After the exhale

Bill Lumley finds the US captive market buoyed up by the withdrawal of proposed IRS regulation and ready once again to compete against the offshore captive domiciles.

April 2008

One chilly New England morning this February, a group of key players in the US captive sector awoke in the glow of a post-party mood. They were celebrating the sudden disappearance of the biggest threat to US captives since their inception in the early 1970s.

A single regulation proposed by the InternalRevenue Service (IRS)in Septemberlast year would have potentially devastated the fast-growing onshore captive sector: it would have ended the allowance of deductions for loss reserves by single-parent captive insurance companies that file income tax returns on a consolidated basis with their parent corporation. It would therefore have threatened much of the raîson d’être of captives domiciled within the US.

The threat both to them and much of the industry that supports them was so great that a coalition was promptly formed between the Vermont Captive Insurance Association (VCIA) and the Captive Insurance Companies Association (CICA) to fight the IRS. The Coalition for Fairness to Captive Insurers (CFCI) drew together a group of what are said to be the finest captive tax experts in the US from the likes of McDermott, Will & Emery, Dewey and Leboeuf, and McIntyre Law Firm to argue against the proposals. So it wasn’t cheap, but it was effective. After just three months, and barely a week before the date set for the coalition to meet the IRS officially for the first time, the proposal was dramatically withdrawn. It took everyone in both the coalition and the Self Insurance Institute of America (SIIA)—not to mention the wider US captive world—completely by surprise. Put another way, these captive associations were prepared for a long fight, but the IRS just caved in.

VCIA president Molly Lambert says: “Uncertainty is never a good thing in any of our worlds. We want to know what’s out there, and having this regulation withdrawn restores the certainty surrounding this critically important part of the environment for captive insurance companies.”

Of course, it is impossible to quantify quite how many businesses considering establishing a US captive cancelled or placed these plans on hold, but CICA president Dennis Harwick says that during this period, there would certainly have been a number of businesses conducting feasibility studies whose lawyers would have had to counsel them that this could have a negative impact unless they opted for an offshore domicile.

The threat didn’t last long enough to set a real trend in that respect, but there was a sense that there had been some slight onshore trend until the IRS threat came along, he says. “Now it’s off the page again, we’ll just have to wait and see if that slight onshore trend resumes. It would certainly have been very different had the legislation been put into effect,” says Harwick.

Captive managers themselves speak of clients whose entire US captive programme plans were put on hold. Gary Osborne, president, USA Risk, says that some of his prospects had begun talking of going to Cayman because they didn’t want that uncertainty. “Two or three we are working on right now have gone back to looking at West coast domiciles over Cayman, now that the IRS has withdrawn its threat, and they are much more comfortable that this is a settled issue.”
Professionals in the captive sector maintain they always emphasise that tax should never be the major driver for establishing a captive, but Osborne stresses that tax was an important enough factor in the decision of these companies on whether to go ahead, and these were the ones who said that unless it was resolved, they would probably end up going somewhere else.

The IRS knew the proposal would effectively have put a brake on growth in US captives, he claims. “They knew what they were doing and were just surprised there was such a concerted effort, in that we got such an ear from important legislators and governors. That took the IRS by surprise,” he says.

The tax victory for US captives also underlines the function and value of trade associations, he says. “It was very encouraging that on an issue like this, almost every domicile was on the same page,” says Osborne.

Now once again, from a tax perspective, the onshore versus offshore debate is considered to be very much a level playing field. Captives make their domicile choice based on a number of issues, but as far as tax is concerned, it’s no longer going to be driven by a big advantage or disadvantage for either side, he says.

One of the most important lessons learned from this whole episode is how the whole US captive insurance sector can speak with one voice on issues so apparently detrimental to its cause, according to VCIA’s Molly Lambert. “It’s a very encouraging sign for anything else that may come along and threaten us in the future. We now have very good experience of bringing people together and producing a good result because of the power of that union,” she says.

She adds that she was very happily surprised at the sudden climbdown, given that their attorneys had warned them that other IRS proposed regulations had tended to drag on for months.

Hawaii, she says, was one of several states extremely supportive of the coalition. It is now the second-largest US captive jurisdiction, having been a captive domicile since 1987, and between 1990 and 2007, the number of captives it hosted grew from 15 to 163. Of those, a total of 155 have US owners and just eight are non-US owned. In January, Senate and Congress representatives from Hawaii wrote to the US Treasury, iterating that captives affect numerous jobs, stimulate the local economy, and generate the direct and indirect payment of millions of dollars in taxes. They also drew attention to the fact that financial services—of which captives are a key component— represented the top contributor to Hawaii’s gross state product.
They spelled out the impact the IR regulation would have had in changing the way captive companies that utilise consolidated returns would be taxed. Now that the threat has receded, there is little point spelling out the whole argument. Suffice to say that it helped bolster the coalition’s cause.

