Captives And Life Insurance: A Bad Combination

     No topic splits the captive insurance world more than the issue of life insurance — or, more specifically, whether or not a captive can purchase a whole life policy as part of its investment portfolio. Those in favor point to the stable returns offered by whole life and the fact that banks are allowed to purchase BOLI as primary reasons for favoring the practice. Those against the practice cite anti-avoidance law along with the IRS’s long history of successfully attacking more aggressive life insurance plans as negative factors. Adding further fuel to the fire is the lack of any formal guidance from the IRS on the issue, leaving both camps with enough legal wiggle room to claim validation.

     I have always fallen in the negative camp, largely based on anti-avoidance law concerns. By way of quick background, anti-avoidance law is a series of judicial doctrines used by the courts and the IRS to attack transactions largely on “substance over form” grounds. This doctrine has a long and extremely convoluted legal history, which can be traced to the Gregory v. Helvering case, and stretches to well over 1,000 citations in cases, law review articles and legal treatise. Highly questionable annuity and life insurance transactions are at the center of several of the more famous citations, such as Knetsch (which involves and annuity transaction) and In Re CM Holdings (which is one of four COLI cases from the 1900s and early 2000s).

     Firmly hardening my antagonism to this transaction is a recent law review article by Beckett Cantley, law professor at John Marshall School of Law in Atlanta. His piece, "Historical IRS Policy Weapons to Combat CIC Deductible Purchases of Life Insurance, provides the most in-depth treatment of this transaction, highlighting the IRS’ successful attacks on more aggressive life insurance planning, the policy reasons behind those attacks and the application of the reasoning of those successful prosecutions to captive purchases of life insurance.

     He concludes, “The IRS will likely view an arrangement where a small business owner funds a CIC for the primary purpose of obtaining deductions on life insurance premium payments (“Insurance Transaction”) as similarly abusive to prior listed transactions involving I.R.C. § 419 plans, I.R.C. § 412(e)(3) plans, and I.R.C. § 831(b) PORCs.”

     Professor Cantley outlines the basic argument that would allow the IRS to successfully challenge these transactions.

     The starting point is section 264(a) of the tax code, which states: “No deduction shall be allowed for—(1) Premiums on any life insurance policy, or endowment or annuity contract, if the taxpayer is directly or indirectly a beneficiary under the policy or contract.”

     The underlying policy reason for this is to prevent tax free accumulation of income, which would disproportionately benefit high-net-worth individuals. If this deduction were allowed, a high-net-worth business owner would be able to purchase vast amounts of life insurance coverage, deduct those premiums as a trade or business expense, and then have the tax-free proceeds benefit his family on his death.

     The next step is the premium payment from the parent company to the captive, which is tax deductible under 162(a) as a trade or business expense. This is followed by the captive’s purchase of life insurance, which benefits the captive owner by either naming his family or business as a beneficiary. Note what’s transpired with this transaction: The business owner has deducted the premium payment for a property and casualty policy, the proceeds of which have been used to purchase a life insurance policy that in some way benefits him. He has done indirectly (purchased life insurance via some type of deductible payment) what he can’t do directly (take a deduction for a life insurance payment via 264(a)). A general underlying concept in tax law is a taxpayer cannot do indirectly what he can't do directly. However, here, he has done just that.

     In addition, there are several basic anti-avoidance law theories which would underlie the services attacks; these involve application of the step transaction doctrine, the economic substance doctrine, general form over substance and the sham transaction doctrine. Professor Cantley outlines these arguments in far more detail in a forthcoming law review article titled, “Relearning the Lesson: IRS Judicial Doctrine Attacks on the Captive Insurance Company Tax Deductible Line Insurance tax Shelter.”  His analysis for all doctrines is very convincing, and indicates the Service has multiple avenues to successfully challenge this transaction.  

     One of the more unfortunate aspects of practicing law is we are forced to read the legal tea leaves when there is no formal guidance from the relevant authorities. However, in-depth research and a broad knowledge of the law often suffice where lack of guidance exists. Here, the history of anti-avoidance law, the general tax policy of preventing a tax deduction (either directly or indirectly) for purchases of life insurance and the IRS’s long and successful history of challenging aggressive life insurance transactions provide a clear picture: Purchasing life insurance as a portfolio investment in a captive insurance company should be avoided.  

