Tax News Update    Email this document    Print this document  

On November 1, 2016, the IRS issued Notice 2016-66 (Notice), designating a new "transaction of interest" (TOI) relating to certain captive insurance companies that make elections under Section 831(b)¹ to be taxed only on taxable investment income (micro-captives). This designation expands the number of TOIs that must be disclosed by taxpayers under Treas. Reg. Section 1.6011-4 and by material advisors under Treas. Reg. Section 301.6111-3.

The description below summarizes the more detailed description provided in the Notice. The Notice applies to any transaction that is the same as, or substantially similar to, the described transaction. The term "substantially similar" is defined in Treas. Reg. Section 1.6011-4(c)(4) to include "any transaction that is expected to obtain the same or similar types of tax consequences and that is either factually similar or based on the same or similar tax strategy." The regulation states that the term "must be broadly construed in favor of disclosure."

Transaction of Interest — Section 831(b) Micro-Captive Transactions

Section 1 of the Notice provides background, including descriptions of the types of transactions involving micro-captives that the IRS believes to be abusive.² The Notice acknowledges that not all micro-captives involve tax avoidance, but the IRS has identified specific transactions that it believes have a potential for tax avoidance or evasion.

Section 2 of the Notice specifies the TOI (micro-captive TOI). The Notice expressly states that a transaction described in Section 2 is identified as a TOI "regardless of whether the transaction has the characteristics described in section 1." Any transaction that is the same as, or substantially similar to the following criteria, which closely tracks the Notice, is a TOI:

1. A person (A) directly or indirectly owns an interest in one or more entities (Insured) conducting a trade or business.

2. An entity (Captive), directly or indirectly owned by A, the Insured or by persons related to A or to the Insured, issues one or more insurance contracts to the Insured, or reinsures insurance contracts the Insured purchased from an intermediary insurance company (commonly referred to as the "fronting" company).

3. Captive elects under Section 831(b) to be taxed only on taxable investment income (if organized offshore, Captive has also elected under Section 953(d) to be taxed as a US taxpayer).

4. A, the Insured, or one or more persons related (within the meaning of Section 267(b) or Section 707(b)) to A or to the Insured directly or indirectly owns at least 20% of the voting power or value of the outstanding stock of the Captive.

and

5. One or both of the following apply:

a. The liabilities for losses and claims administrative expenses of the Captive during the "Computation Period" are less than 70% of premiums earned by the Captive during the Computation Period, reduced by policyholder dividends paid by the Captive during the Computation period.

or

b. During the Computation Period, the Captive has, directly or indirectly, made (or has agreed to make) any portion of the payments under the insurance contract(s) available to A or to the Insured or to any party related (within the meaning of Section 267(b) or Section 707(b)) to A or to the Insured (a Recipient), either as financing or in some other transaction that did not result in taxable income or gain to Recipient, such as through a guarantee, a loan or other transfer of the Captive's capital.

The Computation Period is the most recent five tax years of the Captive or the period of the Captive's existence if it has been in existence for less than five tax years. If the Captive has been in existence for less than five tax years and is a successor to one or more Captives created or availed of in connection with a transaction described in the Notice, tax years of the predecessor entities are treated as tax years of the Captive. For purposes of defining the Computation Period, a short tax year is treated as a tax year.

An arrangement under which a Captive provides insurance for employee compensation or benefits and for which the Employee Benefits Security Administration of the US Department of Labor has issued a Prohibited Transaction Exemption is not treated as an arrangement identified as a TOI under Notice 2016-66.

Implications

Participants: A taxpayer "participating" in a micro-captive TOI on or after November 2, 2006,³ must disclose the transaction as described in Treas. Reg. Section 1.6011-4. Each of the taxpayer parties described in Section 2 of the Notice as A, Insured, Captive or the intermediary fronting insurance company participates in the micro-captive TOI if the taxpayer's return reflects a tax consequence or a tax strategy of the transaction. A taxpayer who fails to properly disclose the transaction under Treas. Reg. Section 1.6011-4 may be subject to the Section 6707A penalty of 75% of the reported tax benefits, with a maximum of $50,000 for entities/$10,000 for individuals and a minimum of $10,000 for entities/$5,000 for individuals. In addition, the IRS may impose other penalties on participants in these transactions, including the accuracy-related penalty under Section 6662 or Section 6662A.

The Notice requires each participant to disclose information as to when and how the taxpayer became aware of the transaction. Captive must provide additional information in its disclosure, including the authority under which Captive is chartered, types of coverage provided, how premiums were determined (including the name and contact number of any actuary or underwriter who assisted in the determinations of such premiums), a description of claims and a description of assets.

Past-year(s) participation: A taxpayer who has participated in a micro-captive TOI on or after November 2, 2006, and during a year for which the tax return has already been filed but for which the statute of limitation for assessment remains open as of November 1, 2016, must disclose that participation by submitting a properly completed Form 8886, Reportable Transaction Disclosure Statement, to the IRS Office of Tax Shelter Analysis (OTSA) (address in Form 8886 instructions) by January 30, 2017. See Treas. Reg. Section 1.6011-4(e)(2).

If a taxpayer participates in micro-captive TOI in a year for which the return has not yet been filed but is due prior to January 30, 2017, the disclosure statement will be considered timely if filed with the OTSA by January 30, 2017.

