Taxation and the Future of Offshore Insurers

By Larkins, Ernest R. | Risk Management, September 1991 | Go to article overview

Taxation and the Future of Offshore Insurers


Larkins, Ernest R., Risk Management


Prior to 1987, U.S. businesses garnered substantial tax advantages when establishing captive insurers in Bermuda, the Bahamas and the Cayman Islands. Typically, a U.S. multinational would organize a foreign corporation to insure its business property and activities. The underwriting income of the foreign entity would be accumulated indefinitely on a tax-deferred basis. As long as the arrangement was not viewed as self insurance, premiums paid to the offshore entity would be deductible by the parent.

Today, the tax incentives to establish offshore insurance companies have been eliminated for the majority of U.S. multinationals that own captives. Rather than a deferral of underwriting income, most offshore profits are now taxed under Subpart F of the Internal Revenue Code. Furthermore, underwriting premiums paid to captives can be deducted only in narrow, well-defined situations. Nonetheless, some tax benefits can still be gleaned by captive insurers.

Controlled Foreign Corporations

Sections 951 through 964 of the code, known as Subpart F, are intended to tax offshore profits during the taxable year they are earned. In so doing, this portion of the code substantially increases, on a present value basis, the U.S. tax liabilities of many U.S. individuals and companies with foreign business interests.

The focus of Subpart F is on controlled foreign corporations, which are defined as having more than 50 percent of their voting power or stock value owned by U.S. shareholders. By definition, U.S. shareholders include only U.S. citizens and residents or entities that own at least 10 percent of the foreign corporation's voting power. For example, a wholly owned foreign subsidiary of a U.S. multinational corporation is considered a controlled foreign corporation. But a foreign corporation owned equally by 11 unrelated U.S. persons is not a controlled foreign corporation since there are no U.S. shareholders.

Controlled foreign corporations are not subject to U.S. taxation unless they earn U.S. source income or income that is effectively connected with a U.S. trade or business. Nonetheless, the U.S. shareholders of such a corporation are taxable via a constructive dividend when the controlled foreign corporation earns "tainted income" derived, for example, from issuing or reissuing certain insurance or annuity contracts or when it invests in certain U.S. property. As a result, the income earned by many offshore insurers is taxable to the U.S. owners, even though the profits are not currently remitted and may remain offshore for several years.

The proliferation of foreign captives has resulted in congressional scrutiny and an obstacle course of Draconian barriers that corporations in other industries are not required to run. For example, a foreign corporation that receives more than 75 percent of its gross premiums from insuring risks outside the country where it is organized is likely to be a controlled foreign corporation. Specifically, it is a controlled foreign corporation if more than 25 percent, rather than 50 percent, of the voting power or value of shares is owned by U.S. shareholders.

Tax Reform Impact

Despite this obstacle, captive insurers organized abroad easily escaped U.S. taxation before the Tax Reform Act of 1986. For instance, share ownership could be dispersed so that no U.S. person owned the 10 percent minimum needed to be considered a U.S. shareholder. Without a shareholder, the captive was not a controlled foreign corporation. But even when the captive was considered to be one, U.S. taxes were often deferred by insuring persons residing, property located or activities occurring outside the United States. Prior to the act, only the insurance of U.S. risks generated Subpart F income.

The act changed the game considerably. Most so-called related party insurance income is now treated as Subpart F income. Related party insurance income is the insurance and reinsurance income from policies issued to U. …

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