TAX ALERT | April 12, 2023
Authored by RSM US LLP
In the wake of a federal district court opinion invalidating the micro-captive insurance transaction notice (Notice 2016-66), the IRS has issued proposed regulations identifying micro-captive insurance transactions as reportable transactions. The proposed regulations define micro-captive insurance transactions and identify them as either listed transactions or transactions of interest. The proposed regulations also provide a safe harbor for owners and an exception for consumer coverage arrangements.
IRS issues proposed regulations on micro-captive transactions
The IRS and Treasury Department issued proposed regulations sections 1.6011-10 and 1.6011-11 identifying micro-captive insurance transactions as listed transactions and transactions of interest (respectively). The proposed regulations define micro-captive transactions differently than they were originally defined in Notice 2016-66 and contain both a safe harbor and an exception to the abuse designation.
Micro-captive insurance transactions
Under the proposed regulations, a micro-captive insurance transaction is generally an insurance agreement between a parent company and an insurer under its control, that is, a captive insurance company. An insurance company that qualifies as a small insurance company under section 831(b) receives favorable tax treatment such as taxation only on investment income and not on premiums received. The proposed regulations make changes to Notice 2016-66’s definition of a micro-captive insurance transaction.
First, they have changed the definition of the term captive. Notice 2016-66 required that for an insurance company to be considered a captive, the company owning the insurance company must be at least 20% related to the captive. The preamble to the proposed regulations specifies that some promoters were getting around this requirement by issuing various types of instruments representing rights to all or a portion of the assets held by the captive but not voting power or equity interests in the captive. In order to remove this loophole, the proposed regulations expand the scope of the definition of captive to clarify that derivatives and interests in the assets of captive are also taken into account.
Next, the proposed regulations make changes to the financing factor. In Notice 2016-66, transactions in which the financing factor is met based on a computation period of the captive’s most recent five taxable years are identified as transactions of interest. In the proposed regulations, however, these transactions are instead identified as listed transactions.
The proposed regulations have also made changes to the loss ratio factor and computation period. Notice 2016-66 identifies transactions in which the loss ratio factor is less than 70% based on a computation period of the captive’s most recent five taxable years as transactions of interest. However, the proposed regulations identify those transactions in which the loss ratio factor is less than 65% for a computation period extended to the captive’s most recent 10 taxable years as listed transactions. Further, the proposed regulations identify transactions in which the loss ratio factor is less than 65% based on a transaction of interest computation period consisting of the captive’s most recent nine taxable years as transactions of interest.
The proposed regulations have also provided a safe harbor disclosure requirement for owners. This safe harbor provides that any person who is subject to the disclosure requirements solely by reason of their direct or indirect ownership interest in an insured entity is no longer required to file a disclosure statement with respect to that transaction provided that the person receives written or electronic acknowledgment that the insured entity has or will comply with its separate disclosure obligation with respect to the transaction.
Finally, the proposed regulations provide an exception for consumer coverage arrangements. The proposed regulations describe a consumer coverage arrangement as one where a seller (e.g., a service provider, automobile dealer, lender or retailer) sells products or services to unrelated customers (e.g., customers who do not own an interest in and are not wholly or partially owned by the seller, an owner of the seller or individuals or entities related to the seller or owners of the seller). The unrelated customer may also purchase an insurance contract in connection with those products or services. This contract generally provides coverage for repair or replacement costs if the product breaks down or is lost, stolen or damaged; coverage for the customer’s payment obligations if the customer dies or becomes disabled or unemployed; coverage for the difference between all or a portion of the value of the product and the amount owed on the product’s financing, including a lease, if the product suffers a covered peril; or a combination of one or more of the foregoing types of coverage. An entity related to or affiliated with the seller may issue or reinsure the contracts. In some arrangements, the contracts may name an unrelated third party, which may be referred to as the provider of the coverage, and an entity related to or affiliated with the seller reinsures the contracts. In other arrangements, the contracts may name an entity related to or affiliated with the seller as the provider of the coverage. In these arrangements, an unrelated third party may reinsure the contracts and may also then retrocede risk under the contracts to the entity related to or affiliated with the seller. The parties may treat the entity related to or affiliated with the seller as an insurance company that elects under section 831(b) to exclude premium payments from taxable income.
The proposed regulations specify that participation in this type of reinsurance arrangement is neither a micro-captive listed transaction nor a micro-captive transaction of interest because the insured is not sufficiently related to the insurer or any reinsurer. However, it is possible that the 20% relationship factor of the proposed regulation may be met in certain circumstances. Thus, the proposed regulations include a limited exception for taxpayers in consumer coverage arrangements provided commissions paid for the contracts issued or reinsured by the seller’s captive are comparable to the commissions paid for contracts covering the seller’s products or services that are not issued or reinsured by the seller’s captive.
Washington National Tax takeaways
Recent court cases have overturned or cast doubt on the validity of Notice 2016-66 (See, Mann Construction v. United States, 27 F.4th 1138, 1147 (6th Cir. 2022), CIC Services, LLC v. IRS, 2022 WL 985619 (E.D. Tenn. March 21, 2022), as modified by 2022 WL 2078036 (E.D. Tenn. June 2, 2022); Green Valley Investors, LLC, et al. v. Commissioner, 159 T.C. No. 5 (Nov. 9, 2022)). The proposed regulations are a response to these decisions. The preamble to the regulations explains that considering the decision by the district court in CIC Services, the IRS will not enforce the disclosure requirements or penalties that are dependent upon the procedural validity of Notice 2016-66. In addition, the proposed regulations obsolete Notice 2016-66 (as modified by Notice 2017-08).
These new proposed regulations serve to overcome the recent court cases and in effect put back most of the rules originally required by Notice 2016-66. While there may be a temporary hiatus in the requirement to disclose micro-captive insurance transactions, that reprieve is likely to be short-lived.
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This article was written by Trina Pinneau and originally appeared on 2023-04-12.
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