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CAPTIVE INSURANCE • The captive would be taxed at the captive level; and its operating results could not be consolidated with that of its ultimate owner, therefore, losses could not be used to offset gains from other of a parent's subsidiary operations. (Losses could, however, be carried forward and used to offset future captive income). • However, this election, once made, is permanent and irrevocable. • A bond must be posted in an amount equal to 10% of the prior year's premiums of the captive shareholder, subject to a minimum of $75,000. • Also, an elector must waive any other wise applicable tax treaty benefits. There are potentially significant benefits in taking the 953(d) Election. For example, because the captive is treated as a U.S. taxpayer, the interest on inter-company loans between the off-shore captive and a U.S. parent would not be subject to any withholding tax of 30%. U.S. shareholders in an offshore insurance company that is a "controlled foreign corporation" or CFC are also subject to the U.S. subpart F anti-deferral rules. An offshore insurance company with 25% of the shares of its stock owned by U.S. shareholders qualifies as a CFC and a pro-rata share of the company's income must, therefore, be included as personal income each year for its shareholders. Under these circumstances, the offshore company's income is calculated based on U.S. insurance tax accounting rules and only that portion of income attributable to U.S. shareholders is included (i.e., portions attributable to non-U.S. shareholders would not be taxable). In the event of an actual distribution of dividends from the offshore company, a shareholder is permitted to exclude such distribution from income to avoid being taxed a second time. As noted above, under section 953(d) of the Internal Revenue Code, an offshore insurance company can make a permanent and irrevocable "domestic election" whereby it is taxed as if it were a U.S. company. Also, as noted above, although the company would be subject to tax on its worldwide net income, it would not be subject to a premium excise tax. Accordingly, it need not be concerned about inadvertently becoming subject to a 30% branch profits tax because it engages in a U.S. trade or business. The domestic election is most appropriate for an offshore company that only has U.S. shareholders. All of the income earned by such a company would 40 E&MJ; • FEBRUARY 2013 be taxable in any event under the CFC rules in the absence of an election, so making the election eliminates various tax issues that would otherwise exist. State Tax Issues in Choice of Domestic Domicile One component of the choice of domicile process generally is evaluation of the incidence of premium, self-procurement and surplus lines taxes. The cost, for example, of a Vermont captive, as compared to an offshore situs such as Bermuda, would be the state premium tax that is due regardless of the IRS treatment of premiums paid to the captive. Vermont imposes a state premium tax of 0.4% on the first $20 million of direct insurance premiums (and uses a declining scale thereafter) as well as 0.225% tax on the first $20 million of reinsurance premiums written (and also uses a declining scale thereafter). The obligation to pay direct-placement tax may arise as a result of the direct procurement coverage from a non-admitted insurance company. When a captive is defined as non-admitted, the policyholder may potentially be liable for paying such taxes based on the net amount of the captive's written premium for the particular coverage. When the coverage is placed with an admitted insurance company, the insurance company is responsible for paying such taxes; whereas for placements through a surplus lines carrier, the agent responsible for the transaction is liable for such taxes. Direct placement tax may be payable based on variable state-to-state rates applied against the proportion of total premiums allocated to each state. Some states do not impose any direct placement tax. are properly classified as "insurance premiums" and underlying the answer to that question, is whether actual risk shifting and distribution are taking place. A comprehensive judicial analysis of many captive insurance issues can be found in Kidde Industries, where the U.S. Court of Federal Claims articulated a sequence of relevant determining factors using a sixpronged analytical framework: (1) Determination of business purpose. Consistent with Moline Properties v. Commissioner, 319 U.S. 436 (1943), when applying the tax laws to captive insurance companies, courts initially have sought to determine whether the arrangements between the captive insur ance company, the parent, and any thirdparty companies could be classified under the circumstances as a "sham." (2) Is there a sham? If the court determines that the corporate arrangement is a sham, then the inquiry ends and the payments to the captive insurance company are treated as nondeductible reserves rather than "insurance premiums." (3) Test conformity with commonly accepted notions of insurance. Next, either as part of this analysis of whether a sham exists, or as part of a separate analysis of whether the payments to the captive insurance company otherwise should be characterized as "insurance premiums," courts have analyzed whether the arrangement among the parties is consistent with commonly accepted notions of insurance. If the arrangement is not consistent with commonly accepted notions of insurance, then the payments are not deductible from income. (4) Apply the "Le Gierse approach." Finally, assuming the arrangement is not a sham and is otherwise consistent with commonly accepted notions of insurance, courts generally have proceeded to apply the definition of "insurance" set forth in Helvering v. Le Gierse, 312 U.S. 531 (1941) to determine whether appropriate…(5) Risk shifting…and…(6) Risk distribution…are present.1 The IRS' most recent revenue rulings pertaining to the captive issue more or less provide a safe harbor for characterizing a captive as an insurance company where the following conditions are satisfied: Key Tax-related Issues The fundamental federal tax issue in captive insurance cases is whether payments made to the captive insurance company Economic Substance Requirements • No guarantees from the corporate parent of any kind are made in favor of the captive. www.e-mj.com