The Treasury Department and the Internal Revenue Service (IRS) recently published proposed amendments to the regulations governing consolidated returns that, among other things, are designed to eliminate the tax advantages of many insurance arrangements between members of a consolidated group and a captive insurance company that is also a member of the same group.
If finalized as proposed, the new regulations will make domestic captive insurance companies, and foreign captives that elect to be taxed as domestic corporations, signifi cantly less attractive from a tax standpoint. This will force many companies who are seeking to achieve tax benefi ts from captive insurance companies to shift to an entirely offshore approach for their captives or to take other steps to avoid the effects of the changes. The proposed amendments to the consolidated return regulations are the latest chapter in a long history of IRS challenges to the use of captive insurance companies to achieve tax benefits.
Taxpayers have for years attempted to use captive insurance companies to accelerate deductions for future contingent liabilities. Instead of waiting to deduct liabilities for such things as breach of warranty claims and health exposures until their amount is “fi xed and determinable” as is required by federal income tax accounting rules, taxpayers have sought to take immediate deductions for premiums paid to insurance companies for insuring against such risks. The insurance companies, in turn, are eligible to use the reserve method of accounting, so that their premium income can be largely offset by reserves for future exposures.
In cases where the insurance companies receiving the premiums are owned by the taxpayer paying the premiums, the IRS for many years took the position that the deductibility of the premium payments should be denied on the ground that a true insurance arrangement does not exist for federal income tax purposes when the taxpayer and the insurance company are part of the same economic family. But the courts have been largely unpersuaded by the IRS’s “economic family theory.”
When an insurance company subsidiary is part of an affiliated group that fi les a consolidated return for federal income tax purposes, transactions between the insurance company and other members of the group are subject to the consolidated return regulations. With respect to certain “intercompany transactions” between group members, these regulations include provisions that have the effect of disregarding those transactions to some extent. This has a tax effect similar to that which would apply if the entire consolidated group were a single entity for tax purposes. To date, most insurance transactions between consolidated group members have not been subject to this single entity treatment under the regulations.
In 2001, the IRS abandoned its “economic family theory,” in view of its lack of success in the courts. The IRS issued a revenue ruling revoking its earlier ruling that had enunciated the doctrine. The IRS’s abandonment of the “economic family theory,” coupled with the exemption of most insurance transactions from the intercompany transaction rules of the consolidated return regulations, has left consolidated groups free in many instances to use domestic captive insurance companies (or foreign captive insurance companies electing to be taxed as domestic ones) as a means of accelerating deductions for future contingent liabilities. The noninsurance company members of the group simply purchase insurance coverage for such liabilities from a group member that is an insurance company.
The New Regulations
The new proposed amendments to the consolidated return regulations are designed to eliminate the attractiveness of domestic captive insurance companies as a tax planning technique for consolidated groups in cases where at least fi ve percent of the captive’s insurance business comes from other members of the group. As amended, the regulations will deny such a captive insurance company the ability to use the reserve method of accounting in the case of intergroup insurance transactions. The net effect in most cases will be to treat the group as a whole as if the insurance arrangement did not exist, so that the group will not be able to obtain the benefi t of tax deductions for future contingent claims until those claims become fixed and determinable.
The preamble to the proposed regulations also indicates that reinsurance transactions designed to circumvent the new provisions will be subject to challenge under the regulations’ anti-avoidance rules. Thus, the interposition of an independent third-party insurer, which insures a consolidated group member’s risks and then reinsures with the consolidated group’s captive insurer, will not enable the group to circumvent the effects of the new regulations.
Responses to the New Regulations
The domestic captive insurance industry is, not surprisingly, vocally opposing the IRS’s proposed changes. A number of comments are expected to be submitted on the proposed regulations, challenging them on tax policy grounds. Some may also question the IRS’s authority to adopt regulations that, in effect, reverse the effects of the existing court decisions for consolidated groups by adopting a special rule denying them the tax benefi ts of insurance arrangements that would be available if they simply fi led separate returns. Similar arguments have prevailed in the courts in other contexts, most notably in connection with the IRS’s efforts to deny consolidated groups the ability to claim capital losses on sales of stock of a group member.
The proposed changes in the consolidated return regulations will apply to insurance transactions entered into in taxable years beginning on or after the date that the regulations are promulgated as fi nal regulations. Therefore, before that time, companies that have existing captive insurance arrangements that would become subject to the new regulations, or are contemplating such arrangements, will want to explore possible steps to avoid the force of the changes. Possible steps to be considered may include:
- Deconsolidating the captive insurance company, by making changes in its ownership structure so that less than 80 percent of the vote or value of its outstanding shares of stock are owned by the consolidated group;
- Shifting the ownership of the insurance company outside the consolidated group entirely by, for example, structuring the insurance company as a sister corporation rather than as a subsidiary of the group parent – an approach that may be particularly viable in the case of a closely held corporation;
- Eliminating the need to fi le consolidated returns by converting existing noninsurance company subsidiaries to limited liability companies that are disregarded entities for federal income tax purposes, and seeking IRS consent to discontinue fi ling a consolidated return with the captive insurance company subsidiary. According to applicable regulations, the IRS will ordinarily grant such a consent if there has been a change in law or regulation that would have a substantial adverse effect on the consolidated group’s tax liability (which may be the case in the event that the new regulations on captive insurance companies are adopted as proposed); or
- Shifting to a foreign captive insurance company structure, with an offshore corporation that does not elect to be treated as a U.S. corporation for federal tax purposes.
Each of these alternatives may, however, have signifi - cant costs or other adverse tax consequences that will also need to be considered before a plan of action is adopted.