Before attending law school, I was an agent for Northwestern Mutual Life. I understand too well the esteemed status given to insurance producers: the hunter-gatherers of the insurance food chain, they are responsible for generating every dollar of insurance company revenue. Without producers, an insurance company has nothing. With this prestigious status, my friends were surprised that I voluntarily chose a career with the analytical side of the business: managing taxes. For every phenomenal group of producers, someone needs to ensure the insurance company, its operations, and its programs do not give away 35% (or more) of its revenue to the IRS.
Recently, the IRS has renewed its focus on the insurance industry. In the last twelve months, the IRS has issued rulings or announcements affecting domestic insurers, foreign insurers, and captives1. The IRS has not issued this much guidance in the insurance industry since its trio of rulings in 2002 (Revenue Rulings 2002-89, 2002-90, and 2002-91). In October, the IRS is even hosting a two-day seminar on the financial services industry, with sessions for its Chief Counsel focused on assessing and auditing tax issues for life settlement transactions, P&C carriers, and captives. Now more than ever, a good Vice President of Taxes may lower your tax costs and ensure you retain a larger percentage of each dollar earned by forcing your company to consider the tax implications of its insurance programs, keeping up to date with insurance tax developments, and strictly adhering to compliance guidelines established by the IRS. I have outlined below one of the three recent IRS rulings to illustrate this point.
Revenue Ruling 2008-15
In Revenue Ruling 2008-15, the IRS kindly reminded every foreign insurer who insures or reinsures U.S. risks that it may be taxable in the U.S. Section 4371 of the Internal Revenue Code (“Code”) imposes a federal tax of 4% on every premium dollar earned by a foreign insurer on casualty insurance or indemnity bonds and 1% on every premium dollar earned by a foreign insurer on life, sickness, accident, and reinsurance policies where the underlying risks are located in the U.S. While this Foreign Insurer Excise Tax (the “Excise Tax”) has been around for years, the IRS outlines four situations where an unsuspecting foreign insurer might trigger this tax.
In the first scenario, a U.S. corporation purchased a casualty policy from a foreign insurer, and paid the required 4% Excise Tax (note a good VP of Taxes would recognize the insured U.S. corporation, and not the foreign insurer, is actually responsible for paying the tax). The foreign insurer decided to cede a portion of the risk to a foreign reinsurer. To the reinsurer’s surprise, the reinsurance premium was subject to the 1% Excise Tax in the U.S. (because the original insured and the risks were both located in the U.S.). In the second scenario, Foreign Reinsurer A agreed to reinsure risks of a U.S. domestic insurance company. To help manage this risk, Foreign Reinsurer A ceded a portion of the risk to Foreign Reinsurer B, an unrelated foreign reinsurance company incorporated in a different jurisdiction from Foreign Reinsurer A. The IRS held that under Sections 4371(3) and 4372, the 1% Excise Tax on reinsurance applied not only to the initial reinsurance transaction with Foreign Insurer A, but also on the second reinsurance transaction. The IRS relied on Treasury Regulations issued in 1970 for their rationale, stating that “[s]ection 4371(3) imposes a tax upon each policy of reinsurance...if issued —(1) [b]y a nonresident alien individual, a foreign partnership, or a foreign corporation, as reinsurer...; and (2) [t]o any person against, or with respect to, any of the hazards, risks, losses, or liabilities covered by contracts described in Section 4371(1) or (2).” Since the original casualty risks were located in the U.S., any subsequent reinsurance transaction had become subject to the U.S. Excise Tax.
Both situations show the IRS is aggressively applying the Excise Tax, and if any policy issued can be connected with “hazards, risks, losses, or liabilities wholly or partly within the United States” the Excise Tax may be due and payable. Moreover, the question of exactly who has liability to pay the tax – the secondary foreign reinsurer or perhaps the original domestic insured – remains unanswered. Revenue Ruling 2008-15 lists as one of its authorities Section 4374 of the Code, which provides that an Excise Tax shall be paid by any person “for whose use or benefit the same are made, signed, issued, or sold.” Could the IRS assert the original domestic insured is liable for the 1% Excise Tax on any foreign reinsurance transaction? It’s certainly possible.
The remaining two scenarios in Revenue Ruling 2008-15 discuss application of U.S. Tax Treaties with respect to the Excise Tax (using facts similar to those outlined in scenario one and two above). In several U.S. Tax Treaties, the Tax Treaty will provide an exemption from the Excise Tax (e.g., the Tax Treaty between the U.S. and Barbados exempts Barbados insurers from the Excise Tax). Not all Treaties have such an exemption. As stated in Revenue Ruling 2008-15, the IRS plans look at each insurance or reinsurance transaction separately to determine whether a Tax Treaty exemption from the Excise Tax might apply. Thus, a U.S. corporation could obtain casualty insurance through a foreign insurer in a favorable Treaty jurisdiction, and under the Tax Treaty, such transaction may be completely exempt from the Excise Tax. If, however, the foreign insurer reinsures a portion of the risk with a reinsurer in another country that does not have a Treaty-based Excise Tax exemption, then suddenly both transactions – the initial casualty policy and the reinsurance policy – become subject to the Excise Tax. The actions of the foreign casualty insurer may have made the U.S. insured suddenly – and unexpectedly – liable for an aggregate 5% Excise Tax (4% on the initial casualty policy premiums and 1% on the reinsurance premiums). Obviously an onerous result.
So what can we learn from this ruling? By allowing a VP of Taxes to approve, or at the very least participate in, insurance transactions from the beginning, the VP of Taxes (working with outside tax counsel) could have saved your company 4% or more from needlessly going out the door to the IRS. First, the VP of Taxes would ensure the transaction qualifies for benefits under a U.S. Tax Treaty, eliminating any potential Excise Tax (and, as an aside, if the foreign insurer happens to be a captive owned by your U.S. corporation, the VP of Taxes may have just gained both a premium deduction in the U.S. and an exemption from the Excise Tax – a significant double benefit). Second, the VP of Taxes would have insisted on notice and consent provisions prior to any reinsurance transaction, giving them the opportunity to confirm whether the reinsurance transaction might violate applicable Tax Treaties and suddenly subject the parties to Excise Tax. Finally, if an Excise Tax was in fact due, the VP of Taxes and his staff would dutifully file and report amounts to the IRS, keeping both the insured and the insurer from losing money to audit expenses and penalties.
Yes, insurance producers are the key to an insurance company’s survival. Without producers, insurance companies would not exist. However, do not overlook the importance of tax and tax compliance. Without it, insurance producers may have to work harder – as much as 35% harder at current U.S. federal income tax rates – to generate bottom line profits. By having someone on hand who will force your company to consider tax implications of its insurance programs, remain abreast of new U.S. tax developments, and undertake the thankless job of tax compliance, you will have more money remaining at the end of the day. Money that very likely will be paid as bonuses to the producers.
William M. Winter is a partner in the firm’s Tax and Insurance Practices. 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.
1For example, the IRS has issued proposed Treasury Regulation 1.1502-13 (addressing treatment of transactions involving the provision of insurance between members of a consolidated group), Revenue Ruling 2008-8 (addressing tax considerations for cell captives), and Revenue Ruling 2008-15 and Announcement 2008-15 (addressing application of the federal excise tax to non-U.S. insurers).