Current-year participation: A taxpayer who is currently participating in this TOI must disclose the transaction by attaching a properly completed Form 8886, Reportable Transaction Disclosure Statement, to its federal income tax returns for the current tax year and each future tax year in which the taxpayer participates. A copy of the Form 8886 must be sent to OTSA at the same time that the transaction is disclosed for the first time.

Material advisors: A material advisor who has made or makes a tax statement on or after November 2, 2006, with respect to a micro-captive TOI entered on or after November 2, 2006, has both disclosure and list maintenance obligations under Section 6111and Section 6112. See Treas. Reg. Section 1.6011-4(h) and Section 301.6111-3(i) and Section 301.6112-1(g). Persons required to disclose these transactions under Section 6111 who fail do so may be subject to the penalty under Section 6707(a). Persons required to maintain lists of advisees under Section 6112 who fail to provide such lists when requested by the IRS, may be subject to the penalty under Section 6708(a).

Generally, a material advisor is any person who provides material aid, assistance or advice with respect to organizing, managing, promoting, selling, implementing, insuring or carrying out any reportable transaction and who, in the case of the micro-captive TOI, directly or indirectly derives gross income in excess of $25,000 (or $10,000, if substantially all the benefits of the transaction are provided to natural persons).

Request for comments

The Treasury Department and the IRS request comments on how the transaction might be addressed in published guidance. Such comments should be submitted in writing on or before January 30, 2017, to the address as provided in the Notice. Alternatively, comments may also be sent electronically to the following e-mail address: Notice.comments@irscounsel.treas.gov

Please include "Notice 2016-66" in the subject line of any electronic communications.

All comments submitted will be available for public inspection and copying.

Observations

In its general description of the types of transactions involving micro-captives of interest to the IRS, the Notice describes the micro-captive's coverage as involving implausible risk, not matching a business need or risk of an insured, being vague, ambiguous or illusory, or duplicative of insurance already procured from an unrelated insurance company at a lower price. This emphasizes the need for any captive arrangement to have business purpose, economic substance and to be commercially rational. Taxpayers should consider if an actuarial analysis, utilization studies or other documentation is required to support existing structures.

Regarding the Captive, this Notice only applies to a company that made or will make the Section 831(b) election and meets at least one of the two aforementioned Computation Period financial characteristics. Accordingly, this Notice does not apply to other captive insurance arrangements. Other participants that are affected by the Notice include a Captive's owners, the insureds, and any fronting company or intermediary insurance company standing between Captive and its policyholders.

An insurance company could inadvertently become a participant in a micro-captive TOI if it cedes risk to an entity that fits the Notice's definition of a Captive; accordingly, an insurance company may need to seek additional information from any organization to which it cedes annually $1.2 million or less in reinsurance premiums (or $2.2 million or less starting in 2017 and indexed for inflation thereafter) to properly determine if it is a participant in this TOI.

The Notice states that the IRS lacks sufficient information to determine whether the Section 831(b) transaction should be identified as a tax avoidance transaction; accordingly, the IRS has requested reporting from all participants, including owners, insureds, the Captive and the fronting company, with the Captive required to provide specific details as part of its reporting responsibilities. These specifics include detailed premium information, detailed claims information and information regarding any loans between the Captive and its owners. It is important to note that this information is likely already reported to the Captive's regulators as part of its annual reporting process. Likewise, some of the numerical data requested is likely already included on the federal tax returns of the Captive.

We note that the IRS previously requested information regarding specific Section 831(b) companies via Notice 2002-70. Notice 2002-70 was subsequently withdrawn after the IRS examined various types of arrangements and such examinations revealed fewer abusive transactions than anticipated (see Notice 2004-65). In light of the evolution of the Captive markets and the expansion of Section 831(b) companies over the last decade, it appears that the IRS has determined it is in need of re-evaluation of such Captives.

Taxpayers should also consider ASC 740-10 and the implications of this Notice on their current evaluations of uncertain tax positions, if appropriate.

———————————————

———————————————
ENDNOTES

¹ For tax years beginning before January 1, 2017, an insurance company (other than a life insurance company) is eligible to elect under Section 831(b) to be taxed only on its taxable investment income and not on underwriting income if its net written premiums (or, if greater, direct written premiums) for the tax year do not exceed $1.2 million. For purposes of determining the taxpayer's net written premiums or direct written premiums, premiums written by all members of the same "controlled group" of which the taxpayer is a member are included. Generally, for purposes of Section 831(b), a "controlled group" is any group of corporations: (1) with a common parent that owns at least 50% of the vote or value of stock of the other corporations, or (2) with five or fewer individual owners that own identical amounts of each corporation (but at least 50% of each corporation). For tax years beginning on or after January 1, 2017, an insurance company (other than a life insurance company) is eligible to make an election under Section 831(b) if its net written premiums (or, if greater, direct written premiums) for the tax year do not exceed $2.2 million. In addition, a diversification test must be satisfied. This diversification test is satisfied if either no more than 20% of the net written premiums (or, if greater, direct written premiums) of such captive insurance company for the tax year is attributable to any one policyholder or if an ownership test is met. The ownership test focuses on the spouse and lineal descendants of an owner of an insured company. The ownership test is met if the spouse or lineal descendant does not own more of the captive insurance company than he or she owns of the insured company.

² See also IR-2016-25, Feb. 16, 2016, in which the IRS describes several "tax shelters," including the characteristics of an "abusive" micro-captive insurance structure.

³ November 2, 2006, is the date that the IRS issued the TOI regulations in Treas. Reg. Section 1.6011-4, hence the cross-reference to that date in the Notice.