The Wall Street Journal reported in a March 31, 2012, article titled, “How to Get the IRS to Notice You,” that the IRS audited 1.1 percent of all tax returns filed in 2010. However, those who filed a Schedule C with gross receipts of $100,000 or more were four times more likely to be audited. Additionally, 12.5 percent of all taxpayers earning more than $1 million annually were audited in 2010. Consequently, it looks like the odds of being audited by the IRS are slightly better than winning the lottery.
The IRS occasionally takes an interest in a special group of taxpayers, and when it does, the rates of audit increase substantially. Foreign captive insurance companies (FCICs) are a group that the IRS has taken a special interest in since at least 2008. During the past four years, the IRS has issued countless internal guidance to IRS examiners on the procurement of information and various methods on how to conduct audits. Additionally, the IRS announced the creation of a voluntary compliance program for FCICs (see Announcement 2008-18).
It is rare is that the IRS has been so blatantly obvious about its intention to focus on a specific type of entity such as FCICs. The IRS has basically stated that it plans to carefully review all such companies when conducting excise tax audits of foreign insurance companies. According to the IRS, excise tax examiners must provide specified information to the IRS’s International Excise Tax Group whenever the examiner encounters a case with an FCIC. Presumably the IRS will use this information to determine whether certain federal excise taxes have been remitted on premiums paid on reinsurance policies.
In its most recent guidance - a memorandum - the IRS indicated that excise tax examiners must collect and forward detailed information to the International Excise Tax Group whenever an examiner encounters an FCIC. Information that must be collected by the examiner includes the name, employer identification number and domicile of the captive subsidiary. In addition, the examiner must provide the amount of premiums insured with the captive subsidiary and the amount of premiums reinsured by the subsidiary with reinsurance companies. Finally, the examiner must indicate whether the captive subsidiary has made a section 953(d) election and whether the FCIC has a closing agreement.
The increased scrutiny of FCICs comes in the wake of the IRS’s interpretation of the foreign insurance excise tax as a “cascading tax.” In Revenue Ruling 2008-15, discussed in more detail below, the IRS held that the federal excise tax (FET) applies not only to the first foreign entity that insures or reinsures certain specified insureds, but also to subsequent reinsurers of the same policies. Thus, the foreign excise tax may apply to numerous subsidiaries of a foreign insurer if its subsidiaries reinsure the initial policy.
The Foreign Insurance Excise Tax
Generally, the U.S. imposes an FET on certain insurance and reinsurance policies issued by foreign insurers. A 4 percent FET is imposed on premiums paid to a foreign insurer on insurance policies issued to either: (1) a domestic corporation or partnership, or an individual resident of the U.S., against or with respect to, hazards, risks, losses, or liabilities wholly or partly within the U.S.; or (2) a foreign corporation, foreign partnership, or nonresident individual, engaged in a trade or business within the U.S. against, or with respect to, hazards, risks, losses, or liabilities within the U.S. In addition, a 1 percent FET is imposed on any premiums paid on contracts or policies of reinsurance of any insurance policy that is subject to the 4 percent FET.
Several income tax treaties provide an exemption for the FET, subject to certain limitations. As a threshold matter, the foreign insurance company must satisfy the limitation on benefits article under a treaty to qualify for treaty benefits. In addition, most income tax treaties that provide an exemption for the FET grant only a qualified exemption. A treaty with a qualified exemption generally provides that the FET exemption only applies to the extent that the risks covered by the premiums are not reinsured with a person not entitled to an exemption from the FET under an applicable income tax treaty. Even if a treaty exempts the FET, the foreign insurer claiming the exemption must comply with procedural requirements including disclosing the treaty-based position.
Revenue Ruling 2008-15
In Revenue Ruling 2008-15, the IRS ruled that the FET is imposed on certain premiums paid on reinsurance transactions between foreign insurers. Under the ruling, premiums paid on certain reinsurance policies are subject to the 1 percent FET regardless of whether the policy being reinsured was already subject to the 4 percent FET. The IRS may therefore assert that the 1 percent FET applies to successive reinsurance policies.
Revenue Ruling 2008-15 also addressed the application of the qualified treaty exemption. The IRS ruled that if a foreign insurer that qualifies for benefits under a qualified treaty exemption insures a risk otherwise exempt from the 4 percent FET under the treaty and then the same risk is reinsured with a foreign reinsurer that is not entitled to an FET exemption under an applicable income tax treaty, then the insurer is subject to the 4 percent FET and the reinsurer is subject to the 1 percent FET.
Liability for FET
Liability for the FET is imposed on any person “who makes, signs, issues, or sells any of the documents and instruments subject to the tax, or for whose use or benefit the same are made, signed, issued, or sold.” The FET must be paid by the person who pays the premium to a foreign insurer or reinsure. If the tax is not paid by the person who pays the premium, the tax must be paid by the person who makes, signs, issues, or sells any of the documents or instruments subject to the FET. Accordingly, both the foreign insurer and the U.S. insured (or foreign insured engaged in a U.S. trade or business) may be held liable for the FET. An insured otherwise liable for the FET may be relieved from such liability if the foreign insurer obtains an FET closing agreement with the IRS establishing that the foreign insurer is entitled to an exemption pursuant to a U.S. income tax treaty.