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The reduction in the U.S. corporate tax rate has had the most impact on 831(b) captive insurers to date, but the effects of other provisions of the 2017 tax overhaul are less clear as industry stakeholders await key guidance from the IRS and possible legislative fixes from the U.S. Congress to mitigate the law’s unintended consequences.
There has not been a decline in captive formations or major shifts in where captives are domiciled as a result of the tax overhaul, but stakeholders continue to watch for such potential results, particularly when it comes to new formations.
In December 2017, President Donald Trump signed the Tax Cuts and Jobs Act, which replaced the graduated corporate income tax structure and its previous top rate of 35% with a 21% rate. The changes to the corporate tax rate have had the most impact on 831(b) captives, also known as microcaptives, so far because those captives paid an alternative tax based only on taxable investment income, with underwriting profits exempt.
“It’s really clear that the value of the tax deduction for premium paid to the captive is less than what it was, and I suppose that might affect some peoples’ thinking, particularly for those people looking to take an 831(b) election,” said Martin Eveleigh, chairman of Atlas Insurance Management in Charlotte, North Carolina. “But I can honestly say that between 2017 and 2018, our new business in 831(b) elected captives was flat.”
The tax revamp did not directly change how insurers are taxed or change the definition that affected whether or not an insurance company qualified as an insurance company for federal tax purposes, but “interestingly, it has the most impact on 831(b) because you will tend if you have an 831(b) to pay more tax in ’18 than you would have in 2017,” Charles Lavelle, senior partner in the tax and employee benefits department of Bingham Greenebaum Doll LLP based in Louisville, Kentucky, said during 2019 World Captive Forum in Miami, sponsored by Business Insurance.
But specific guidance is needed on provisions pertaining to controlled foreign corporations, passive foreign investment companies and the Base Erosion Anti-Abuse Tax provision, experts say.
“I still think this is an evolving issue,” said Ryan Work, vice president of government relations for the Self-Insurance Institute of America Inc. in Washington. “This is going to take a number of additional years to get all the information, the guidance, the clarification that everybody needs to get through all the various changes.” The rule determining what constituted a controlled foreign corporation was changed during the tax overhaul.
A CFC is generally defined as a foreign corporation in which U.S. persons owned more than 50% of the corporation’s stock, with the standard for insurers being that the combined voting power of all classes of stock had to exceed 25%.
However, the definition of U.S. shareholder, which had been defined as a U.S. person who owns 10% or more of the voting stock of a foreign corporation, was expanded to include U.S. persons who own 10% or more of the value of the stock of the foreign corporation.
“It’s made non-CFCs into CFCs,” said Thomas Jones, Chicago-based counsel on tax, regulatory and legal matters involving captives for McDermott Will & Emery LLP in Chicago. This has led to some efforts to help offshore group captives avoid CFC status, which is “an ongoing challenge,” he said.
Meanwhile, the passive foreign investment company rules were essentially designed to prevent U.S. persons from investing in corporations with a view toward not reporting the earnings and profits, as they were earned in a foreign corporation, with penalties imposed on the taxes that must be paid on this income. A company is defined as a PFIC based on either income, meaning that at least 75% of the corporation’s gross income is “passive” income that is derived from investments rather than from the company’s regular business operations; or assets, meaning at least 50% of the company’s assets are investments that produce passive income or held for the production of passive income. Companies in the “active conduct” of the insurance business were exempt under the old law and can remain so under the new law, but they must now meet a test that their active insurance assets constitute more than 25% of the insurer’s total assets.
The CFC and PFIC changes are of “great interest to me,” Mr. Eveleigh said. “The PFIC reserving requirement that 25% of the assets need to be in reserves — and those reserves are only loss reserves, not unearned premium reserves — that has certainly had an impact on some captives. Captives that either always knew they were going to have really great underwriting results and low loss ratios or captives that hadn’t thought too much about that and then looked at results and said ‘our results are so good we don’t have the reserves, now we’re going to have to do something about it’ and now … suddenly people are paying a lot out in dividends. That is real. That has happened.”
The U.S. tax overhaul also included the BEAT provision, which imposes a minimum tax on certain deductible payments made to a foreign affiliate.
“Congress tends, when they do large legislation, to try to fix a specific issue but unintentionally impacts a much larger base than they originally thought,” Mr. Work said. “That comes to mind for me with PFIC and BEAT. For PFIC, my take on it from talking to folks on the (Capitol) Hill, was that Congress was looking at PFIC to deal with offshore private equity and its flow back and forth internationally and domestically. Unintentionally, some captives, particularly on the CFC side, have been roped into that. I don’t think that was necessarily Congress’ intent.”
Congress will have to pass legislation clarifying some of the tax bill provisions, he said. “It’s going to have to be tackled,” Mr. Work said. “I just don’t think it’s going to be anytime soon.”
Onshore vs. offshore
As Mr. Eveleigh currently works on forming new group captives, “the question now is onshore or offshore,” he said.
“Before tax reform, the answer was very likely offshore. Post-tax reform, I am canvassing opinion. I’m not suggesting that we’re going to see group captives redomesticating, but I think it could mean
that more group captives in the future will actually choose an onshore jurisdiction.” Mr. Jones said he has not seen redomestications related to the tax overhaul, as most of the provisions were not aimed at captives and they were “just along for the ride.” But redomestications could happen in a few years once the full impact of these provisions is digested and if there is an adverse impact on the regulatory flexibility that has been a traditional advantage of offshore domiciles, he said.
“I don’t think we’ve seen a direct impact, but there’s been a lot of discussion within industry about what some of these provisions mean for onshore and offshore entities,” particularly with regard to CFCs,
Mr. Work said. “It goes back to uncertainty. If you’re an owner of a CFC, is this really what I want to be doing or is this getting too complicated for what I want to accomplish? I think the best thing for right now is making sure you’re doing due diligence and riding out the uncertainty until you can have all these fact patterns in place to make sure you’re managing your risk where and when you need to.” “There’s obviously a lot more complexity now with offshore entities in general.
But at the same time, I think some of the new tax reform issues are also having domestic folks look at what their other options are,” he added. “It’s a dichotomy in both directions.”
Microcaptives continue to come under fire from tax authorities as the IRS aggressively audits captive insurers that take advantage of long-standing rules that allow captive owners to reduce their tax bills.