Captive Insurance Taxation: Compliance, Tax Reform and Section 953(d) Election
Mar 26, 2018
A “Captive Insurance Company” is a closely held insurance company whose insurance business is primarily supplied and controlled by its owners. Captives provide operational, business and tax advantages to businesses and owners. While many captive insurance companies are domiciled off-shore in no- or low-tax jurisdictions, US taxpayers owning captives were generally taxed on their world-wide income prior to the Tax Cut and Jobs Act of 2017. In this article we explore in more detail captive insurance taxation for US companies.
Ownership of a captive by a tax-exempt organization may remove the payment of US tax, but such ownership does not remove the compliance burden. The US owners of a foreign captive insurance company need to be especially mindful of the myriad of compliance requirements as the penalties for failure to file these foreign-related forms are draconian. Some of the forms which might be required include (but are not limited to):
- Form 5471: Information Return of U.S. Persons with Respect to Certain Foreign Corporations. A separate form is required for each foreign corporation and it is filed with the US shareholder’s tax return. Form 5471 is used to gather information about the foreign corporation, calculate SubPart F income, calculate Earnings & Profits, and report related party transactions. Penalty for failure to file? $10,000 per form per year.
- Form 926, Return by a US Transferor of Property to a Foreign Corporation. This form is used to report the transfer of tangible or intangible property to a foreign corporation. A cash transfer is required to be reported if it was in exchange for ownership of 10% or more of the foreign corporation or if the amount of the transfer(s) exceeds $100,000. Penalty for failure to file? 10% of the Fair Market Value of the property transferred up to $100,000, unless there is reasonable cause.
- Form 8621: Return by a Shareholder of a Passive Foreign Investment Company. When a US person owns less than 10% of a captive (or if the US owner owns more than 10% but the captive is not a controlled foreign corporation), the captive may be considered a Passive Foreign Investment Company (PFIC) in the hands of the shareholder; however, there is an “active insurance” exception. Elections can be made on Form 8621 in the initial year of PFIC status to either recognize the income from the PFIC currently (a “Qualified Electing Fund Election”, which generally treats the PFIC similarly to a US mutual fund) or to recognize as income the increase in the value of the PFIC stock annually (a “Mark-to-Market” election). If the form is not filed, meaning appropriate elections are not made, upon disposition of the PFIC, the US taxpayer will pay the tax on any gain at the highest rate of tax (not the capital gains rate), allocating the gain back over the years of ownership and paying interest on the tax. Losses on the sale of the PFIC stock cannot be recognized.
- Form FinCEN 114: Foreign Bank Account Reports. This is a filing with the US Department of the Treasury, not the IRS. FBARs must report all foreign accounts which a US taxpayer owns, has a financial interest in, or signature authority over (if the total in all foreign accounts exceeds $10,000). Failure to file an FBAR is a criminal office (meaning jail time is not out of the question) and the financial penalty for willful violation can be up to 50% of the undisclosed account or $100,000, whichever is less.
- Form 990, Schedule F: Statement of Activities Outside the United States. This schedule requires a tax-exempt organization to report in detail their activities outside of the US, including both financial and qualitative information.
The Tax Cut and Jobs Act (TCJA) of 2017 requires all US taxpayers to reassess their tax position: from a cut in the corporate tax rate to 21% (actually, a FLAT rate of 21%, so corporate taxpayers previously in the 15% tax bracket will see a tax increase), to a shift to a (partial) territorial system of taxation requiring a deemed repatriation, to a new SubPart F category of income (GILTI) and a minimum tax when payments are made to foreign related persons (BEAT). While the new tax rules add complexity and potentially harsh consequences to US taxpayers with international activities, a properly structured organization can still obtain significant benefits from an offshore captive. The actual impact of the TCJA should be carefully evaluated as restructuring of operations and business activities might be necessary to avoid adverse tax consequences.
- Change to a Territorial System of Taxation: The major international tax provision of the TCJA is the change from the prior “World-Wide System” of taxation to a “Territorial System”, allowing corporations to repatriate profit from offshore subsidiaries without being subject to further taxation in the US. Think of this as a “dividends received deduction” available for offshore subsidiaries (or what most of the rest of the world calls a “participation exemption”).
- Deemed Repatriation: In order to make the change to a Territorial System of taxation, a one-time “deemed repatriation” of all post-1986 earnings and profits (E&P) of specified foreign corporations occurred effective 12/31/2017. The complex calculation of this deemed repatriation essentially results in the E&P supported by cash and cash equivalents on the balance sheet being taxed at a 15.5% rate and all remaining E&P being taxed at 8%.
- GILTI: As the acronym suggests, GILTI is not a favorable category of income for a U.S. shareholder to have. GILTI is income that exceeds 10% of a Controlled Foreign Corporation (CFC)’s Qualified Business Asset Investment (QBAI). A CFC’s QBAI is defined as the CFC’s fixed assets that are depreciable as trade or business assets under IRC Section 167 and does not include the CFC’s intangible property such as patents trademarks and other that are amortizable under Section 197. Generally, income that is Effectively Connected Income, Foreign Base Company Income, or income that is taxed at a rate that is more than 18.9% will not be GILTI.
- BEAT: If transacting business internationally, corporations will also need to consider the Base Erosion Anti-abuse Tax (BEAT). BEAT applies to taxpayers with average annual US gross receipts in excess of $500 million over a three-year period and a “base erosion percentage” of at least three percent. The BEAT rate is 5 percent in 2018, increased to 10 percent until 2025 and then 12.5 percent thereafter, and is calculated on a modified base income of taxable income plus certain payments to related parties outside of the US. Premiums paid to an offshore captive would be a form of disallowed payment, however, there are a number of inputs that will influence the calculation of any new BEAT tax due. Whether or not BEAT will apply will require a look at not only insurance premiums, but all related party payments, so a holistic analysis would be required to determine if your benefit from a captive would be impacted.
Under Internal Revenue Code Section 953(d), a non-disqualified captive insurance company may be able to avoid the special rules governing offshore captive insurance companies (and the onerous foreign reporting requirements) by electing to be treated as a domestic corporation, if certain conditions are met. If the election is made, the corporation is treated as having reorganized as a domestic corporation and the activities of the foreign captive will be considered “effectively connected” with at US trade or business. Avoiding foreign reporting, however, should not be the foremost motivator to make a Section 953(d) election.
Captive owners and managers, including tax-exempt organizations, should consult with their tax advisors on the foreign reporting requirements, the impacts of the Tax Cut and Jobs Act of 2017, and the potential benefits and costs of making a Section 953(d) election.