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.

 

The OECD v. Tax Havens: Pt IV The Digital Economy

     The current tax rules underpinning practically every tax code around the globe are derived from a "bricks and mortar" or manufacturing based economy.  What this means is the underlying concepts were developed when all world economies were based on building physical products that were bought and sold (think industrial revolution).  For example, the tax treaty phrase "permanent establishment" was actually developed by League of Nation's negotiators during their preliminary discussions to develop a working tax treaty framework.  Compare this to today's digital economy where "products" are actually multiple lines of computer code that exist in cyber-space (or a trademark or patented item) or where a "store front" (the old "permanent establishment") is in fact a web site located halfway around the globe on a server in a tax haven.  This mismatch between the underlying concepts of the old tax code and the new economy have allowed tax planners to devise tax plans that exploit the inherent conceptual incongruity between the underlying tax code and actual business being taxed.

     The original OECD model tax treaty attempted to deal with some of the problems created by this situation in their electronic commerce section of the OECD model tax treaty commentary (paragraphs 42.1-42.10).  Paragraph 42.8 of that section concluded:

Where, however, such functions form in themselves an essential and significant part of the business activity of the enterprise as a whole, or where other core functions of the enterprise are carried on through the computer equipment, these would go beyond the activities covered by paragraph 4 and if the equipment constituted a fixed place of business of the enterprise (as discussed in paragraphs 42.2 to 42.6 above), there would be a permanent establishment.

(for further explanation, you may also wish to see this presentation available on slideshare)

     However, this solution is rather narrow; serious exploitation of the old rules when applied to a more modern business is still part and parcel of modern international tax planning.  As such, this is an area which the OECD recommendations target for change, including a targeting of the following areas:

1. the ability of a company to have a significant digital presence in the economy of another country without being liable to taxation due to the lack of nexus under current international rules, 
2. the attribution of value created from the generation of marketable location-relevant data through the use of digital products and services,
3. the characterisation of income derived from new business models, 
4. the application of related source rules, and 
5. how to ensure the effective collection of VAT/GST with respect to the cross-border supply of digital goods and services. Such work will require a thorough analysis of the various business models in this sector.

Each of these areas is a topic onto itself, but suffice it to say that breadth of the potential changes is incredibly broad.

The OECD v. Tax Havens: Pt III New Concerns

On July 13, the OECD issued a new paper titled, Action Plan on Base Erosion and Profit Shifting.  The purpose of this paper was to outline the OECD's new round of concerns regarding tax havens and their use in international tax planning.  It's first important to understand what is behind the issuing of this new report:

Over time, the current rules have also revealed weaknesses that create opportunities for BEPS. BEPS relates chiefly to instances where the interaction of different tax rules leads to double non-taxation or less than single taxation. 

One of the central purposes of the OECD's original tax treaty was to divide taxing rights and privileges between the two sovereigns that sign a particular treaty.  Essentially, each country can tax transactions which occur within their borders (hence the residence requirements of section 1, the residency stipulations of section 4 and the permanent establishment/business profits interaction in sections 5 and 7 of the OECD model treaty).  However, through the interaction of two different tax systems, planners have come to exploit situations so no taxation occurs.  Hence the issue of "double non-taxation."  

In addition, less than single taxation is also possible.  While this term may seem a misnomer, in fact it's not.  One of the central ideas both of accounting and taxation is to effectively align income and expenses.  For example, when a company produces a product, it is allowed under most tax and accounting systems to deduct expenses incurred in production of that product.  This is sometimes referred to as the matching principal.  Less than single taxation occurs when a company manipulates transfer pricing rules to drain money away from the location where the expense should occur to a lower tax jurisdiction.  One of the most common examples is placing intellectual property in a low-tax jurisdiction and paying royalties to that jurisdiction for use of the property, even though the production of that IP occurred in the higher tax jurisdiction. 

