Captives and Health Insurance, Part I

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Health insurance is a hot topic right now.  First, as new regulations implemented several years ago are going into effect, lawyers and advisers are trying to get a handle on exactly what has changed and how to explain those changes to their clients.  Second, the foundation of the new law has been challenged by various state attorneys general, with the Supreme Court expected to rule in the next few months.  However, underlying all of these events is a fundamental question: how do employers lower the cost of their health care?

A solution does exist: by utilizing a captive insurance company as part of their health care coverage, a company has the opportunity to gain more control over their health care cost and demand, thereby lowering the cost of their health care over the medium term (3-5 years).  However, an important caveat is in order: this strategy will require the ongoing participation and endorsement of management, who will probably have to change important aspects of their human resources philosophy to gain the most from this program.

All that being said, let’s move forward by answering the “who, what, where, when and why” of this important topic by starting with the “who.”

Let me begin by presenting a hypothetical company, which we’ll call “Company X.”  Company X is a professional services firm with about 150 employees.  For the last five years, they have paid approximately $1.2 million in health insurance premiums.  However, in four of those years, they only extracted between 65% and 85% of their premiums from the plan.  Put another way, 80% of the time, the company actually obtains fewer benefits than those they’ve paid in, with the excess amount paying either administrative fees or the excess risk of other parties.  While this is typical with most insurance, it's far harder for the company to swallow considering the amount they pay for health insurance on an annual basis.  In addition, in one of the years, the company had total claims higher than their premiums.  This spike in claims led to a proposed increase in their health insurance costs of approximately 25%-35%. 

The company described above is a great candidate to consider this possibility.  First, they’ve had the “I’m not going to take it anymore” moment as premium quotes were returned with higher than desired increases.  This is really key: a company that is content with its current coverage will probably not be open to this idea.

Second, they have a fairly large employee population of 150.  While there is obviously no maximum amount to the number of employees a company should have for this concept, there is a minimum.  The ideal minimum is about 100, although the absolute lowest you should go is 50.

Third, they’re paying more than they’re getting out of their current coverage.  80% of the time (4 out of 5 years), the company overpaid for their coverage, or, put another way, they only received 65%-85% of their premiums back. 

Fourth they have the financial sophistication to understand and implement the concept.  With 150 employees, the company probably has a dedicated CFO, or a person who performs that function with a fairly high degree of regularity.

In the next article, I’ll delve a little deeper into this new and exciting strategy.

The OECD Model Treaty; Business Profits

For the last few weeks, I've been talking about the OECD Model Treaty and how it deals with permanent establishments (see here, here, here, here, here and here) .  Today, we'll explain why all of this talk has been so important, as we'll discuss the idea of business profits, and how the treaty deals with them.  The following italicized paragraphs are from section 7 of the OECD Treaty dealing with business profits:

1. The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to that permanent establishment.

2. Subject to the provisions of paragraph 3, where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment.

3. In determining the profits of a permanent establishment, there shall be allowed as deductions expenses which are incurred for the purposes of the permanent establishment, including executive and general administrative expenses so incurred, whether in the State in which the permanent establishment is situated or elsewhere.

There is hardly anything in the above statements that is controversial.  It simply states that if a business has a permanent establishment within a jurisdiction, that jurisdiction can levy taxes on the PE to the extent of the profits which are attributable to that country.  In addition, the PE may deduct the expenses that the PE incurs to promote their business.

The opening commentary to this section makes three interesting and oft-debated points.

1.) By expressly stating the PE rule, the treaty is creating a situation that will lead to increased evasion.  For example, a company will deliberately attribute income to a PE established in a low tax country, precisely for the reason that the country has a low tax rate.  For example, Apple is doing this very thing in its tax strategy.

2.) While this is true, the above system's primary benefit -- namely, ease of administration -- outweighs that burden.  Put another way, "Much more importance is attached to the desirability of interfering as little as possible with existing business organization and of refraining from inflicting demands for information on foreign enterprises which are unnecessarily onerous." (from the OECD Model Treaty Commentaries)

3.) This does not mean that fiscal authorities shouldn't be looking for tax evasion; it does mean there should be a balance between investigation and vigilance on one side and a pro-business attitude on the other.

I'll be looking in more detail and the business profit rules in the following posts.

The OECD Model Tax Treaty: Permanent Establishment and Agents, Pt. II

Last week we looked at dependent agents and their ability on the treaty to create a permanent establishment for an enterprise.  Today I'll be looking at independent agents, which do not lead to the determination of a permanent establishment for tax purposes and hence do not create a tax presence.

The commentaries provide this general definition to begin the discussion:

37. A person will come within the scope of paragraph 6, i.e. he will not constitute a permanent establishment of the enterprise on whose behalf he acts only if

a) he is independent of the enterprise both legally and economically, and

b) he acts in the ordinary course of his business when acting on behalf of the enterprise.

The above definition is very similar to the definition of an independent agent under agency law.  In general, under common law rules, the following factors are used to determine whether or not an agent is independent or dependent, and thereby creating some kind of liability.

1.) The extent of control the agent
2.) Is the agent employed in a distinct line of business
3.) The kind of work done and whether or not the work is usually done by an agent
4.) The skill of the agent
5.) Does the agent supply the tools of the craft
6.) The length of time of employment
7.) The method of payment
8.) Is the work part of the regular business of the "employer."
9.) Do the parties of the relationship believe they are creating an independent or dependent agency status

The OECD commentary adds this clarification:

Whether a person is independent of the enterprise represented depends on the extent of the obligations which this person has vis-a-vis the enterprise. Where the person's com-mercial activities for the enterprise are subject to detailed instructions or to comprehensive control by it, such person cannot be regarded as independent of the enterprise. Another important criterion will be whether the entrepreneurial risk has to be borne by the person or by the enterprise the person represents.

You'll note that it is very similar to the 10 points made above, especially in relation to the control the principal has over the agent.  The more control, the more likely the agent is a permanent establishment for the client. 

