© 2015 locke lord llp brian t. casey, esq. partner, co-chair regulatory & transactions...

© 2015 Locke Lord LLP

Brian T. Casey, Esq.Partner, Co-Chair Regulatory & Transactions Insurance Practice

Group

Insurance Accounting & Systems Association

Georgia Chapter Fall Educational Conference 2015

Insurance Tax Law Updates

October 26, 2015

Atlanta I Austin I Boston I Chicago I Dallas I Hartford I Hong Kong I Houston I Istanbul I London I Los Angeles I Miami I Morristown I New Orleans

New York I Orange County I Providence I Sacramento I San Francisco I Stamford I Tokyo I Washington DC I West Palm Beach

© 2015 Locke Lord LLP 2

Agenda

• Affordable Care Act

• Captive Insurance Companies

• Federal Excise Tax on Retrocession Reinsurance

• State Insurance Retaliatory Tax

• Insurance Risk vs. Investment Risk

• Passive Foreign Investment Companies

• Investor Control of Life Insurance

• Warranties/Service Contracts




Affordable Care Act

• King v. Burwell, U.S. Supreme Ct., June 2015

– Taxpayers in Virginia sued to declare that purchasers of health insurance via FFE are not entitled to federal tax subsidies under ACA; if they got subsidies, then they would become subject to individual shared responsibility

– Exchange established by a state means federal exchange too

– No Chevron deference to IRS

– Ambiguity and contextual meaning and perhaps results driven analysis

• U.S. House of Representatives v. Burwell

– failure of Congress to appropriate funds for federal government’s cost-sharing payments to insurers

– delay of implementation of employer mandate

– D.C. District Court rules House has standing in Sept. 2015 for non-appropriation, but not delayed employer mandate claim




Rent-A-Center v. Internal Revenue Commissioner, (U.S. Tax Ct., January 2014)

Rent –A-Center

Legacy Insurance Company

Rent-A-Center Subsidiary






Captive Insurer Arrangement Upheld by U.S. Tax Court

• Rent-A-Center v. Internal Revenue Commissioner, (U.S. Tax Ct., January 2014)

• Tax Court in a 9-6 opinion upheld deductibility of premiums paid by RAC’s 15 brother-sister subsidiaries to captive insurer

• Legacy Insurance Company formed as Bermuda subsidiary of RAC to insure 15 other subsidiaries’ workers’ compensation, commercial auto and general liability risks

• IRS attacked $43mm in insurance premium deductions over 5 year period

• Legacy permitted by Bermuda Monetary Authority to treat deferred tax asset on Legacy’s balance sheet for minimum solvency margin

• RAC guaranteed value of Legacy’s deferred tax assets

• Legacy purchased RAC treasury shares which Bermuda Monetary Authority also allowed Legacy’ to carry on its balance sheet for minimum solvency margin




Rent-A-Center v. Internal Revenue Commissioner, (U.S. Tax Ct., January 2014)• Legacy formed for legitimate business (non-tax) purpose

• No impermissible circular flow of funds from insureds to RAC

• Legacy’s premium-to-surplus ratio not indicative of a sham arrangement

• Insurance premiums paid to Legacy were deductible because:

– Risk-Shifting by RAC subsidiaries to Legacy under Humana brother-sister arrangement balance sheet/net worth test because Legacy’s claim payments did not reduce net worth of insureds as the didn’t own stock of Legacy

– Parental guaranty of Legacy’s DTA did not negate risk shifting as guaranty did not affect insureds’ balance sheets and cases of parental guaranty of captive reinsurer’s reinsurance obligations to unaffiliated ceding primary insurers were distinguishable as Legacy wasn’t undercapitalized

– Risk-Distribution existed with 2,800 stores, 17,000 employees and 7,500 autos insured

– IRS decided not to appeal the case




Rent-A-Center v. Internal Revenue Commissioner, (U.S. Tax Ct., January 2014)• Judge Lauber’s Dissent (4 other Judges joining)