This point leads nicely into the third primary concern of the OECD:

The spread of the digital economy also poses challenges for international taxation. The digital economy is characterised by an unparalleled reliance on intangible assets, the massive use of data (notably personal data), the widespread adoption of multi-sided business models capturing value from externalities generated by free products, and the difficulty of determining the jurisdiction in which value creation occurs. This raises fundamental questions as to how enterprises in the digital economy add value and make their profits, and how the digital economy relates to the concepts of source and residence or the characterisation of income for tax purposes. At the same time, the fact that new ways of doing business may result in a relocation of core business functions and, consequently, a different distribution of taxing rights which may lead to low taxation is not per se an indicator of defects in the existing system. It is important to examine closely how enterprises of the digital economy add value and make their profits in order to determine whether and to what extent it may be necessary to adapt the current rules in order to take into account the specific features of that industry and to prevent BEPS.

Over the last 6-9 months, the tax planning of Apple, Google, Amazon and Adobe have been publicized in a negative light.  Because these companies all utilize IP, they are able to send their valuable assets to offshore low-tax jurisdictions and use these venues as "hubs" which collect vast sums of money in a low tax manner.  The OECD is concerned that these structures remove money from higher tax jurisdictions in a manner that does not reasonably employ matching concepts.  The OECD expresses their concern thusly:

It also relates to arrangements that achieve no or low taxation by shifting profits away from the jurisdictions where the activities creating those profits take place. No or low taxation is not per se a cause of concern, but it becomes so when it is associated with practices that artificially segregate taxable income from the activities that generate it. In other words, what creates tax policy concerns is that, due to gaps in the interaction of different tax systems, and in some cases because of the application of bilateral tax treaties, income from cross-border activities may go untaxed anywhere, or be only unduly lowly taxed.

 

The OECD v. Tax Havens, Part II: Initial Recomendations

As discussed in the previous post, the OECD originally went after tax havens in a 1998 document titled, Harmful Tax Competition, An Emerging Global Issue.  They defined a tax haven as a low or no tax jurisdiction that employs secrecy and does not exchange information with other taxing officials.  To counter-act the effect of havens, the OECD proposed a number of options.  There are several that stand out.

Recommendation concerning Controlled Foreign Corporations (CFC) or equivalent rules: that countries that do not have such rules consider adopting them and that countries that have such rules ensure that they apply in a fashion consistent with the desirability of curbing harmful tax practices.

Most advanced economies have some form of CFC rules, the purpose of which is to attribute offshore income to onshore shareholders.  The US adopted its rules in the early 1960s, as did most of the larger European countries.  

Recommendation concerning foreign information reporting rules: that countries that do not have rules concerning reporting of international transactions and foreign operations of resident taxpayers consider adopting such rules and that countries exchange information obtained under these rules.

The US tax system -- as with most other tax systems -- is a self-reporting system.  Taxpayers annually report their income, and the threat of an audit prevents abuse.  However, in the age of electronic banking, it's very easy for people to open an account and then fund it in an un-reportable manner.  This led to the passage and implementation of FATCA rules.

Recommendation concerning greater and more efficient use of exchanges of information: that countries should undertake programs to intensify exchange of relevant information concerning transactions in tax havens and preferential tax regimes constituting harmful tax competition.

While the OECD Model Tax Treaty contains an exchange of information section, after the organization published the Harmful Tax Competition document, they began to encourage the signing of mutual assistance treaties between countries that focused exclusively on the exchange of relevant information.  A report issued in 2007 noted the progress that had been made:

The 2006 Report showed that both OECD and non-OECD countries had implemented or made considerable progress towards implementing the transparency and effective exchange of information standards that the Global Forum wishes to see achieved. It also showed that further progress is needed if a global level playing field is to be achieved. Thus, the Statement of Outcomes issued after the Global Forum meeting in Melbourne on 15-16 November 2005 outlined a series of steps involving individual, bilateral and collective actions which would be needed to both achieve and maintain the goal of a level playing field.

Countries continue to sign mutual assistance treaties. 

The report contained other recommendations; those listed above are simply the more important proposals.