The OECD Model Tax Treaty; Agents, Pt. I

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The permanent establishment section in the OECD Model Tax Treaty is a remarkably complete section; it anticipates the work-arounds that most attorney's would consider to avoid PE status.  Case in point: the agent rules.

Remember that a permanent establishment is "a fixed place of business through which the business of an enterprise is wholly or partly carried out.  In seeing that definition, an attorney would start to think," what if, instead of a bricks and mortar establishment, we contract with a person?"  Well, the treaty has that covered as well.  

5. Notwithstanding the provisions of paragraphs 1 and 2, where a person —other than an agent of an independent status to whom paragraph 6 applies —is acting on behalf of an enterprise and has, and habitually exercises, in a Contracting State an authority to conclude contracts in the name of the enterprise, that enterprise shall be deemed to have a permanent establishment in that State in respect of any activities which that person undertakes for the enterprise, unless the activities of such person are limited to those mentioned in paragraph 4 which, if exercised through a fixed place of business, would not make this fixed place of business a permanent establishment under the provisions of that paragraph.


6. An enterprise shall not be deemed to have a permanent establishment in a Contracting State merely because it carries on business in that State through a broker, general commission agent or any other agent of an independent status, provided that such persons are acting in the ordinary course of their business.

The above two paragraphs are great examples of good treaty drafting, as they anticipate the intended side-stepping that a lawyer would engage in.  

The primary, in country activity that that treaty is looking for is the ability to conclude contracts; in the words of the commentaries:

Persons whose activities may create a permanent establishment for the enterprise are so-called dependent agents i.e. persons, whether or not employees of the enterprise, who are not independent agents falling under paragraph 6. Such persons may be either indi-viduals or companies and need not be residents of, nor have a place of business in, the State in which they act for the enterprise. It would not have been in the interest of interna-tional economic relations to provide that the maintenance of any dependent person would lead to a permanent establishment for the enterprise. Such treatment is to be limited to persons who in view of the scope of their authority or the nature of their activity involve the enterprise to a particular extent in business activities in the State concerned. Therefore, paragraph 5 proceeds on the basis that only persons having the authority to conclude contracts can lead to a permanent establishment for the enterprise maintaining them.

In trying to determine the appropriate level of activity within a state to apply PE status, the drafters had to find some type of balance; they concluded that the ability to habitually conclude contracts in the country was a strong enough fact to demonstrate a companies intent to avail themselves of the benefits and burdens of a particular jurisdiction.

I'll add more detail to this concept in the next post.

The OECD Model Treaty; Permanent Establishment Exceptions

Not only does the OCED model treaty provide an in-depth explanation of what a PE is, there is also a section that outlines what a PE isn't  Here is the section in its entirety:

4. Notwithstanding the preceding provisions of this Article, the term “permanent establishment” shall be deemed not to include:

a)  the use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise;

b)  the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery;

c)  the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise;

d)  the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise or of collecting information, for the enterprise;

e)  the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character;

f)  the maintenance of a fixed place of business solely for any combination of activities mentioned in sub-paragraphs a) to e), provided that the overall activity of the fixed place of business resulting from this combination is of a preparatory or auxiliary character.

All of these classifications have one element in common: they are either preparatory (they occur before the "main activity") or auxiliary (they are not the primary activity that is occurring at a particular location).

The classic example is section "c," where goods are held for further processioning.  Here, the company is typically importing raw materials into a jurisdiction for the purpose of manufacturing a product in that jurisdiction, with the intention of converting the imported material into another product.  Counting the storage facility as a permanent establishment would create a compliance burden on the importer, and would most likely hinder the development of world trade.

Sections a and b can be seen in combination; they occur where a company has a store that displays or presents goods to the public and/or stores the same.  What is absent from this definition is the selling of goods through the location; once that occurs, a PE clearly exists because then there would be "a fixed place of business through which the business of an enterprise is wholly or partly carried on."

It's also important to remember the differences between the above mentioned activities and a permanent establishment, which the commentary explains thusly:

It is often difficult to distinguish between activities which have a preparatory or auxiliary character and those which have not. The decisive criterion is whether or not the activity of the fixed place of business in itself forms an essential and significant part of the activity of the enterprise as a whole. Each individual case will have to be examined on its own merits. In any case, a fixed place of business whose general purpose is one which is identical to the general purpose of the whole enterprise, does not exercise a preparatory or auxiliary activity. Where, for example, the servicing of patents and know-how is the purpose of an enterprise, a fixed place of business of such enterprise exercising such an activity cannot get the benefits of subparagraph e). A fixed place of business which has the function of managing an enterprise or even only a part of an enterprise or of a group of the concern cannot be regarded as doing a preparatory or auxiliary activity, for such a managerial activity exceeds this level. If enterprises with international ramifications establish a so-called "management office" in States in which they maintain subsidiaries, permanent establishments, agents or licensees, such office having supervisory and coordinating functions for all departments of the enterprise located within the region concerned, a permanent establishment will normally be deemed to exist, because the management office may be regarded as an office within the meaning of paragraph 2. Where a big international concern has delegated all management functions to its regional management offices so that the functions of the head office of the concern are restricted to general supervision (so-called polycentric enterprises), the regional management offices even have to be regarded as a "place of management" within the meaning of subparagraph a) of paragraph 2. The function of managing an enterprise, even if it only covers a certain area of the operations of the concern, constitutes an essential part of the business operations of the enterprise and therefore can in no way be regarded as an activity which has a preparatory or auxiliary character within the meaning of subparagraph e) of paragraph 4.

The above examples all contain professional individuals performing a certain amount of management or professional activities that contribute -- even in a small way -- to the overall enterprise as a whole.  In contrast, the exceptions are more about storing, preparing and or displaying "things."  

The Complete Captive Case Law History Through UPS

Since the last quarter of last year, I've been chronicling the case law history of captive insurance.  Before I move into the safe harbor Revenue Rulings and subsequent PLRs, I wanted to stop and assemble the work in one place.  So, on the right side of my blog, you'll see a section titled "The Captive Cases in Chronological Order" which has links to the various articles.


