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Morris Manning & Martin, LLP

LETTER FROM WASHINGTON - Captives Show their Clout on Taxation

04.01.2008

The “alternative market” has grown to such an extent that, by some estimates, the premium paid into the “alternative market” exceeds that paid into the standard commercial property/casualty market. Even in the recent soft market, the number of captives, both on-shore and off-shore, has continued to grow. At least half of the states have some form of captive legislation, and new risk transfer concepts, such as securitizations for a wide variety of risks, continue to gain adherents.

This increase in economic activity in the “alternative market” brings with it expanded political and regulatory clout, particularly in those states with captive legislation. Recent developments in the federal taxation of captives illustrates this new power and influence.

Treasury’s “September Surprise”

On September 27, 2007 the U.S. Treasury issued proposed regulations that would have amended the intercompany transaction rules under I.R.C. § 1502 in a manner that would have essentially rendered almost all single parent captives unable to treat their captive insurance subsidiaries as “insurers”. It would have done so by excluding from such favorable tax treatment all captive insurers that insured risks from sister companies in excess of 5% of total risks insured. This would have overruled the Humana case (and succeeding cases), which have been relied upon for decades.

The Internal Revenue Service has never favored captives. In 1977, it advanced its own “economic family” theory, which asserted that affiliated companies had to account for risks as if they were one “economic family” and therefore no “risk shifting” or “risk transfer” could occur (a pre-requisite for “insurance” treatment under the Internal Revenue Code). However, two decades of adverse case law prompted the I.R.S. to acknowledge the demise of the “economic family” theory, and it issued Revenue Ruling 2001 – 31, which expressly so stated. It then followed with Revenue Rulings 2002-89 and 2002-90, which established “safe harbor” guidance for the captive industry. As recently as 2005, it elaborated on those safe harbors in Revenue Ruling 2005-40.

Accordingly, the September 27, 2007 proposed rules came as a complete surprise to the captive industry. However, it did not take long for the industry to recognize the threat and to rally. Under the leadership of the Vermont Captive Insurance Association (VCIA) and the Captive Insurance Companies Association (CICA), a coalition was formed to focus the efforts of the captive industry and captive states (Coalition for Fairness to Captive Insurers (CFCI).

As in most lobbying campaigns, the effort required both technical and political expertise. CFCI assembled a group that was well versed in both respects. After “working the Hill” and petitioning the Treasury, a meeting took place with Treasury representatives that resulted in a further exchange of information on both the economic impact of the proposed regulations on interested persons (including several significant states) and the technical flaws (from a tax perspective) of the rules. The theme was that not only were the proposed rules “bad law,” but, after implementation, would both (1) damage important economic interest. and (2) worsen the Tax reporting of the genuine economic effect of the legitimate business activity.

A hearing had been scheduled for February 28. However, in a surprise move, the proposed rules were withdrawn by Treasury.

Protected Cell Company Taxation

Protected cell companies (PCCs) have been in existence for at least fifteen years and have more recently become popular as mechanisms to insure risk without establishing an independent captive insurer. In brief, a segregated “cell” or separate account can be established within a PCC. By the laws of the chartering jurisdictions, the liabilities of one cell cannot be attributed to another cell within the same PCC.

As the use of PCCs has increased, additional domiciles (both on-shore and off-shore) have passed laws which elaborate upon the initial regulatory regime, first established in Bermuda. In all of this time, no case has ever been decided that clearly establishes a precedent that the borders of a cell will be respected in the event of an insolvency.

In Notice 2005-49, the I.R.S. asked for comment regarding the tax treatment to be provided to cells. Should they be treated as “insurers”? Should the boundaries of the cells be respected? Comment was provided by a group of tax practitioners under the auspices of VCIA.

Very recently, the I.R.S. issued Notice 2008-19 along with Revenue Ruling 2008-8. In almost all respects, the I.R.S. adopted the positions taken by the captive industry panel. The I.R.S. concluded that an individual cell could be treated for tax purposes as an “insurer” separate from any other entity (e.g., the PCC itself), but only if it legally acted as a separate insurer. The criteria set by the I.R.S. were: (1) the assets and liabilities of the cell were segregated from the assets and liabilities of the PCC, and (2) the law of the domicile and the contractual documentation of the cell supported its independence. In order to establish and implement these requirements, the cell would have to: (1) make any tax elections required of an insurer; (2) apply for a taxpayer identification number (if subject to U.S. tax); (3) segregate its economic activities from that of any other entity including its PCC; (4) file all applicable returns as an insurer; and (5) make certain that the PCC did not include any of the cell’s income, deductions, reserves or credits in its income tax filings. In other words, to be treated like an insurer, the cell would have to both appear and act as one.

Captive Clout

Captives are now part of the insurance mainstream and are valued contributors to the insurance industry and the economies of numerous states and off-shore jurisdictions. Nothing shows this more clearly than the recent actions of the U.S. Treasury.

Robert “Skip” Myers is co-chairman of the firm’s insurance group and practices in the areas of insurance regulation, antitrust, and trade association law. Skip received his bachelor’s degree from Princeton University and his law degree from the University of Virginia.