– Humana did not need to be overruled and that based on facts and circumstances of RAC, no insurance between Legacy and RAC’s subsidiaries

– DTA and RAC treasury shares were not income producing assets and supported inadequate capitalization finding

– IRS Revenue Ruling 2002-90 excluded all forms of parental guarantees

– Legacy had no real employees

– Netting of claims due from Legacy against premium payments due to Legacy




Securitas Holdings v. IRS (U.S. Tax Ct., October 2014) - Risk-Distribution • Case involves corporate group as follows:

Securitas AB

Securitas Holdings, Inc.

Non-US Op. Sub.

Non- US Op. Sub

Non- US Op. Sub.

Non- US Op. Sub

US Op. Sub.

US Op. Sub.

US Op. Sub.

US Op. Sub.

US Op. Sub.

Securitas Group Reinsurance, Ltd.

(Irish Captive)

Protectors Ins. Co.(Vermont Captive) APPEAL PENDING

Reinsurance Agreement




Securitas Holdings v. IRS (U.S. Tax Ct. October 2014) - Facts

• IRS challenged captive’s insurance company status seeking $30 million tax deficiency

• Securitas USA bought companies in USA, including Protectors Ins. Co. (VT captive) and Pinkerton’s

• Securitas Group Reinsurance Ltd. (“SGR”) formed as captive reinsurer in Ireland

• Protectors insured brother-sister operating subsidiaries’ self-insured retentions under their workers’ compensation, commercial auto, general, fidelity and employment practices insurance policies

• SGR reinsured 100% of Protectors’ risks under its insurance policies

• Securitas issued parental guaranty to Protectors to disqualify it as an insurance company to preserve tax-exempt status of Centaur Ins. Co., a captive that came in an acquisition

• No payments ever made under parental guaranty and no parental guaranty issued to SGR




Securitas Holdings v. IRS (U.S. Tax Ct. October 2014) - Risk-Shifting• IRS argued that Securitas’ parental guaranty negated risk-shifting from

insured brother-sister subsidiaries to Protectors

• Prior cases disqualifying insurance company status of captives where parental guaranty was issued distinguished because there 3rd party insurer required guaranty

• Affirmed RAC case in that parental guaranty does not per se negate risk-

shifting

• IRS rebuffed in arguing Protectors had inadequate capitalization based on premiums to surplus ratio, which was 0:1 on net of reinsurance basis

• IRS rebuffed in arguing that, because claims payments made by parent company and Pinkerton’s and then reimbursed by SGR, Protectors did not pay claims under its insurance policies, which arrangement RAC case upheld as common journal entries practice for corporate conglomerate




Securitas Holdings v. IRS (U.S. Tax Ct., October 2014) - Risk-Distribution • IRS argued that most of the premiums paid to SGR came

from Protectors compared to SGR’s premiums for Securitas’s non-U.S. subsidiaries’ risks

• Protectors insured 5 lines of insurance risk involving 200,000 employees and 2,250 vehicles of Securitas USA

• SGR’s premiums for non-U.S. risks involved another 100,00 employees and 25-45 worldwide subsidiaries in years at issue

• SGR had exposure to large number of risks, and they don’t change simply because they ultimately become reinsured in single entity and thus adequate risk distribution existed

• Appeal pending




IRC 831(b) Small Captive Insurers

• Also known as “micro”, “mini” or IRC 831(b) captives

• State captive insurance laws do not distinguish between IRC 831(b) vs. non-IRC 831(b) captive insurers; simply a tax election, which cannot be revoked except with consent of Treasury Secretary

• Designed for captives with annual written premiums of $1.2 million or less

• 831(b) captive is taxed only on its investment income as a C-corporation, so underwriting profits can accumulate on a tax-deferred basis, potentially for long period for long-tail insurance risks