In the future, if you have any questions on the captive cases, please feel free to drop by and brush up on your knowledge. 

Captive Case Law Conclusions: The Harper Test and Corporate Substance

If you're interested in forming a captive, or simply want to learn more about the topic, please see this website.

The third prong of the Harper Test is "whether the arrangement was for “insurance” in its commonly accepted sense."  The case provides further guidance in this paragraph:

Rampart was both organized and operated as an insurance company. It was regulated by the Insurance Registry of Hong Kong. The adequacy of Rampart's capitalization is not in dispute. The premiums charged by Rampart to its affiliates, as well as to its shippers, were the result of arm's-length transactions. The policies issued by Rampart were valid and binding. In sum, such policies were insurance policies, and the arrangements between the Harper domestic subsidiaries and Rampart constituted insurance, in the commonly accepted sense.

Several other cases have added clarification to this definition.  From the Ocean Drilling Case: 

Several factors contribute to recognizing Mentor as a valid insurance company. The parties that insured with Mentor, both plaintiff and unrelated parties, truly faced hazards. Events such as hurricanes and accidents were real possibilities and could result in losses to the insured parties. The business underwritten by Mentor was understood to be insurance provided by Mentor. Insurance contracts were written and premiums were paid. Unrelated parties purchased reinsurance from Mentor. Unrelated parties co-insured a portion of the direct insurance Mentor wrote for plaintiff. Unrelated parties reinsured policies that Mentor wrote for plaintiff. Premiums charged to plaintiff and unrelated parties were based on the commercial rates in London. The validity of claims was established before payments were made on them. Claims were paid from funds of Mentor that were maintained separately from plaintiff's funds. Mentor's capitalization was adequate, and the policies it entered into were valid and binding. Mentor's business operations were separate from plaintiff's.  Cumulatively, these facts indicate that Mentor's existence as an insurance company was valid and not a sham.

From the Malone Case:

Eastland was adequately capitalized according to Bermuda's insurance law. The record establishes that Eastland was formed for legitimate business purposes. We have found that Eastland operated in the same manner as other insurance companies. It established reserve accounts, paid claimed losses only after the validity of those claims had been established, and was profitable, much in accordance with industry standards. The policies into which it entered were valid and binding. All of these factors cumulatively indicate that Eastland was a valid insurance company.
.....
As discussed above, Eastland was both organized and operated as a valid insurance company and was not a sham corporation. It was regulated by the authorities of Bermuda, and its capitalization was adequate under Bermuda law. The insurance agreements between Malone & Hyde and Northwestern and the reinsurance agreements between Northwestern and Eastland were the result of arm's-length negotiations and were properly evidenced by written policies and endorsements. The reinsurance policies issued by Eastland were valid and binding. Eastland operated as a separate and viable entity, financially capable of meeting its obligations. In sum, the arrangements among Malone & Hyde, its subsidiaries, Northwestern, and Eastland constituted insurance in the commonly accepted sense.

Several elements stand out in the above excerpts;

1.) The importance of adequate capital.  A captive is a stand-alone insurance company.  Central to this idea is the importance of the ability to pay claims and, to do that, it must have money.  An under-capitalized captive will create a red flag.

2.) Forming the captive for a legitimate business purpose.  If there is one key takeaway from looking at the case law history, it's that a captive -- first and foremost -- is about risk.  That must be clearly demonstrated from the beginning of the transaction.  If someone says, "we need to find a business purpose for the captive," they're missing the point.  

3.) The importance of valid insurance policies.  An insurance policy is a contract between the insured and the insurer.  The existence of a policy indicates there are two parties, each with enforceable rights under the contract. 

4.) The importance of being subject to a regulator: while I understand the reason for this, I personally think it's a bit of a misnomer for this simple reason: practically every jurisdiction has some kind of regulatory authority 

Let me add a few other points which I think are worth mentioning, all of which revolve around the idea of corporate substance.  On an ongoing basis, it's imperative to demonstrate the captive is a separate, viable entity.  There are many ways to do this, but I believe the best method is to regularly hold and document company meetings.  Most statutory codes for corporations have a detailed set of rules and requirements for annual meetings (here is a link to Delaware's corporate code on shareholder meetings to give you an idea for what's involved).  The reason for these meetings is simple: to discuss important matters related to the corporation and formulate a direction for the company.  In doing this, the board of directors demonstrates the captive is indeed a separate and viable business entity. 

In addition, there is the concept of alter ego, which is defined by the law.com law dictionary as, "a corporation, organization or other entity set up to provide a legal shield for the person actually controlling the operation."  The best way to think about this concept is that an individual uses the corporation not as a separate, viable company, but instead utilizes the corporation to essentially act as or for the individual with the benefit of limited liability.  This is something we most definitely want to avoid.  According to AMJUR, here are the factors the court will look at to determine if an alter ego exists:

In determining whether to pierce corporation veil, courts will consider whether there was (1) majority ownership and pervasive control of the affairs of the corporation, (2) thin capitalization, (3) nonobservance of corporate formalities or absence of corporate records, (4) no payment of dividends, (5) nonfunctioning of officers and directors, (6) insolvency of the corporation at the time of the litigated transaction, (7) siphoning of corporate funds or intermingling of corporate and personal funds by the dominant shareholder(s), (8) use of the corporation for transactions of the dominant shareholder(s), (9) use of the corporation in promoting fraud, 1 (10) the authorized diversion of an entity's funds, (11) failure to issue stock ownership, (12) ownership of the entity by one person or one family, (13) the use of the same address for the individual and entity, (14) concealment of the entity's ownership, (15) attempts to segregate liabilities to the corporation, (16) whether there was a failure to collect paid-in capital, (17) employment of the same attorneys and employees, (18) use of the entity as a subterfuge in an illegal transaction, (19) formation and use of entity to transfer to it the existing liability of another person or entity, and (20) the failure to maintain
arm's length relationship between related entities.

Taking the above in combination with the third Harper fact, we see the need to make sure the captive operates as a separate and stand alone insurance company.
 

