By Bill Winter
True or False: By establishing your captive insurance company in an exotic island locale, you will enjoy the best beaches, your company will gain instant international status, and, best of all, you will not have to pay taxes. Answer? False. At some point all of us must pay our income taxes. However, in certain situations, an offshore captive may provide a valuable deferral of U.S. income taxes.
Clients regularly ask the question: should my captive be domestic or offshore? Should I choose Washington, D.C. or the Cayman Islands? By establishing your captive as a reinsurance captive and not conducting any business activities inside the U.S., you may gain the benefit of a significant U.S. tax deferral. For most other captives covering U.S. risks, and especially for captives issuing direct policies, no significant tax advantage is gained by choosing Rum Point Beach over the Lincoln Memorial. Under the current U.S. tax rules, three main factors are involved: the ability to deduct unpaid losses, the ability to avoid premium taxes, and the cost of bringing cash home.
Deducting Unpaid Loses
Federal income tax rules allow captives to deduct paid losses from their taxable income. In addition, captives may deduct the discounted present value of any unpaid losses (adjusted, in part, based on actuarially anticipated losses). This generally translates into a tax deduction that equals or exceeds premium income, leaving little or no income to be taxed regardless of the captive’s domicile. For example, assume a captive reinsures P&C policies. The reinsurance captive receives $1 million in annual premiums in exchange for reinsuring up to $10 million of risk over a four year period. Assume the captive has $60,000 in operating expenses and paid losses of $240,000 in the first year (all of which are deductible for income tax purposes). In addition to this $300,000 tax deduction, the reinsurance captive would be entitled to deduct the discounted present value of the $9.76 million in unpaid losses, adjusted based on the actuarially anticipated losses1. Assume the present value of those unpaid losses in year one is $1.1 million. For federal income tax purposes, the captive has a net operating loss of $400,000 (i.e., $1 million of premium income less $1.4 million of deductions). Moreover, the deduction for unpaid losses is adjusted annually, keeping taxable income to a minimum. While some limitations and restrictions may apply, one can see how the captive will not be paying federal income taxes anytime soon. Because the deduction for unpaid losses already minimizes or eliminates the captive’s income taxes, no significant income tax advantage is gained by locating your captive offshore.
Premium Taxes
While captives may not pay significant income taxes, they still must contend with premium taxes. For a domestic captive, they will pay premium taxes in any state where they write business. For an offshore captive, they potentially are subject to both a federal excise tax and state premium taxes. The federal excise tax applies to all foreign insurers2. The excise tax equals 1 percent of gross premiums on life and reinsurance policies covering U.S. risks and 4 percent of gross premiums on casualty policies covering U.S. risks. In addition, an offshore captive may be subject to state premium taxes if they “transact business” in a given state. The concept of “transacting business” is beyond the scope of this article; suffice it to say this is a very liberal standard that may impose premium taxes on an offshore captive if any business activities occur (or are deemed to occur) within the state (whether by issuing policies directly, issuing under self-procurement statutes, or through unrelated agents).
If a captive is not paying income taxes (as a result of its deduction for discounted unpaid losses), then its next largest tax expense likely will be premium taxes. Assume for example that a state’s premium tax rate is 2.25 percent of gross premiums. If the captive generates $1 million in premiums for issuing P&C policies in that state, the captive will owe $22,500 in premium taxes. If the captive is offshore, you must add to this an additional 4 percent excise tax, or $40,000, making the offshore captive more costly.
Now assume that the captive is writing only reinsurance business and that the direct insurer is a large multinational insurance company. By forming an offshore captive and conducting all business activities outside the U.S. (including soliciting the direct insurer outside the U.S., negotiating the reinsurance treaty outside the U.S., and signing the reinsurance treaty at the offshore captive’s foreign offices), the offshore captive likely has avoided “transacting business” in any state. As a result, the offshore captive has removed the 2.25 percent premium tax from the cost equation and has reduced the foreign insurer excise tax to 1 percent—for a total tax cost of $10,000 on $1 million of premium income. The offshore captive has effectively minimized both its income and premium taxes. If the captive avoids paying significant losses over the policy term, then you may be depositing $990,000 a year (i.e., $1,000,000 in premium less the $10,000 excise tax) into an offshore bank account to grow tax-deferred. Apply conservative investing and the laws of compound interest and suddenly you have a very cash-rich captive. Not to mention the sugar-sand beaches surrounded by sapphire waves.
Bring Cash Home
Fast-forward to the end of our offshore captive’s policy period and assume the captive has significant surplus cash. Upon distribution of the surplus cash to the offshore captive’s U.S. parent, the U.S. parent will be required to include the cash as ordinary income, taxable at a 35 percent federal rate (plus any state income taxes). The tax-deferral ends here. At some point, profit from an offshore captive is eventually subject to U.S. income taxes. While an offshore reinsurance captive that does not conduct business in the U.S. may temporarily defer paying U.S. income taxes, in most other situations a domestic captive pays the same or less taxes than its offshore counterpart. In summary, if your decision to locate a captive is based strictly on taxes, you may want to consider locating closer to the Lincoln Memorial than Rum Point Beach. And no matter where your captive is located, always consider hiring an experienced captive tax professional. With careful planning, you may save enough money for that vacation in the Cayman Islands.
William M. Winter is a partner in the firm’s tax and insurance groups. His practice focuses on addressing U.S. tax matters for growing businesses, with an emphasis on helping U.S. and foreign companies successfully expand their business overseas. Mr. Winter received his bachelor’s degree from University of Illinois and law degree from Emory University School of Law.
1 Section 846 of the Internal Revenue Code and the related Federal income tax regulations provide guidelines for determining the discount rate and for determining loss payment patterns, both of which affect calculation of the total deduction.
2 The foreign insurer excise tax would not apply to foreign insurers that have made an election to be treated as a domestic insurance company under Section 953(d) of the U.S. Internal Revenue Code.
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