01-Jun-2018

US Tax Reform

Written by Andrew Blevins
Senior Tax Manager, KPMG

Introduction

For those who have never lived, worked, or done business in the Cayman Islands, it’s nearly certain their first comments when meeting someone who has goes something like, “So you have money hidden there?” or “Isn’t that where Tom Cruise hid his money in that movie, ‘The Firm’”? They probably have a hard time believing much, if any, legitimate business can get done in a place with so many palm trees and beautiful beaches. 

Cayman, as a jurisdiction, is always fighting an uphill public relations battle. Depending on which side is making the argument, recent U.S. political campaigns have been littered with accusations that the Clintons and Mitt Romney have money “stashed” or “parked” in the Cayman Islands, always with a negative connotation and an implication that these funds are somehow escaping or avoiding U.S. taxes. This implication is simply not true. It is true that Cayman is a tax neutral jurisdiction and it does not impose direct income taxes on its citizens, businesses, or residents. That fact should not be construed to mean, however, that income generated by Cayman businesses, captive insurance companies, and investment funds is not properly taxed under the applicable laws in the country where the beneficial owners maintain tax residence.  

Considering the recent worldwide shift to freely exchanging tax information between countries, it is now nearly impossible to “stash” or “hide” investments or “shift” profits without someone’s home country finding out about it. In 2013, Cayman signed an intergovernmental agreement (“IGA”) with the United States to comply with the foreign account tax compliance act (“FATCA”). Cayman was also an early adopter of the Organisation for Economic Co-operation and Development’s (“OECD”) Common Reporting Standard (“CRS”). The CRS is commonly referred to as “global FATCA” and functions similarly to FATCA in that they are both automatic exchange of information agreements. Cayman’s Tax Information Authority annually shares beneficial owner information with the U.S. under FATCA, and it shares beneficial owner information under CRS among the more than 100 participating countries. In spite of the headlines that too often paint Cayman in negative light, it has demonstrated commitment to global transparency by being a leader in adopting and implementing these two information sharing initiatives.  

US Tax Reform – Initial Reaction 

The most recent newsworthy event that caused some ripples through the Cayman financial services community was the passing of H.R. 1, more commonly referred to as “U.S. tax reform in December, 2017. The initial frenzy in late December and early January, 2018 was a sense of urgency among industry professionals and service providers to read and digest the new legislation and understand how it would affect structures currently in place. Consideration had to be given to how these broad changes could impact clients individually, as well as the jurisdiction as a whole. Anyone who followed the legislation timeline as it went from an unofficial framework in late September, 2017 to a House bill on November 2nd, to a fully enacted law on December 22, 2017 knows what a whirlwind the process was. Articles, markups, reconciliations, industry reactions, opinions, and more were released on what seemed like an hourly basis. It was like buying cutting edge electronics. By the time one figured out how to use the latest and greatest version they ordered online, it was outdated and replaced by a newer model.     

Now that the initial tide of meetings and discussions among industry professionals has ebbed, the general consensus is that U.S. tax reform is not expected to have a significant negative impact on the Cayman Islands captive insurance industry. That’s not to say there will be no impact to the insurance companies or the owners, but the impact should not affect the overall suitability of Cayman as a domicile for managing business risks.

US Tax Reform – Effect on Cayman captives

The Insurance Managers Association of Cayman (“IMAC”) recently conducted an informal survey among members to try and gauge how U.S. tax reform may impact subsets of captive insurance companies domiciled in Cayman. The results came out largely as expected to members of the Cayman captive community, but may be surprising to any newcomers who may be less experienced in dealing with U.S. tax filings for Cayman captives 

Of the captives surveyed, nearly 70% of respondents will see no change to their filing requirements for 2018 versus 2017. This 70% of surveyed companies is comprised of three types of captives: 1) not-for-profit single shareholder “NFP pure” captives2) group captives, and 3) captives that have made an election under Section 953(d) of the Internal Revenue Code (“IRC”) to be taxed as U.S. corporation. The primary reason such a substantial number of Cayman captives will see no filing requirement changes is one that surely has never headlined a show on CNN or Fox News. The truth of the matter is many Cayman captive insurance companies, or their beneficial owners, pay tax currently on taxable profits generated each year regardless of whether the beneficial owners receive any cash distributions.  

The first two types (NFP pure captives and group captives) are typically controlled foreign corporations (“CFCs”) for U.S. tax purposes. The entity itself does not file an income tax return or pay tax. The beneficial owners file Form 5471 with their income tax return and pick up any income allocated to them under the Subpart F rules of the IRC. U.S. tax reform contained some changes to the CFC filing requirements that made them stricter for certain structures. However, all U.S. shareholders of these types of Cayman captives were generally already filing Form 5471. Additionally, there were no changes to the Subpart F anti-deferral rules, so the beneficial owners will continue to receive their Form 5471 and pick up their allocable share of Subpart F income as they have grown accustomed to for as long as they’ve owned these captives. 