The OECD Model Treaty: Permanent Establishment, Pt. III

Continuing the look at the OECD Model Treaty's definition of permanent establishment, we find the treaty specifically stating the following are PEs in Article 5, Section 2:

2. The term “permanent establishment” includes especially

a)  a place of management;

b)  a branch;

c)  an office;

d)  a factory;

e)  a workshop, and

f)  a mine, an oil or gas well, a quarry or any other place of extraction of natural resources.

The accompanying commentaries add the following

This paragraph contains a list, by no means exhaustive, of examples, each of which can be regarded, prima facie, as constituting a permanent establishment. As these examples are to be seen against the background of the general definition given in paragraph 1, it is assumed that the Contracting States interpret the terms listed, "a place of management", "a branch", "an office", etc. in such a way that such places of business constitute permanent establishments only if they meet the requirements of paragraph 1.

To practitioners, the list should hardly seem controversial.  These are all common terms used in regular parlance, all of which would denote some level of physical commitment to a jurisdiction such as to allow for a taxing nexus to arise.  

As I previously noted, the commentaries cast a very wide net to encompass most situations that would logically lead to a PE.  In addition, the commentaries add the following regarding the typical length of time necessary to establish a PE:

Since the place of business must be fixed, it also follows that a permanent establishment can be deemed to exist only if the place of business has a certain degree of permanency, i.e. if it is not of a purely temporary nature. A place of business may, however, constitute a permanent establishment even though it exists, in practice, only for a very short period of time because the nature of the business is such that it will only be carried on for that short period of time. It is sometimes difficult to determine whether this is the case. Whilst the practices followed by Member countries have not been consistent in so far as time requirements are concerned, experience has shown that permanent establishments normally have not been considered to exist in situations where a business had been car-ried on in a country through a place of business that was maintained for less than six months (conversely, practice shows that there were many cases where a permanent es-tablishment has been considered to exist where the place of business was maintained for a period longer than six months).

 Also of importance is that the activity conducted does not have to be "productive," meaning the PE does not have to add to the profits of the overall enterprise.  As the commentary notes:

It could perhaps be argued that in the general definition some mention should also be made of the other characteristic of a permanent establishment to which some importance has sometimes been attached in the past, namely that the establishment must have a pro-ductive character, i.e. contribute to the profits of the enterprise. In the present definition this course has not been taken. Within the framework of a well-run business organisation it is surely axiomatic to assume that each part contributes to the productivity of the whole. It does not, of course, follow in every case that because in the wider context of the whole organisation a particular establishment has a "productive character" it is consequently a permanent establishment to which profits can properly be attributed for the purpose of tax in a particular territory (cf. Commentary on paragraph 4).

In the next piece, I'll look at the exemptions to PE.

Captive Case Law Conclusion: The Harper Test, Part I: What Is Insurance?

If you're interested in forming a captive, or simply learning more, please see this link.

Today, I want to turn to the Harper Test, which states that a captive must comply with the following three factors:


(1) whether the arrangement involves the existence of an “insurance risk”;

(2) whether there was both risk shifting and risk  distribution; and

(3) whether the arrangement was for “insurance” in its commonly accepted sense.


I've already discussed the idea of risk shifting and risk distribution.  For the next few posts, I want to focus on factors 1 and 3, starting with one, that the arrangement involves the existence of an "insurance risk."  


Legally, insurance risk has three factors: an insurable interest, risk shifting and risk distribution and risk of loss.  The following excerpts are from my doctoral dissertation and discuss insurable interest and risk of loss:

The historical roots of this policy [insurable interest] date back to England when maritime insurance was sold to an insured whether or not he had a personal or financial interest in the ship or cargo. This sales practice “caused many pernicious practices, whereby great numbers of ships with their cargoes, [were] either … fraudulently lost or destroyed.”[1]  The second root of the insurable interest doctrine is judicial policy to prevent using insurance for gambling or wagering.[2]  During the 1800s, people purchased life insurance on famous elderly persons as a way to speculate on the time of their death.[3]  This practice displaces the primary purpose of insurance -- to protect the purchaser against unforeseen losses that directly impact his personal or financial interests.[4]  The third root of the insurable interest doctrine is the prevention of waste[5] by preventing non-essential insurance policies (such as those previously mentioned) from being written.

A person has an insurable interest in property “when he or she will derive a pecuniary benefit or advantage from its preservation or will suffer a pecuniary loss or damage from its destruction, termination or injury by the happening of the event insured against.”[6]  The interest can exist in law or equity[7] and can be found in a legal interest that is slight,[8] contingent or beneficial.[9]  In fact, outright ownership or title of ownership is not relevant to the inquiry.[10]  Obviously, courts construe the interest very liberally.[11]  The amount of insurance purchased cannot be disproportionate to the insurable interest or the court will rule the insurance policy is a wagering contract and therefore void against public policy.[12]

...

The primary purpose of an insurance contract is to transfer risk, which is an unforeseen and uncertain event that is a “disadvantage to the party insured.”[1]  The insured can’t prevent the risk from occurring;[2] it must be accidental[3]  or “fortuitous,” also defined as

‘…an event which so far as the parties to the contract are aware, is dependent on chance.  It must be beyond the power of any human being to bring the event to pass; it may be within the control of third persons; it may even be a past event, such as the loss of a vessel, provided that the fact is unknown to the parties.’[4]

Fortuitous should not be confused with natural degradation or depreciation – which is foreseeable but whose timing may be unpredictable.  In contrast, a fortuitous event is unforeseen and its timing is unknown, thereby impacting the insured when he is less prepared to mitigate the damages.[5]  The unknown or unforeseen element of the fortuity definition is best explained by the three primary fortuity-related defenses insurers offer to challenge an insured’s claim, the first of which is the “known loss” defense, where an insurer will argue the loss had “already occurred or [the insured should have known] the loss already occurred at the time the policy was written.”[6]  The second fortuity related loss defense is the “known risk” defense, where the insured knew the probability of loss was so high as to warrant some type of advance preparation or attempt to avoid the event on the part of the insured.[7]  “Loss in progress” is the third defense, which the insurer will argue when the loss was preceding at the time the insured purchased the insurance contract.[8]  The one common element to all of these defenses is actual or legally impugned knowledge on the part of the insured of the risk actually occurring or having a statistically significant possibility of occurring when he purchases the policy.

