. Section 846 applies a discount factor to each applicable loss reserve year and type of reserve, reducing the deduction on the insurance company’s tax return.
Discounting loss reserves acknowledges that the taxpayer’s current deduction for a future payment is a way to present value for that deduction.
“Beyond tax benefits, captives provide an increase in risk awareness, better coverage, and improved risk management and risk mitigation.”
Under the new rules, the corporate bond yield curve will be used instead of the applicable federal rate used in prior years when calculating the actual loss reserve discounting factors issued by the IRS and used in the discounting process. The new rules also change the payout pattern used to determine the discount factors.
Between the change in the discount factors and the change to the payout pattern in calculating the discount factors, smaller incurred loss deductions likely can be expected for tax purposes for insurance companies. It is important to note that the discounting of the loss reserve is temporary in nature, meaning that the full amount of the deduction ultimately will be recognised when the claim is actually paid.
Impact on small captives
The Section 831(b) election allows insurance companies to elect to be taxed solely on their investment income, essentially earning underwriting income tax-free. These underwriting profits then could be repatriated back to the owner in the form of a dividend. Captives participating under the Section 831(b) election are not mentioned in the TCJA but, like large captives, they have been affected by the tax rate change.
Although the impact of the TCJA on small captives is not as great as it is on large captives, the biggest change is the reduction of the corporate tax rate and the effect that change will have on the premium deduction received by the insured. As with large captives, the 21 percent tax rate ultimately will decrease the federal tax benefit to small captive owners.
An insured that is structured as a pass-through entity likely will be less affected by the change in tax rate than those organised as C corporations. While tax reform reduced individual and corporate rates, individual taxpayers in the highest bracket saw only a modest reduction from 39.6 percent to 37 percent. Thus, the premium deduction received still is substantial for those pass-through entities. The dividend rate has not changed for those taxed as individuals. When a captive returns surplus to its owners, the tax rate will remain at 23.8 percent.
In 2017, the threshold on the amount of premiums that qualify an insurance company to be eligible to elect under Section 831(b) increased from $1.2 million to $2.2 million (subject to future indexing for inflation).
While many taxpayers will find that the 21 percent tax rate substantially reduces their tax liability, many small captives electing Section 831(b) status will witness an increase in their tax liability. Because many small captives did not generate substantial taxable income, their tax rate before the recent tax reform likely was 15 percent. Moving from a graduated rate system to a flat 21 percent rate will cause many of these captives to experience an increase in their tax liability on their taxable investment income.
Despite the changes that affect small captives, tax benefits still exist, although in some instances the benefits might be substantially reduced.
Impact on group captives
Group captives seem to be the biggest winners from the tax reforms. Since many are acting as small mutual companies that form to reduce overall insurance costs and not for tax benefits, the new 21 percent tax rate should aid in reducing premiums and insurance costs. This benefit also will provide a larger return from surplus for these companies.
The TCJA enacts significant changes for controlled foreign corporations (CFCs) and passive foreign investment companies (PFICs), and it introduces the Base Erosion and Anti-Abuse Tax (BEAT).
For CFCs, there are two major changes under the TCJA. First, the definition of a US shareholder has changed from a US shareholder holding 10 percent of voting power over the foreign corporation to the US shareholder holding either 10 percent of voting power or 10 percent of total value of the company.
The second change affecting CFCs is the number of days required to be classified as a CFC. Under the old rules, if a foreign corporation was a CFC for less than 30 days, it ultimately was not considered a CFC. The TCJA eliminated the 30-day rule, so if the foreign entity is a CFC for one day, the US shareholders must include their pro rata share of income on their current-year income tax return.
The changes described for PFICs apply only to investments in captives formed before 1997 or that do not also qualify as CFCs. In the captive insurance arena, the description of a CFC is expanded to include any foreign corporation that is more than 25 percent owned (rather than 50 percent) directly or indirectly, by US shareholders of any size (rather than a 10 percent threshold) under pre-TCJA law.
The TCJA did not change the expanded definition of a CFC. Consequently, the changes described in this section generally will apply only to captives that are less than 25 percent US-owned.
Changes to the PFIC rules have caught many foreign captives off-guard and searching for solutions. The PFIC rules are designed to address US persons investing in offshore companies in order to avoid reporting current income. A PFIC is a foreign company that, in any year, has more than 70 percent passive income or that holds more than 50 percent of the company’s assets to generate passive income. Many captives currently would meet the 50 percent asset test.
Before the TCJA, many offshore captives were not deemed as PFICs because of the active trade or business exemption, but tax reform modified these rules. Now, passive income for PFICs does not include income derived in the active trade or business of an insurance business by a corporation that: (1) would be subject to tax as an insurance company if it were a domestic company; and (2) that has more than 25 percent of its total assets as reported on the company’s applicable financial statements as applicable insurance liabilities.
The more-than-25-percent test has created an issue for those captives writing low-frequency, high-severity types of risk and other coverages such as warranty coverage. Failing to properly report as a PFIC can result in penalties and can eliminate certain important elections.
Other foreign tax changes
Fearing that multinational companies were receiving an unfair advantage by being able to shift tax liabilities out of the US to a low tax jurisdiction, Congress implemented the BEAT, which is its version of an anti-base erosion system. There now is a minimum tax on multinational corporations that have at least $500 million of annual US gross receipts over a three-year lookback period and a base erosion percentage of at least 3 percent for the taxable year.
The BEAT is intended to ensure that companies doing business in the US pay a minimum level of tax on the expenses paid to a foreign affiliate. Calculated in a similar fashion to the retired alternative minimum tax system, corporations now are required to add their base erosion payments back to taxable income and multiply the result by 5 percent in 2018 to arrive at their BEAT.
The BEAT will be compared to their regular tax to determine any additional taxes owed. The rate increases to 10 percent of the taxpayer’s modified taxable income after 2018 to 12.5 percent after 2025.
Tax reform overall
The biggest disadvantage of the TCJA for captives is that the tax benefits for closely held captive programmes appear to have diminished. Because of the change in discount factors, the modified 21 percent tax rate, and the new rules for offshore entities, the tax benefits of the captive industry have probably decreased.
Despite the change in the tax law, captives still produce many benefits for several types of companies. Even though the tax benefits are reduced, they have not been eliminated. In addition, beyond tax benefits, captives provide an increase in risk awareness, better coverage, and improved risk management and risk mitigation. Captives also reduce the commercial insurance premiums for the company.
While the TCJA has limited the tax benefits of the captive industry, planning and forming a captive should be driven by a reasonable business need, not by a desire to gain a tax deduction. The benefits of a captive insurance arrangement include many types of risk awareness, risk management, and risk mitigation.
Captives also allow companies to have better coverage that commercial carriers cannot provide and help reduce commercial insurance premiums. When executed for the right reasons, a captive remains a reliable risk-financing tool. These benefits should be kept in mind when considering the captive industry and the potential benefits it holds.
Niki Garceau is a tax senior staff accountant at Crowe Horwath. She can be contacted at email@example.com
Dan Kusaila is a partner at Crowe Horwath. He can be contacted at firstname.lastname@example.org