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Regulations, tax court decision change captive landscape

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FORT LAUDERDALE, Fla. — International regulatory changes targeting financial services companies will have a direct effect on captive insurers and are already influencing domicile choices by captive owners, captive experts say.

In addition, a recent U.S. tax court decision will also affect captives, particularly those established by financial advisers rather than specialty captive management firms, they say.

Captive owners, particularly in Europe are reacting to the Organization for Economic Cooperation and Development’s Base Erosion and Profit Shifting initiative, or BEPS, said Ciaran Healy, director of consulting-global captive practice at Willis Towers Watson P.L.C. in London, speaking at Business Insurance’s 2018 World Captive Forum in Fort Lauderdale, Florida.

The initiative, which began in 2012, targets multinational companies that use tax planning strategies that exploit gaps and mismatches in tax rules to shift profits to low or no-tax locations where they have little economic activity, such as through a small subsidiary. About 100 countries and jurisdictions have signed up to the project, according to the OECD.

“This is going to have a big impact on captives,” Mr. Healy said. “BEPS wasn’t set up for captives, but obviously a captive is a subsidiary and a lot of times it’s in a location with a lower tax rate.”

In Europe, BEPS is influencing domicile decisions for captives and is driving more companies to form captives onshore rather than offshore. In addition, domiciles that have not traditionally been viewed as captive domiciles are seeking to attract captive business, he said.

“For instance, France is trying to attract captives, and a lot of French-owned corporates that may have captives in Luxembourg or Dublin are now considering whether they should set up in Paris. So this is a game changer for European captive management,” Mr. Healy said.

The decision on when to impose the BEPS initiative is taken by the tax authorities of individual countries, so it’s application is not consistent, he said.

The effect of BEPS has not yet been felt in the United States, but similar domicile decisions will likely soon be made by U.S. corporations, Mr. Healy said.

The United Kingdom’s decision to leave the European Union will also affect domicile choice and costs, because U.K.-based insurers are expected to lose their passporting rights, Mr. Healy said. Under EU law, insurers authorized to conduct business in one EU-member country can transact insurance in other EU countries without obtaining additional authorization.

If passporting rights end for U.K. insurers in the EU and EU insurers writing business in the U.K., a captive in Dublin, for example, would not be able to write U.K. business directly and would need to contract with a fronting insurer, he said.

“We don’t think it’s going to have a massive impact, generally speaking … it’s just an additional layer of fronting,” Mr. Healy said.

Brexit could, however, affect domicile choice in other ways, he said. For example, Gibraltar, as a British overseas territory, will lose its passporting rights, so EU-based captives may be more likely to consider other EU domiciles; but Gibraltar will be able to write U.K. business directly, so it may be attractive to captives with U.K. books of business, he said.

Captives and captive managers in the United States are also facing changes, particularly in light of last August’s Benyamin Avrahami and Orna Avrahami v. Commissioner of Internal Revenue tax court decision against the owner of an 831(b) captive.

In the case, the IRS alleged that the microcaptive for a jewelry business in Phoenix that ostensibly covered insurance risks charged unrealistic premiums and did not meet risk distribution requirements for captives.

The Avrahami decision “basically calls into question what is a captive, what do they do and why do you have captives” and has the potential to tarnish captives, said Robert Myers, managing partner of the Washington office of Morris, Manning & Martin L.L.P. and co-chair of the law firm’s insurance and reinsurance practice.

The case “is a good guide on how not to form and operate a captive, but we don’t have a guidebook as to what is the way to do it,” he said.

The Avrahami case shows that the IRS views small captives as “the wild, wild West” and are pursuing the promoters or managers of microcaptives — which often are captive managers, said Steve Kinion, director of Delaware’s Bureau of Captive and Financial Insurance Products in Dover, Delaware.

The main targets will likely be financial advisers who promote microcaptives as tax shelters and who generally are subject to less oversight than larger captive managers, which are often owned by brokers, Mr. Myers said.