---

[1] 1A Couch on Insurance Section 17.7

[2] Id

[3] Appleman, Section 1.05[2][a]

[4] Appleman, section 1.05[2][b]

[5] Id

[6] Id

[7] Id

[8] Id

---

[1] Robert H. Jerry II, New Appleman on Insurance Law Library Edition, © 2009 Matthew Bender and Co. Section 1.05

[2] 44 Am. Jur. 2d Insurance Section 934

[3] Appleman, Section 1.05

[4] Id

[5] Id

[6] 44 C.J.S. Insurance Section 318

[7] Id

[8] Id

[9] 44 Am. Jur. 2d Insurance Section 932

[10] Id

[11] 44 C.J.S. Insurance Section 319

[12] 3 Couch on Ins. Section 41:2

Captive Case Law Conclustion: The Need For A Valid Business Purpose

If you are interested in forming a captive or simply have questions about the industry, please see my website.

In looking at the cases, a few points immediately become apparent.

First, all the captives that were challenged by the IRS were formed because of business necessity.  They are all great examples of the business purpose test outlined in the Frank Lyon case, where has the following factors:

1. there is a genuine multiple-party transaction
2. with economic substance that is
3. compelled or encouraged by business or regulatory realities,
4. that is imbued with tax-independent considerations, and
5. that is not shaped solely by tax-avoidance features to which meaningless labels are attached.

Perhaps the best example of this was the Humana case, where the company clearly weighted the need to create a captive against all the alternatives and determined a captive was the best option.  As I previously noted:

Humana was a groundbreaking case because it was the first major victory for a taxpayer in the captive insurance area.   Humana was (and is) a publicly traded health care company.     By the mid-1970s, it was incredibly difficult for the company to find adequate insurance.   The company considered going uninsured but did not have enough funds to withstand a catastrophic risk.   They also considered setting up a reserve, but payments to a reserve fund are not deductible, and the trust fund would not allow Humana to access the third-party insurance market.   A third option was combining with other hospitals in a 5-year pooling arrangement, but Humana did not want to commit to a 5-year program and was unsure about the financial viability of other possible participants.   Finally, the company could set up a captive insurance company – an option which was accepted because

it possessed none of the perceived disadvantages associated with the other options and it would provide a regulated method of insuring risks which would both isolate funds for the settlement of claims and satisfy interested lenders, mortgagees, and securities analysts.  In addition, Option (4) [establishing a captive] would provide access to world reinsurance and excess insurance markets.

Also note that Humana could demonstrate this need before they formed the captive; they had corporate records that clearly outlined and demonstrated the decision making process that led to their creation of a captive.  Corporate minutes were maintained that outlined the research that went into the decision.

Stearns Rogers also shows a clear business purpose.  The following excerpt is from my book:

The plaintiff in Stearns Rogers designed and manufactured “large mining, petroleum and power generation plants.”   In order to bid on projects, the company had to obtain insurance for its own contractors as well as its clients.   Starting in the early 1970s, the company “found it difficult or impossible to obtain from traditional companies the types and huge amounts of coverage needed.”   Therefore the company formed a captive insurance company under the Colorado Captive Insurance Company Act.   In order to gain approval from the Colorado Insurance Commissioner, Stearns Rogers had to demonstrate the company could not find other insurance.   The plaintiff named the company Glendale Insurance Company, which only issued insurance policies for the plaintiff, the plaintiff’s subsidiaries and the plaintiff’s clients.

While there were other issues with captive, their problem was not a lack of business purpose.

The above mentioned Frank Lyon factors should first and foremost,  always be at the forefront of our thinking when putting captives together.

The OECD Model Tax treaty; Permanent Establishment, Pt. II

Today I'm going to continue looking at the OECD model tax treaty's definition of permanent establishment.  Let me start with, Article 5, Section 2, which states:

2. The term “permanent establishment” includes especially:

a)  a place of management;

b)  a branch;

c)  an office;

d)  a factory;

e)  a workshop, and

f)  a mine, an oil or gas well, a quarry or any other place of extraction of natural resources.

These are nothing more than specific terms which are used across jurisdictions which "can be regarded, prima facie, as constituting a permanent establishment."  While like most things legal the actual determination will be based on a specific cases facts and circumstances, it goes without saying that the above terms are commonly understood throughout the taxing world. 

Article 5, section three offers the following definition regarding construction sites: " A building site or construction or installation project constitutes a permanent establishment only if it lasts more than twelve months."

The commentaries provide important clarification.  For example:

This paragraph provides expressly that a building site or construction or installation project constitutes a permanent establishment only if it lasts more than twelve months. Any of those items which does not meet this condition does not of itself constitute a permanent establishment, even if there is within it an installation, for instance an office or a workshop within the meaning of paragraph 2, associated with the construction activity. Where, however, such an office or workshop is used for a number of construction projects and the activities performed therein go beyond those mentioned in paragraph 4, it will be considered a permanent establishment if the conditions of the Article are otherwise met even if none of the projects involve a building site or construction or installation project that lasts more than 12 months.

It's standard practice to have a portable office on the work site.  However, having one does not in and of itself create a PE -- unless that office also manages other work sites.  This will be very difficult to deal with.  My recommendation would be for the parties involved to maintain immaculate records.  There would also need to be extremely strict rules regarding communications, especially with other work sites (if they exist).

Also consider the following:

The term "building site or construction or installation project" includes not only the construction of buildings but also the construction of roads, bridges or canals, the renovation (involving more than mere maintenance or redecoration) of buildings, roads, bridges or canals, the laying of pipe-lines and excavating and dredging. Additionally, the term "installation project" is not restricted to an installation related to a construction project; it also includes the installation of new equipment, such as a complex machine, in an existing building or outdoors.

While the first part of the commentary shouldn't come as a surprise, it's important to note the second part -- name, the installation of equipment.   For companies that sell heavy machinery who also service and install that machinery, this is a very important piece of information.