It’s worth noting here that Cayman captives were similarly not impacted by the mandatory repatriation provisions that dominated many headlines on various news outlets. Those provisions were enacted to put all U.S. corporations on an even playing field with respect to any deferred foreign income, or untaxed offshore earnings. Since the earnings of most Cayman captives are taxed when earned, Cayman captives and their beneficial owners generally have no untaxed offshore profits subject to mandatory inclusion.  

Even though U.S. tax reform did not bring about substantial filing requirement changes for the group captives and IRC Section 953(d) captives, these entities will see some changes to how taxable income is calculated beginning in 2018. The main change relates to the loss reserve discounting rules that dictate the amount of the tax deduction allowable to an insurance company as it establishes its liability for unpaid losses on its balance sheet. The ultimate effect of this change is that the deduction for unpaid losses will slow down relative to rules in place for 2017. The loss reserve discounting rule change has a transition period of eight years, the first being the tax year beginning after 2017. This new rule, and a few others that are less significant but still applicable to the calculation of taxable income for property and casualty insurance companies, affects Cayman captives the same way it affects commercial insurance companies and captives domiciled in the U.S.  

U.S. tax reform actually brought a couple of doses of good news to captives that have made the IRC Section 953(d) election. The most significant of them being a decrease in the top marginal tax rate from 35% to 21%. This was obviously the hallmark portion of the new legislation and is applicable to all U.S. tax paying corporations. While the new reduced tax rate will require a revaluation of any deferred tax items on the financial statements as of the enactment date, the overall reaction to a much lower corporate tax rate has been a positive one. Additionally, corporate AMT was repealed. Any IRC Section 953(d) companies with AMT credit carry forwards will either use them or eventually claim a refund from the Internal Revenue Service (“IRS”).  Furthermore, the new law preserved the present law for net operating losses of property and casualty insurance companies. The net operating losses can still be carried back two years or carried forward up to twenty years, and there is no limitation on how much taxable income can be offset by a net operating loss carryforward. Alternatively, beginning in 2018 other U.S. corporations cannot carry net operating losses back to claim refunds of prior tax liabilities. Any tax losses can only be carried forward to offset future taxable income. Additionally, other U.S. corporations will have an 80% limitation on how much taxable income can be offset by a net operating loss carryforward.  

Cayman is not only home to the three types of aforementioned captives (NFP pure, group, and IRC Section 953(d) electors). Many large multi-national corporations utilize Cayman captives to manage business risks. Approximately 18% of the captives surveyed were this type of pure captive that have not made the IRC Section 953(d) election. These pure captives differ from the NFP pure captives, and were intentionally separated in the IMAC survey results, because the parent entity is a for profit corporation. Since the for profit parent entity or other related parties are making tax deductible payments to the Cayman captive, the parties making the payment are in play to be subject to the Base Erosion and Anti-Abuse Tax, which was introduced by U.S. tax reform. The “BEAT”, as acronym-spouting tax professionals prefer to call it, functions as a minimum tax with the goal of trying to curtail large tax deductions for payments made by U.S. corporations to foreign related parties. The BEAT applies to domestic corporations that are part of a group that meets the following thresholds: 1) at least $500 million of annual domestic gross receipts and 2) deductible payments made to foreign affiliates (“base erosion payments”) that equal over 3% of total deductible payments for the tax year. Related party cross-border reinsurance payments are explicitly included in the definition of base erosion payments. The ownership threshold to be considered a related party for the BEAT to apply is generally 25%.  

The owners of most Cayman captives will not be affected by the BEATEven though NFP pure captives are commonly owned by U.S. healthcare systems with well over $500 million of gross receipts, these transactions are typically not treated as “insurance” transactions for U.S. tax purposes. Therefore, the premium payments from the parent company to the Cayman captive are not deductible tax payments, and do not qualify as base erosion payments to meet threshold item 2) above. Owners of group captives will avoid BEAT implications primarily because of the relatively high ownership threshold. Group captive members typically own less than 5% of the Cayman captive’s stock. With such a small ownership percentage, the gross receipts and base erosion payment thresholds do not come into play. Further, if an affiliate of a Cayman insurance company finds it may be negatively affected by the BEAT, it could look into the possibility of making the IRC Section 953(d) election for its affiliated Cayman captive. The IRC Section 953(d) election removes the BEAT implications because the deductible insurance premium payment is now being made to a taxable U.S. company rather than a foreign affiliate. 

