Critical Issue Report
Upon further review
The IRS reverses its proposal concerning the taxation of captives
By Michael J. Moody, MBA, ARM
On September 28, 2007, the Internal Revenue Service (IRS) fired a warning shot across the bow of the captive insurance industry. The Federal Register for that day noted without fanfare that the IRS was putting forth a proposed regulation. It was one destined to be felt throughout the captive industry. And while the proposed regulation dealt specifically with single-parent, onshore captives, there was little doubt that it would negatively impact the industry at large.
This surprise package came gift wrapped in Sec. 1.1502-13 (e) (2) (ii) (C) or as it has come to be known, “the Proposed IRS Regulation on Insurance between Members of a Consolidated Group.” While there are a number of aspects to the proposal, in essence it would greatly restrict single-parent captives where the parent uses a consolidated tax return. From a tax deductibility standpoint, it would basically require them to defer the tax deduction for any incurred loss until the actual loss is paid.
True, the primary effects from the proposed regulation were “limited” to single-parent captives that were domiciled onshore. But as many captive experts noted early on, any reductions to the effectiveness of onshore single-parent captives would have a negative impact across the industry as a whole. What was particularly troubling to the captive industry was the fact that this proposal emanated from within the Consolidated Returns Group of the IRS. This is in sharp contrast to most of proposed captive-related legislation which comes from the Financial Products side of the IRS. As a result, it was going to represent a significant challenge.
Attorney Tom Jones of McDermott Will & Emery, LLP, notes, “The consolidated tax return area of the IRS has a huge amount of authority to promulgate regulations.” In this regard, he also notes, “Congress has given the Consolidated Returns Group the authority to write ‘legislative regulations’ as contrasted with ‘interruptive regulations’ that other code areas are limited to.”
The only standard that applies here is that any new legislation must be a “clear reflection of income.” And as Jones points out, this proposed regulation was put forth “to clean up some minor issues.” He says that the original intent was to “purify” the code area dealing with consolidation returns by making the regulations more of a “one size fits all” approach. And from the IRS standpoint, they saw little reason to make a special exception for insurance subsidiaries. They felt that all subsidiary operations should be handled the same way; however, as is frequently the case, one size does not always fit all.
Marshalling the forces
Shortly after the Federal Register was published, the Vermont Captive Insurance Association (VCIA) and the Captive Insurance Company Association (CICA), the two largest captive-related groups, saw that something significant was going to be required to dissuade the IRS from enacting this legislation. And within days of the first notice in the Federal Register, the VCIA board and the CICA board had agreed to a joint approach that would require the industry as a whole to move in concert to ward off this significant challenge. And within days, the Coalition for Fairness to Captive Insurers was born, notes Molly Lambert, VCIA president and co-chair of the Coalition.
From the start, the Coalition realized that one of the key elements to obtaining a successful decision, according to Dennis Harwick, CICA president and co-chair of the Coalition, was that “we must have strong technical arguments.”
As a result, Lambert points out, “We retained the best legal experts, which included Jones, to draft a 40-plus page technical response.”
Harwick says, “There was agreement that we needed a detailed legal response that would be compelling to the IRS. This way, if the IRS wishes to reverse their decision, we would have given them ample ammunition.”
However, Lambert points out, “It was not sufficient to just provide a strong legal response, but the situation also required a political response.” And it needed to be a meaningful response as well. The Coalition was successful in marshalling broad support from a number of quarters.
Harwick says, “The IRS is certainly used to receiving feedback from the industry segment involved with any proposed legislative efforts, but this was different.” Certainly, the captive industry responded in large numbers; captive owners, captive managers, services providers and other interested parties, all made their opposition to the proposed regulation known to the IRS. But then things really got interesting when the IRS and Treasury began hearing from state insurance departments, state and federal legislators, state governors (including the National Governors Association) and a raft of other concerned groups.
Also included in this group, according to Jones, were two property and casualty insurance associations. Jones, who had been retained by the Coalition as one of its lead legal experts notes that all of these parties were submitting comments in favor of withdrawal of the proposed legislations.
Chilling effect
By late 2007, it was clear that the proposed legislation would have a profound effect on the captive industry. After filing its 40-plus pages of comments with the IRS, the Coalition focused on preparing for the February 29, 2008, mandatory hearing. It would be at this hearing that most believed that the Coalition would be able to plead its case. But, prior to this hearing, the IRS was willing to meet with the Coalition representatives, so a meeting was scheduled for January 7, 2008.
Lambert states that this meeting was important because it was a “face-to-face” with the people who wrote the proposed regulations, as well as the Assistant Secretary of Treasury for Tax Policy. This way, “The Coalition had an opportunity to explain our position,” states Harwick. But over and above their position, he notes, “we could also illustrate what a ‘chilling effect’ just publishing the proposed regulation has had on the industry.
“This also gave us a chance to discuss our feeling that a definitive resolution was needed to resolve this issue,” says Harwick. Further damage to the industry was imminent, if the proposed legislation was not acted upon, but rather was left to languish. Most participants in the January meeting left the meeting quite optimistic. Harwick says it was a great meeting, and he goes on to note that “the IRS was willing to discuss the issues.” And he felt it was very helpful to dialog directly with the technical people.
Following the above noted meeting, the Coalition continued to prepare for the February 29, 2008, hearing. But then in the February 20 Federal Register, they noticed that the IRS had canceled the hearing. Then the February 25 issue of the Federal Register provided the news that the IRS was withdrawing “the portion relating to the treatment of transactions involving the provision of insurance between members of a consolidated group.” Obviously, great news to all interested parties. Harwick says that “from the beginning our goal was to have the proposed regulations withdrawn.”
Conclusion
Lambert says, “Credit for this victory goes to the entire Coalition,” and all the interested parties from the political side as well. But she says credit also has to go to the IRS “for being open to this and willing to listen to our point of view.”
Harwick notes that it was the quick action of the entire captive industry that allowed the Coalition to move forward in a timely manner.” He says that the Coalition has invested heavily, “already in excess of $300,000, in our technical response,” but he notes, “Our investment has already paid dividends.”
Lambert also points to the technical response: “We got the best talent possible to prepare our points to the IRS.” And she goes on to say, “The results show just how good that talent was.”
Despite the success attained, Jones puts it this way, “We won a battle, but by no means is the war over.” He says it’s important to remember that “the IRS has many other initiatives to limit the definition of insurance for tax purposes.”
But for today, Lambert notes, “We are still on a level playing field with the offshore domiciles, from a tax standpoint.”
Harwick says that at this point, he believes that this was an unintended consequence from a housekeeping issue with the IRS. But at the end of the day, he says, “We had a good case to make, and we made it.” *