Finally, consider that under the UN model treaty, the length of time necessary to establish a permanent establishment is lowered to 6 months.

 

The IRS' War on Captives; UPS, Pt. III

If you're interesting in forming a captive insurance company, please visit my captive management website.

The following is an excerpt from my book U.S. Captive Insurance Law:

After mentioning the general facts, the appellate court first noted, “It is not perfectly clear on what judicial doctrine the holding rests.”   Next, the court noted that this was essentially a sham transaction case, with the IRS arguing that the court should not respect the transaction, because its only motive was tax avoidance.   The court first outlined the basic concept of the sham transaction doctrine:

This economic-substance doctrine, also called the sham-transaction doctrine, provides that a transaction ceases to merit tax respect when it has no “economic effects other than the creation of tax benefits.” Even if the transaction has economic effects, it must be disregarded if it has no business purpose and its motive is tax avoidance.

In other words, the plaintiff must prove that there is a legitimate, non-tax business purpose to the transaction in order to avoid the application of the sham-transaction doctrine. 

The appellate court noted that “economic effects” include the creation of genuine obligations enforceable by an unrelated party.   The court noted that a legitimate insurance contract existed between OPL and NUL, which NUL had the right to enforce.   The tax court “dismissed these obligations” because of the reinsurance agreement between NUL and OPL, arguing that NUL was nothing more than a conduit for payment from UPS to OPL.   In addition, UPS actually lost the income, given OPLs separate taxable status.   Finally, the court noted that the tax court was stretching the business purpose doctrine farther than it was intended to go.   The court sided with UPS and remanded the case back to the trial level. 

End excerpt

I previously noted that the UPS appellate decision is incredibly weak.  The above excerpt explains why.  The appellate court completely ignored the assignment of income doctrine, which was fully developed and painstakingly documented by the lower court.  Instead, we see the incredibly weak, "a valid contract was created" argument, followed by the statement this is adequate grounds to uphold the transaction and satisfy the economic substance doctrine.

To put it bluntly, the appellate court has absolutely no idea or concept regarding the economic substance doctrine, which is a two prong test that has both an objective and subjective component.  In addition, many transactions voided by previous courts because they lacked economic substance contained valid contracts.  Either the court knew this and chose to ignore it, or they didn't know it and marched forward.  Either way, their decision is at best laughable.

However. it is also apparent from the lack of true legal justification for their decision, that the appellate court was sending a message: we will not void a captive insurance transaction, period.  As this was the last case brought by by the IRS, it's obvious they got the message.

The OECD Model Treaty; Permanent Establishment, Part I

Today, I'm going to move forward and look at the OECD Model Treaty's rules on permanent establishment.  This is important for a simple reason: in order to exert its taxing rights over a transaction or individual, a jurisdiction must either prove the person/business is a resident (which we covered over the last few weeks) or prove the transaction took place within the jurisdiction's borders.  A permanent establishment is where a transaction occurs; hence the determination of a permanent establishment is of vital importance.

Let's start with the basic definition: "For the purposes of this Convention, the term “permanent establishment” means a fixed place of business through which the business of an enterprise is wholly or partly carried on."  The commentary adds important, further clarification.

-- the existence of a "place of business", i.e. a facility such as premises or, in certain instances, machinery or equipment;

-- this place of business must be "fixed", i.e. it must be established at a distinct place with a certain degree of permanence;

-- the carrying on of the business of the enterprise through this fixed place of business.

Key to the above ideas is the importance of attachment to the jurisdiction's geography.  The tax authority must be able to point to a place on the map and say with certainty, "economic activity over which we can exert taxing authority occurs at this location."   The length of time the location is established is irrelevant; for example, as soon as the business is formally incorporated it will exist at the address listed in its articles of incorporation.  In addition, the commentary notes that some enterprises only exist for a short period of time, but should still be considered permanent establishments.

The commentary continues:

The term "place of business" covers any premises, facilities or installations used for carrying on the business of the enterprise whether or not they are used exclusively for that purpose. A place of business may also exist where no premises are available or required for carrying on the business of the enterprise and it simply has a certain amount of space at its disposal. It is immaterial whether the premises, facilities or installations are owned or rented by or are otherwise at the disposal of the enterprise. A place of business may thus be constituted by a pitch in a market place, or by a certain permanently used area in a customs depot (e.g. for the storage of dutiable goods). Again the place of business may be situated in the business facilities of another enterprise. This may be the case for instance where the foreign enterprise has at its constant disposal certain premises or a part thereof owned by the other enterprise.

The purpose of the above paragraph is to cover as many situations as possible, and to prevent ultra-technical lawyering from getting around the PE statute.  In short, this is what I personally call a legal "duck test;" if it walks and talks like a PE, it is a PE.  

Over the next few posts, I'll delve deeper into this concept.

The IRS' War on Captives; UPS, Part II

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In analyzing UPS’ situation before and after it established the captive, the tax court noted that UPS performed all the work related to the EVCs before and after the transaction:

Before January 1, 1984, petitioner performed all the functions and activities related to the EVC's and was liable for the damage or loss of packages up to their declared value.  After January 1, 1984, petitioner continued to perform all the functions and activities related to EVC's, including billing for and receiving EVC's, and remained liable to shippers whose shipments were damaged or lost while in petitioner's possession.  Petitioner continued to receive shippers' claims for lost or damaged goods, investigate and adjust such claims, and pay such claims out of the EVC revenue that it had collected from shippers.  The difference between petitioner's EVC activity before and after January 1, 1984 was that after that date it remitted the excess of EVC revenues over claims paid, i.e. gross profit, to NUF, which, after subtracting relatively small fronting fees and expenses, paid the remainder to OPL, which was essentially owned by petitioner's shareholders.

The only difference between UPS’ pre- and post-1984 arrangement was the insertion of NUF and OPL into the equation.   However, if that arrangement did not have economic substance, the court would not recognize the arrangement.   Hence, at trial this case’s focus was the objective and subjective substance of the transactions between UPS and NUF and NUF and OPL.