Double Irish Loophole to Close

From CBS Marketwatch:

Ireland's finance minister, Michael Noonan, said Tuesday that he will work to close a legal loophole that allowed Apple Inc. AAPL +0.56% to sidestep big tax payments, the Financial Times reported on Wednesday. Noonan said he will publish leglislation that ensures companies registered in Ireland declare a tax residency in another jurisdiction or become liable for a 12.5% corporate tax rate in 2015.

Cadbury's Tax Plan and Inverse Mergers: More Corporate Tax Planning Enters the Spotlight

     One of the more interesting business reporting trends over the last few years is the focus on corporate tax planning.  I believe this started in conjunction with the investigations by the US and other OECD countries into offshore/tax haven planning mechanisms which has led to some embarrassing tax disclosures.  Regardless of the cause, we are seeing far more actual disclosure about aggressive corporate tax planning techniques.  For example, the Financial Times has recently issued a two part report on Cadbury's tax planning.  

Cadbury, the British confectionery maker that became a cause célèbre for tax justice campaigners after it was acquired by US food group Kraft in 2010, engaged in aggressive tax avoidance schemes before the takeover that were designed to slash its UK tax bill by more than a third.

A Financial Times investigation into the tax affairs of the company – established in 1824 by Quakers and known for its philanthropic ethos – has uncovered tax avoidance schemes former senior executives admit were “highly aggressive”.

.....

Like many multinationals, Cadbury reduced its corporation tax bill by loading operations in high tax countries, such as the UK and US, with debt, while using equity to fund its growth through low tax jurisdictions such as Ireland.

But it went even further by devising schemes to engineer interest charges that could be deducted from its gross profits and reduce UK tax.

     And the New York Times Deal Book recently published an article on the increased use of international mergers as a way to cut corporate tax bills:

From New York to Silicon Valley, more and more large American corporations are reducing their tax bill by buying a foreign company and effectively renouncing their United States citizenship.

“It’s almost like the holy grail,” said Andrew M. Short, a partner in the tax department of Paul Hastings, which advises a number of American corporations on deals. “We spend all of our time working for multinationals, thinking about how we’re going to expand their business internationally and keep the taxation of those activities offshore,” he added.

Reincorporating in low-tax havens like Bermuda, the Cayman Islands or Ireland — known as “inversions” — has been going on for decades. But as regulation has made the process more onerous over the years, companies can no longer simply open a new office abroad or move to a country where they already do substantial business.

Instead, most inversions today are achieved through multibillion-dollar cross-border mergers and acquisitions. Robert Willens, a corporate tax adviser, estimates there have been about 50 inversions over all. Of those, 20 occurred in the last year and a half, and most of those were done through mergers.

OECD v. Tax Havens Part V: Intra-Company Transfers

     The IRS (nor any other taxing authority) does not like intra-company transfers. This is a prime reason for section 482 of the US tax code, which reads:

In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.  In the case of any transfer (or license) of intangible property (within the meaning of section 936(h)(3)(B)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.

The accompanying Treasury Regulations provide guidance on US transfer pricing rules.  The OECD has issued its transfer pricing guidelines, which can be accessed here.  Both organizations are extremely concerned that related organizations will use their relationship to manipulate their respective earnings.

     This is an issue at the forefront of the new OECD list of potential actions to prevent BEPS -- base erosion and profit shifting.  One of their first concerns is the use of interest deductions between related companies.  Action point 3 states:

Develop recommendations regarding best practices in the design of rules to prevent base erosion through the use of interest expense, for example through the use of related-party and third-party debt to achieve excessive interest deductions or to finance the production of exempt or deferred income, and other financial payments that are economically equivalent to interest payments.

One of their primary concerns is the use of a conduit company in an offshore haven to hold financial assets, which in turn makes a loan to the parent company to drain corporate profits form a high tax environment to a non-tax environment. 

     But there are other concerns related to intra-company transfers.  Action point 8 is to "develop rules to prevent BEPS by moving intangibles among group members," while action point 9 is meant to "develop rules to prevent BEPS by transferring risks among, or allocating excessive capital to, group members."  Action 10 states: "develop rules to prevent BEPS by engaging in transactions which would not, or would only very rarely, occur between third parties."  And finally there is action point 14 to "develop rules regarding transfer pricing documentation to enhance transparency for tax administration, taking into consideration the compliance costs for business."

     Central to all of these concerns is the creation of a wide corporate structure encompassing many jurisdictions and then using the inter-relationships between the companies to manipulate earnings in a manner not intended or envisioned by the code.  All of the recommendations point to new rounds of intensive scrutiny on the part of the OECD.