• Drawbacks include inability to use underwriting losses to offset investment income





• Must meet definition of an insurance company like any captive insurer to obtain deductions premiums paid by insureds

• Typically used for a closely-held company

• Generally better suited to higher severity, lower frequency loss exposures

• Some State Insurance Departments will give greater scrutiny to micro captives and their business plan, professional operation and viability to avoid financial failures and being perceived as a micro captive haven





• Proliferation of marketing use of small captives by captive insurance company consultants and accounting and law firms during last 2-3 years, resulting in IRS focus

– Some marketers tout estate planning advantages

• IRS included for the first time in 2015 small captive insurance companies on the IRS’ Dirty Dozen list of abusive tax transactions

• IRS is aggressively auditing small captive insurance companies and Avrahami v. Commissioner tried in March 2015 with decision pending

• Bottom line is that small captive insurance company must be operated as an insurer (not as an investment company vehicle), insure real risks borne by its insured owners and price its premium charges on actuarially sound basis




IRS’ Cascading Federal Excise Tax Theory

• IRS Revenue Ruling 2008-15:

• US corporation insures with foreign insurer (no treaty) and foreign insurer reinsures with foreign reinsurer (no treaty) = 4% FET and 1% FET

• US insurer reinsures with foreign reinsurer (no treaty) and foreign reinsurer retrocedes to another foreign reinsurer (no treaty) = 1% FET and 1% FET

• US corporation insures with foreign insurer (qualified FET treaty) and foreign insurer reinsures with foreign reinsurer (no treaty) = 4% FET and 1% FET

• US corporation insures with foreign insurer (FET no conduit treaty) and foreign insurer reinsures with foreign reinsurer (no treaty) = o% FET and 1% FET




IRS Loses on CascadingFederal Excise Tax on Reinsurance Theory• Validus Reinsurance v. Internal Revenue

Commissioner, (D.C. Dist. Ct., February 2014)

• Validus reinsured US casualty insurers and retroceded to foreign reinsurers not in US tax treaty countries

• 4% FET on premiums ceded to Validus paid

• IRS claimed FET deficiency for reinsurance premiums retroceded by Validus to foreign reinsurers

• Validus paid taxes asserted by IRS, IRS sat on refund request, so Validus sued for tax refund




Validus Reinsurance v. Internal Revenue Commissioner, (D.C. Cir. Ct., May 2015)

Ceding Insurer

ValidusNon-Exempt

Foreign Reinsurer

Non-Exempt Foreign

Reinsurer

Reinsurance

Retrocession




Validus Reinsurance v. Internal Revenue Commissioner, (D.C. Dist. Ct., Feb. 2014)• IRC 4371: Imposes tax as follows:

– (1) Casualty insurance and indemnity bonds 4 cents on each dollar…of the premium paid on the policy of casualty insurance….

– (2) Life insurance, sickness, and accident policies, and annuity contracts 1 cent on each dollar…of the premium paid on the policy of life, sickness, or accident insurance, or annuity contract; and

– (3) Reinsurance 1 cent on each dollar, or fractional part thereof, of the premium paid on the policy of reinsurance covering any of the contracts taxable under paragraph (1) or (2).

• IRC 4372 (f): “policy of reinsurance” means any policy…or contract of reinsurance … or with respect to, any of the hazards, risks, losses, or liabilities covered by contracts taxable under paragraph (1) or (2) of Section 4371.

• Summary judgment for Validus holding IRC 4371 does not apply to any retrocessions of reinsurance, even where underlying insurance policies cover U.S. based risk, but ruling not based on fact that transaction was wholly between non-U.S. persons.