UPS first stated it created the transaction between UPS, NUF and OPL out of concern that the EVCs were insurance for which UPS did not have the requisite state licenses.   As a result, UPS’ business purpose for the transaction was to bring an existing business practice in line with various state laws.  However, for this claim to be valid, UPS would have to demonstrate that it “was motivated by a good faith concern that it was illegal for petitioner to continue to receive the excess value income.”   But UPS never obtained a legal opinion regarding the possible legal status of the ECV program.    In addition, after the program was in place, UPS continued to sell ECV policies to shippers in the same manner as before the transaction was established.   Finally, at trial, UPS did not offer any documentary evidence to back up this assertion.

Other of petitioner’s arguments were proven inaccurate by documentary evidence or testimony at trial.  First, UPS argued that its business purpose for establishing OPL was to create a viable insurance company as a profit center for the company overall.  However, the court noted that there were plenty of ways UPS could capitalize this new venture without diverting excess value premiums to OPL.  UPS also argued its business purpose was to allow the company to raise insurance rates.   But this assertion was proven incorrect by testimony from petitioner’s own witness at trial.   UPS also argued the new arrangement was a form of asset protection – that it lowered UPS’ exposure to risk and therefore protected the company’s core assets.   However, UPS continued to be primarily liable on many aspects of the ECV after the implementation of the captive insurance company.   Therefore, the company was still essentially liable, and its claim was proven incorrect by the facts. 

The court next determined whether the rate charged by UPS for its ECV policy was an arm’s length price.  The service procured an expert named Mr. Kelly to demonstrate that the rates charged for EVCs were higher than would be charged in a competitive market.   To demonstrate this fact, Mr. Kelly noted that OPL had a loss ratio of 33% – meaning the company paid out approximately 33% of premiums received in the form of payment for claims.   Mr. Kelly testified that this rate of profit retention would have driven clients away.   The court also noted that another UPS subsidiary named PIP charged a lower rate (0.125 cents per $100 – about half the ECV rate) for its insurance.  Several other experts backed-up this claim.  Even an expert procured by the petitioner conceded that UPS’ ECV rates were high.   As such, the court determined that the rates charged were not at arm’s length, making the transaction a sham for tax purposes.

Finally, the court noted that the petitioner’s sole purpose for entering in the transaction was lowering its federal tax burden.   The petitioner’s insurance broker prepared an original report stating that UPS could save $16 million in federal taxes the first year the plan was put in effect.   Other documents procured at trial demonstrated that tax reasons were the petitioner’s primary motivation for entering into the transaction.  

For all of the reasons listed, the court ruled that the payments UPS deducted as insurance premiums were not legitimate business deductions.   UPS appealed the decision.

The OECD Model Treaty; Residence, Part II

Last week, I looked at the residence provisions of the OECD Model Tax Treaty for individuals.  This week, I'll take a look at the provisions for non-individuals.

Before moving forward, however, it's important to briefly diverge into an area of academic discussion: partnerships, and how the OECD treaty deals with these business entities.  Under Article 1, the treaty applies to "persons who are residents of one or both of the contracting states."  This leads to the question of, "how does the treaty deal with a pass-through entity?"  Is the entity actually a separate company or is the entity a collection of its partners?  If the latter, how do we deal with that?  While this might seem like an academic debate, in reality it's not, as some jurisdictions treat these business entities in a very different manner.  The debate went so far as to have the OECD issue a paper on this topic, titled, "Double Taxation Conventions and the Use of Conduit Companies."  I would highly recommend reading the paper, as it offers some fascinating insights into partnerships the world over and how they are used in complicated business transactions.

All that being said, the word "person" (which is used in the above referenced Article 1 of the treaty) is defined in Article 3, which states, "the term person includes an individual, a company and any other body of persons."  The accompanying commentary adds this:

The definition of the term "person" given in subparagraph a) is not exhaustive and should be read as indicating that the term "person" is used in a very wide sense (cf. especially Articles 1 and 4). The definition explicitly mentions individuals, companies and other bodies of persons. From the meaning assigned to the term "company" by the definition contained in subparagraph b) it follows that, in addition, the term "person" includes any entity that, although not incorporated, is treated as a body corporate for tax purposes. Thus, e.g. a foundation (fondation, Stiftung) may fall within the meaning of the term "person". Partnerships will also be considered to be "persons" either because they fall within the definition of "company" or, where this is not the case, because they constitute other bodies of persons.

In short, after a long debate about partnerships and how to deal with them, we see they are covered by the convention.

That leads us to the question of residence of a non-person, which the treaty deals with thusly (Article 4(3)):

Where by reason of the provisions of paragraph 1 a person other than an individual is a resident of both Contracting States, then it shall be deemed to be a resident only of the State in which its place of effective management is situated.

The commentary adds this clarification:

As a result of these considerations, the "place of effective management" has been adopted as the preference criterion for persons other than individuals. The place of effective management is the place where key management and commercial decisions that are necessary for the conduct of the entitys business are in substance made. The place of effective management will ordinarily be the place where the most senior person or group of persons (for example a board of directors) makes its decisions, the place where the actions to be taken by the entity as a whole are determined; however, no definitive rule can be given and all relevant facts and circumstances must be examined to determine the place of effective management. An entity may have more than one place of management, but it can have only one place of effective management at any one time.

There are two possible ways to deal with a business entity: either the entity is a resident of the country where it is incorporated or it's a resident based on its place of effective management.  As the commentary points out, the primary reason the treaty settled on the place of effective management test was some companies with extensive international transportation operations (shipping and air transport companies) would be placed at an extremely advantageous tactical advantage using the place of incorporation test.   As such, the place of management test was adopted.

Finally, residence is usually a non-issue.  The rules are written in such a way as to provide clear guidance and procedures to determine residence with little difficulty.  

The IRS' War on Captives; The UPS Case, Part I

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The UPS case is the last big captive case.  However, there is a bit of history between UPS and Harper that we need to explain before moving forward.

