Proposed regulations by the U.S. Treasury Department that would eliminate a tax deduction for captive insurers have resulted in a full-force response by nearly every sector of the captive industry.

The regulations--proposed on Sept. 28, 2007--would eliminate the tax deduction for reserves established by captive insurers for insurance sold to affiliates, if the insureds and insurer file in the same consolidated return. Treasury invited taxpayer comments by Dec. 27, 2007.

Responses came from trade associations, service providers, state captive regulators and even the National Governors Association. Taken together, these comments amply advance arguments challenging the appropriateness of the theory behind, and application of, these proposed regulations.

There will be a formal public hearing later this year in Washington, D.C. Further, the captive industry has commenced, and plans to pursue, an intense lobbying effort in an attempt to have this proposal withdrawn.

The proposed regulations apply only to captive insurance companies that are part of a consolidated federal income tax return. Thus, these regulations generally apply to public corporations and large privately-held companies that file a consolidated return.

They do not apply to a foreign insurer, unless the captive has both elected to be treated as a U.S. taxpayer under Internal Revenue Code ?953(d) and has been included in a consolidated return.

The proposed regulations are quite technical, but they have a very severe and practical consequence.

Normally, insurers are allowed to deduct the discounted present value of their reserves for future losses, rather than wait until the losses are paid. The proposed regulations would treat related-party insurance as "self-insurance," and would deny a deduction for related-party reserves for a captive in a consolidated return.

Despite the fact there was no change in the law that would favor the IRS since 1995, when the current regulations were issued, late last September the Treasury decided to change the treatment of related-party insurance in consolidated returns as a subordinate part of issuing proposed regulations on broader issues only tangential to captive insurance.

Congress has granted the Treasury a great deal of latitude in issuing regulations implementing consolidated returns, but all parties are agreed that the appropriateness of such regulations must be measured against a "clear reflection of income" standard.

The following is a summary of comments made public to date by the various:

o Coalition for Fairness to Captive Insurers.

By far the longest, and most technical, comments were submitted by the Coalition for Fairness to Captive Insurers. The coalition was sponsored by the Captive Insurance Companies Association and the Vermont Captive Insurance Association.

More than 40 coalition members joined in the comments, including individual captives, captive owners, state insurance departments, state and industry associations, captive managers, attorneys and other service providers.

The 36-page coalition comments--drafted by the law firms of McDermott Will & Emery LLP and Dewey & LeBoeuf LLP--address the technical issues raised by the proposed regulations in a very thorough and persuasive manner. They focus on six points:

o Self-insurance is an improper model to adopt and ignores the special treatment granted to insurance companies under the Internal Revenue Code.

o Allowing deductions for reserves more clearly reflects income than a self-insurance model, which distorts the group's income by failing to take into account the unique nature of insurance liability in computing income.

o Application of the self-insurance model to captives would be administratively complex, just as the Treasury correctly concluded in 1995. Elaborate rules would have to be issued for both the transition and for ongoing transactions.

o Treasury's reasons for changing the regulations (set forth in its preamble) do not justify the change. In fact, when the 1995 regulations were issued, the Treasury knew of taxpayers' favorable trend line in winning tax cases and also was aware of the large and growing worldwide captive market.

o The courts (in both the third-party and brother-sister cases) have soundly rejected the argument that the self-insurance model reflects the substance of related-party insurance.

o There are many legitimate nontax business reasons for captive insurance. In any event, the IRS is adequately protected against any perceived abuse without these proposed regulations.

On Jan. 23, the coalition will hold a two-hour seminar on the proposed regulations. Information on the seminar is available at www.vcia.org and www.cicaworld.com.

o SIIA, SCCIA, MCIA and CIC-DC.

The Self-Insurance Institute of America and the individual captive insurance associations of South Carolina, Montana and the District of Columbia submitted separate but similar comments.

The associations argue that reserves are the most important component of an insurance company's balance sheet and are already discounted for tax purposes, and thus should not be eliminated. Reserves are highly regulated by insurance departments.

Insurers are allowed reserve deductions under the IRS code; it should not matter if the premiums are from related or unrelated insureds. The proposed regulations are contrary to numerous court cases and the IRS's abandonment of the "economic family" theory.

Finally, the proposed regulations will encourage captives to form or move offshore, causing a loss of jobs in the domestic captive industry.

o Governors:

The effect on the domestic captive industry was echoed by the National Governors Association, as well as the individual governors of Vermont and Utah. Utah Governor Jon Huntsman Jr. also warned that the United States will be perceived in world markets as an unfriendly regulatory environment for financial service businesses.

o RIMS:

The Risk and Insurance Management Society filed comments focusing on the uses of captives to assist in managing risk, the extensive use of such alternative risk-transfer facilities, and the proposed regulations' inappropriate departure from the current tax treatment of intercompany insurance transactions.

o Service Providers:

Beecher Carlson Insurance Services LLC expressed concern about the domestic captive industry and chastised the proposed regulations' inconsistency with the captive case law.

KPMG argued that the regulations should be withdrawn because they are inconsistent with the historic and current taxation of insurance companies.

It also asserted that if the regulations are not withdrawn, they should at a minimum be clarified with respect to section 831(b) companies, the anti-abuse rule and the effective date.

Willis North America emphasized the bona fide nature of captive insurers, which offer nontax business benefits to both U.S. and non-U.S. entities, arguing that captives offer effective vehicles to manage risk.

The proposed regulations would create an unfair playing field and are inconsistent with the IRS' abandonment of the "economic family" doctrine, the brokerage added.

Informal discussions have been held with the Treasury by various groups in the industry. As noted above, a formal hearing will be held later this year.

The captive industry obviously cannot prohibit the Treasury from issuing any regulations it desires. For this reason, many captive associations and the coalition are busy asserting the impropriety of the regulations and pressing these issues on Capitol Hill.

No doubt, discussions will continue as long as the proposed regulations are outstanding.

Special Reports /

Captives Fight To Derail IRS Tax Proposal

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