• IRS appealed case; oral arguments heard in February 2015




Validus Reinsurance v. Internal Revenue Commissioner, (D.C. Cir. Ct., May 2015)• Appellate Court affirmed lower court’s decision but on narrower

grounds

• Appellate Court held the word “covering” was ambiguous as used in IRC 4371(3) regarding wholly foreign retrocessions: policy of reinsurance covering any of the contracts taxable under paragraph (1) or (2)

– IRS argued retrocessionaire “covers” risks insured by underlying insurance contract

– Validus argued retrocessionaire “covers” only Validus’ risks assumed under its assumed reinsurance agreements

• Appellate Court resolved ambiguity via presumption against extraterritoriality, holding that FET does not apply to retrocession by foreign reinsurer to another foreign reinsurer




State Insurance Retaliatory Tax

• Chartis et. al v. Tennessee, TN Supreme Ct, Oct. 2015)

• TDCI audited 5 insurers and assessed $16m for 2005-2007 tax years based on retaliatory taxes for workers’ compensation charges collected by insurers under PA law

• Insurers paid assessments under protest and sought refunds

• TN Claims Commission granted TDCI’s motions for summary judgment

• TN Appellate Court affirmed

• Taxpayer insurers appealed




State Insurance Retaliatory Tax

• Chartis et. al v. Tennessee, TN Supreme Ct, Oct. 2015), continued

• TN has standard retaliatory tax statute

• Before July 1, 1998, PA workers’ compensation insurers paid assessments to 3 PA workers’ compensation funds, but law changed to impose assessment collection, but not liability, on insurers from insureds and self-insureds, made clear by TN DOL’s implementing regulations

• TN Supreme Court reversed holding that prior law repeal clear and tasking insurers with duty to collect and remit with no financial penalty on insurers for insureds’ failure to pay surcharges not financial burden on insurers within meaning of retaliatory tax statue




Insurance Risk vs. Investment Risk

• IRS Chief Counsel Advice 201511021 (March 2015)

• Captive insurer issued “insurance” policies to affiliates for loss of earnings due to currency fluctuations (increases or decreases)

• Not an insurance risk, but rather an investment risk

• Not insurance in commonly accepted sense

– Existence of similar contracts, like financial guaranty insurance, does not per se carry the day; no casualty event here

– Derivatives are typical type of contract for mitigating currency risks





• RVI Guaranty Co. v. Internal Revenue Service, U.S. Tax Ct., September 2015

• IRS TAM 201149021

– RVI by unrelated insurer for lessor’s leased equipment, real estate and autos assets risks

– IRS’ position that residual value insurance is not insurance for tax purposes:

No fortuitous event; mere passage of time

Not insurance in commonly accepted sense; no casualty risk, and contract termination is not such a risk





• RVI Guaranty Co. v. Internal Revenue Service, U.S. Tax Ct., September 2015, continued

• Tax Court held residual value insurance policies are insurance for tax purposes

– state insurance law treated as residual value insurance

– low loss ratios and deferred period for loss trigger not fatal to insurance classification, similar to catastrophe insurance

– adequate risk distribution existed; perfect independence of risks not required

– rejected investment risk and “pure” insurance argument and casualty event causing loss is unnecessary





• IRS Chief Counsel Advice 201533011 (August 20150

• Captive insurer scenario where captive insured 6 brother-sister corporations’ risks that their costs of health care services would exceed capitated amounts under 10 year excess of loss policies

• Attachment points not set until year 4

• All claims payable at end of 10 year policy term

• Policies’ liability initially capped at 150% of premiums, which were paid in 10 annual installments, and later raised to 170%

• No risk shifting because losses were certain to occur and partially incurred when attachment points set and losses expected to exceed policy limit

• Taxpayer only assumed investment risk, pre-funding of future claims and that premiums would grow by 70% over 10 years




Hedge Funds’ Use of ReinsurersPassive Foreign Investment Income

• Passive Foreign Investment Company – under IRC 1297 a foreign corporation is a PFIC if 75% or more of gross income is passive income or 50% or more of assets produce passive income

• Passive income excludes income from active conduct of insurance business by corporation predominately engaged in insurance business