In the 1990s, the IRS expanded the scope of their captive litigation, targeting bigger companies.  Humana was one of the first truly large, fortune 500 style companies subject to captive litigation.  It was not the last.  Harper (which I discussed last week) was a large, international company.  The service went so far as to argue Allstate -- then a subsidiary of Sears -- was a captive, even though Allstate wrote a a very small part of their business with Sears.  UPS fits with this general case theory of the service generally targeting larger companies after establishing a legal foundation with smaller companies.  However, this tactic did not work.  The dam started to burst with the Humana (see here, here and here).  The service began to abandon the economic family doctrine in the Kidde caseby arguing a corporation was in fact a Nexus of contracts.  However, the court did not buy this argument which meant the service would again have to change their tactics in the UPS case if they wanted to continue litigating against captives.

Many practitioners argue that UPS represents the "final nail in the coffin" of captive litigation.  This is a generous reading that is belied by the facts of the case. First, the IRS won at trial by basing their argument on the assignment of income doctrine.  While the appellate court over-turned the trial court, they should not have as the lower court's decision was the correct outcome.  Simply put, UPS was a poorly designed transaction that should have gone against the taxpayer.  What's surprising about this result is that UPS' counsel was sophisticated enough to propose a diverse share ownership structure to avoid CFC application to the original captive, but completely blind when it came to the issue of anti avoidance law.  The lesson here is clear: if you're involved with captives (or any tax based planning) and you can't name the five anti-avoidance doctrines in US law (or, for good measure, the assignment of income doctrine), you have some CLE in your future.

While the lower court's decision prints at over 105 pages on Lexis, the appellate court's decision is 7 pages.  The lower court's decision goes into extensive detail supporting its decision, reprinting long excerpts from relevant testimony and explaining the law in "law review" detail.  The appellate court , frankly, could care less.  I often wonder whether they even read the entire decision.  They begin their legal analysis thusly: "It is not perfectly clear on what judicial doctrine the holding rests."  A reading of the case would have dispelled this statement, as the lower court was very clear.  In retrospect, I believe UPS represents more exhaustion than legal theory, as the appellate court is basically stating that, regardless of the thoroughness of the arguments at trial, captives will stand as a business tool.

Let's move forward with a basic outline of the case's facts.  The following excerpt is from my book, U.S. Captive Insurance Law: 

United Parcel Service (UPS) charged its clients an extra fee to insure packages above $100 in value.   This was income to UPS.   UPS’ insurance broker suggested UPS restructure this transaction to avoid the addition to UPS’ gross income of excess value charges.   UPS implemented this plan by forming a Bermudan captive named Overseas Partners (OPL) in 1983.   UPS then purchased an insurance policy from National Union Fire Insurance Company (NUF), who in turn purchased reinsurance from OPL.   As a result, the payment from UPS to NUF would be classified as an insurance premium and therefore deductible under 26 USC 162(a). 

The IRS attacked this arrangement, arguing “that the excess-value payment remitted ultimately to OPL had to be treated as gross income to UPS.”   In effect, the IRS was now making an assignment–of-income argument in an attempt to thwart UPS’ captive arrangement.   There were two reasons for this change of tactic.  First, the IRS’ previous arguments were not successful; no court had accepted the “economic family” doctrine, and after the court in Humana rejected that argument, the service made a new and unsuccessful use of the “corporations are a series of contracts” argument.  Secondly, the assignment of income doctrine avoided having to work around the separate corporate entity issue of the captive that had plagued previous captive cases.  


Next, I'll start to look at the lower court's legal reasoning.

The OECD Model Tax Treaty; Residence, Part I

If you have further questions about international tax, please contact my law office.

Article 1 of the OECD treaty states, "This Convention shall apply to persons who are residents of one or both of the Contracting States.."  As such, for a person to claim treaty benefits, they must be residents.  Today, I'll focus on residence for individuals, which is covered in Article four of the treaty:

Article 1, Section 4 states, 

For the purposes of this Convention, the term “resident of a Contracting State” means any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, place of management or any other criterion of a similar nature, and also includes that State and any political subdivision or local authority thereof. This term, however, does not include any person who is liable to tax in that State in respect only of income from sources in that State or capital situated therein.

The above paragraph has several key points as noted in the accompanying commentary.  "The definition refers to the concept of residence adopted in the domestic law."  Put another way, the model treaty melds with the existing domestic law to create a hybrid concept.  Second, "the definition aims at covering the various forms of personal attachment to a State which, in the domestic taxation laws, form the basis of comprehensive liability."  What the treaty is looking for is some outward, easily documented manifestation of an individual's presence in the state.  Also note, this definition does not extend to companies that are taxed in a jurisdiction simply because of their business done in the state.

In the event a person is a resident of both contracting states, the treaty has a comprehensive list of "tie-breaking" provisions:

a)  he shall be deemed to be a resident only of the State in which he has a permanent home available to him; if he has a permanent home available to him in both States, he shall be deemed to be a resident only of the State with which his personal and economic relations are closer (centre of vital interests);

b)  if the State in which he has his centre of vital interests cannot be determined, or if he has not a permanent home available to him in either State, he shall be deemed to be a resident only of the State in which he has an habitual abode;

c)  if he has an habitual abode in both States or in neither of them, he shall be deemed to be a resident only of the State of which he is a national

d)  if he is a national of both States or of neither of them, the competent authorities of the Contracting States shall settle the question by mutual agreement.

The criteria start with an easily understood concept: where is the individual's physical home?  If only one exists, the investigation stops.  If there are two homes, then we need to determine where his "center of vital interests" exists -- where he has his closest community.  Here we look at where he has friends, which community he more actively participates in etc... 

The preceding two points are typically where most inquiries stop.  However,  in the event it's difficult to determine, we next look to a "habitual abode."  Habitual abode refers more to the length of time an individual stays in a particular location, regardless of the type of residence (which could even be a hotel).  Finally, if that test doesn't work, we look to nationality and then an agreement between the countries.

In reality, most inquiries are easily handled under these rules.  Typically it stops at at section (a).  

Next, we'll talk about residence for business entities.