The SIIA also lobbied the IRS, albeit independently of the CFCI. President-elect Dick Goff wrote in a letter to the department: “The use of administrative procedures for consolidated tax returns to eliminate this ability to deduct losses on an accrual basis circumvents the legislative and judicial intent.” His letter also cited six court rulings in favour of the captive insurance industry on this issue.

Although it is very difficult to ascribe motives, Harwick remains convinced that the whole threat arose as an unintended consequence. The proposal, he suggests, came out of the corporate consolidated return side of the IRS, and not the financial services or insurance side, and therefore it was probably never really a full-frontal assault on captives—although it certainly had that effect. “They thought they were cleaning up a technical area on consolidated corporate tax returns and they just forgot that captives were real insurance companies,” Harwick says.

He suggests that when the IRS first published the proposal, they realised that they weren’t going to achieve the standard they had to meet, which was a clear reflection of income. In the case of insurance companies, forcing them into that kind of consolidated return wasn’t going to result in a clear reflection of income. “It’s one of those things where we take great joy in having reached the result we got,” he says. “I don’t think it changes the fact that in the long run, the IRS is sceptical about captives, but they have a losing track record in court, and we just have to bide our time and see if they come back with something else at some later date.”

As the dust settles, Harwick says he believes the problem has gone away for the foreseeable future, not least because the timing with which the IRS decided to withdraw exceeded his most optimistic estimates of what might ultimately have resulted. The withdrawal was based on the fact that the coalition had a strong technical and legal argument, and that it made the strategic decision early on to try to convince the IRS to withdraw the administrative level and only use the legislative side as a back-up, he says. “We think that the language they used [in their climbdown], reserving the right to look at the issue again in the future, is pretty much standard boilerplate language and that this issue is not likely to be revisited any time soon,” he says.
Karey Dearden, director at Aon, says: “Taxpayers can continue to rely on these provisions as they were doing before the proposed regulations were issued. The cloud of uncertainty generated by the proposed regulations has been lifted.”

But he warns that the chance of the threat looming again in the future has not gone away. “The IRS left the door open,” he says. “They had quite a response to the proposed regulations, and they didn’t even have the hearing. That’s telling. It doesn’t appear as though the consolidated return branch will revisit this matter quickly. Does this mean other branches of the IRS won’t try and address this? We don’t know.”

He is not alone in being unconvinced that the threat has gone for good. MichaelR. Mead, president, M.R. Mead & Company, says: “Certainly, the IRS’s withdrawal of its proposal on consolidated returns is a great victory for the US captive industry, but it is likely not the final chapter. It was very gratifying to see the industry pull together, thanks in large part to the leaders of VCIA and CICA, to work toward a common goal and achieve success in a fairly short time frame.

“That said, the offshore domiciles were sitting quietly in the sure knowledge of huge increases in captives under management if the proposal stood,” he says, as none of the professional offshore captive players would encourage or enjoy a flood of business arriving on their doorsteps purely for tax reasons. However, arrive they would have, and it would have meant jobs and revenues and profits for the offshore domiciles. “Until the IRS arrives at a solid, comprehensive understanding of the captive industry, such proposals are likely to be repeated, and some captive owners may go ahead and move just to avoid the recurring hassle,” says Mead.

Whatever the IRS motives were, for the time being, risk teams within corporations with existing or planned US captives can once again get on with the job they were doing. There are now 30 states, with Michigan being the latest, that have the enabling legislation—although a dozen of these have just a handful of captives and two or three have no captives whatsoever. The classic example is Colorado, which was the very first state to have the enabling legislation but which currently has no captives and has not been active for a number of years.

Over time, there have been states that have actively pursued captives and then dropped away. More recently, there has been a maturing of the industry. There are now a number of US domiciles that are here to stay because they have the critical mass to be in the captive game for a long time, including Vermont, Hawaii, South Carolina, Arizona, Nevada and Washington DC. Utah could be added to that list too. Its attraction as a captive domicile is that it has no insurance premium tax and imposes no tax, but charges an annual fee. Indeed, the ‘Beehive State’ has seen a sharp rise in the number of formations in the last year or so, and this growth has predominantly been in single-parent captives—the type of course that would have been most affected were the IRS regulation to have been passed.