• Perceived issue is hedge funds forming offshore reinsurers to defer or reduce income taxes that would be paid on investment income




Hedge Funds’ Use of InsurersPassive Foreign Investment Income

• IRS Proposed Regulation 1.1297-4 in April 2015

• “Active Conduct” does not include officers and employees of related entities

• “Insurance Business” only includes investments and administrative services required to support or substantially related to insurance contracts issued or reinsured by foreign corporation

– Investments are required to support or substantially related to insurance contracts to extent income is earned from assets held to meet obligations under insurance contract

• Comment period ended July 2015 and IRS hearing held in September 2015




Hedge Funds’ Use of InsurersPassive Foreign Investment Income

• Senate Bill 1687, Offshore Reinsurance Tax Fairness Act, would amend IRC 1297 for years after 2015, in Senate Finance Committee

• Qualifying Insurance Corporation definition:

– foreign corporation which would be taxable as Subchapter L corporation if it were domestic corporation

– insurance liabilities more than 25% of total assets

insurance liabilities are loss and loss adjustment expenses and reserves other than deficiency, contingency or unearned premium reserves for life and health insurance

– U.S. person owning stock of foreign insurer if (1) insurance liabilities at least 10% of total assets, (2) foreign insurer predominantly engaged in insurance business and (3) failure of 25% test due to temporary circumstances of insurance business under facts and circumstances as IRS may promulgate




Variable Life InsuranceInvestor Control Rule

• Webber v. Internal Revenue Service, U.S. Tax Ct., June 2015)

• Very bad taxpayer facts

• Issue was who owned assets held in separate account, life insurer v. policyholder

• Cayman Islands insurer issued private placement variable life insurance policies to grantor trusts established by taxpayer insuring lives of his relatives

• IRS determined taxpayer owned separate account investments and assessed income tax deficiencies totaling $665,000 and $130,000 in accuracy penalties for 2006 and 2007 tax years




Variable Life InsuranceInvestor Control Rule

• Webber v. Internal Revenue Service, U.S. Tax Ct., June 2015) - continued

• Taxpayer was a venture capitalist, and essentially all investments made by insurer in separate account were in start-up companies in which taxpayer invested outside of the life insurance policies

• Insurer’s investment manager selected by policyholder and took no investment “recommendations” from taxpayer’s CFO and attorney and made no discretionary decisions

• Taxpayer won on accuracy penalties based on his good faith reliance on his sophisticated tax lawyer’s advice




Warranties/Service Contracts

• IRS Technical Advice Memo 201438022– Taxpayer offered “Certified Warranty Program” for its used products

sold by retailers Extended Service/Warranty Agreement (“ESA”)-extended warranty on used

product for optional purchase price, which could be canceled

Supplement-extended manufacturer’s warranty resulting in higher price for used product, which could not be canceled

– Taxpayer treated both ESA and Supplement as insurance contracts for federal income tax purposes

– TAM concludes that ESA is insurance contract for federal income tax purposes

– TAM concludes, however, that Supplement is not insurance contract for federal income tax purposes because it was not separately bargain for and part of product sale, and is warranty

• State DORs assessing sales/use tax for service contracts




QUESTIONS? ANSWERS!

Brian T. Casey, Esq.Locke Lord LLPTerminus 200

3333 Piedmont Rd., NE, Suite 1200Atlanta, GA 30305

Direct: 404.870.4638 Fax: 404.806.5638 Email: [email protected]

DISCLAIMER: Mr. Casey and Locke Lord LLP (“LL”) disclaim all liability whatsoever in relation to any materials or information provided at this event.

In addition, any written materials or other information provided by Mr. Casey or LL, and any presentations made generally to the participants at this event, are solely for informational purposes; they do not, nor are they intended to, constitute legal advice or

create an attorney-client relationship.

mailto:[email protected]

© 2015 locke lord llp brian t. casey, esq. partner, co-chair regulatory & transactions...

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