The change introduced by U.S. tax reform that generated the most discussion, particularly when considering the relatively small number of captives it affects, was the modification of the insurance exception to the Passive Foreign Investment Company (“PFIC”) rules. A complete discussion of PFIC rules is far beyond the scope of this overview. Suffice to say that the PFIC rules are anti-deferral rules contained in the IRC. The purpose is to make U.S. persons who invest in them recognize income and pay taxes under the same timing as if those persons had invested in a U.S. domiciled corporation. Shareholders of foreign corporations engaged in an active trade or business are not subject to these anti-deferral, and often punitive, rules. Pre-U.S. tax reform, investment income derived from passive assets held for the active conduct of an insurance business did not cause the foreign insurance company to be a PFIC to U.S. shareholders. U.S. tax reform amended this exception so that it is now only available to a foreign insurance company with insurance liabilities that constitute more than 25% of its total assets. Insurance liabilities for this test include loss reserves and loss adjustment expenses, but do not include unearned premium reserves. This provision was enacted because of a perceived abuse where insurance activities were being used to shelter large investments. Congress and the IRS are not convinced that a foreign insurance company with, for example $100 million of invested assets to cover loss reserves of $5 million, should be treated as being engaged in an active insurance business. From their perspective these companies look more like offshore investment entities that call themselves insurance companies to give their shareholders tax deferral on investment gains.  

The insurance exception to the PFIC rules can come into play for Cayman insurance companies that are owned by 11 or more unrelated shareholders and insure all unrelated third party risks such as automobile warranties. Since the vote and value ownership is less than 10% for each shareholder, the company is a non-controlled foreign corporation (“NCFC”) for U.S. tax purposes and its shareholders avoid the Form 5471 filing requirementsThe advantage to qualifying for the insurance exception and avoiding PFIC status to the shareholders is that the income tax liability on the appreciation of the investment is deferred until the foreign corporation pays distributions to the shareholders or the shareholders dispose of their interest in the foreign corporation.  

NCFCs accounted for approximately 5% of the companies polled in the IMAC survey. Likely the reason such a small percentage of the Cayman insurance industry dominated the discussions is that these changes have the potential to cause a more significant shift in the tax treatment of these entities when compared to the relatively minor changes for pure captives and group captives. Some questioned whether this change to the PFIC rules will negatively affect the Cayman business landscape or its attractiveness as a jurisdiction. Before jumping to conclusions, it’s important to know that being classified as a PFIC does not spell the end of the company. It does not negate the ability for the insurance company to continue operating as such. The potential impact is at the shareholder level in the way they report the investment, recognize income, and pay taxIt requires additional analysis and communication so shareholders are aware of the potential pitfalls and additional filing requirements, but as long as the structure still satisfies the core business purpose, the business can continue to thrive. Not all NCFCs will be affected by this change, but companies with an assets to loss reserves ratio that hovers around 4 to 1 will need to pay careful attention to avoid inadvertently becoming a PFIC. Alternatively, if the shareholders want to avoid PFIC status, the company could evaluate the feasibility of making a distribution to bring its assets to loss reserves ratio down closer to 2.5 or 3 to 1. NCFCs that maintain a ratio below 4 to 1 during the year will not be negatively impacted by this provision. Finally, while the NCFCs may be negatively affected by falling under these PFIC rules, a move to another offshore domicile would not magically cure the problem.   

Is Cayman still a feasible and stable jurisdiction? 

Perhaps the most refreshing data from the IMAC survey is that less than 2% of the responses indicated an interest in changing domiciles because of U.S. tax reform. Hospitals, multi-national corporations, small and mid-sized businesses are still confident in Cayman’s stability and future as a captive domicile, even in light of U.S. tax reform. When the aforementioned implications brought about by U.S. tax reform are evaluated closely, one can see that Cayman captives are largely unaffected. Thus, the attractiveness of Cayman as a captive domicile is not mitigated solely because of U.S. tax reform changes from 2017 to 2018. Cayman is still a quality domicile for all the same reasons captives have been forming there for decades – reasonable capital requirements, an available and attentive regulatory body, and a concentration of specialized talent to make sure the captive is run efficiently.   

In an interview published in the January, 2018 issue of “Captive International,” Ruwan Jayasekera, head of the Insurance Supervision Division at the Cayman Islands Monetary Authority (“CIMA”) noted that Cayman’s captive insurance sector showed robust activity in 2017. Cayman licensed a strong number of 33 new captives, even with U.S. tax reform seemingly eminent since President Trump’s inauguration in January, 2017 

Tax efficiency was certainly somewhere on the list of items for consideration for each of those formations. Beneficial owners need to make sure they do not put themselves at a significant disadvantage that would restrict the Cayman captive from meeting their business needs. Tax avoidance, however, is not a realistic goal of a Cayman captive insurance company. Potential captive owners should not underestimate the significant degree of scrutiny to which business plans behind Cayman captive applications are subjected before they reach CIMA’s office for approval. It’s common that tax advisors, auditors, actuaries, legal counsel, fronting carriers, insurance managers, banks, and investment managers all have a chance to provide some type of input on certain sections of a new captive’s business plan. Jayasekera further points out in the interview that CIMA considers whether tax avoidance may be a motivator to the beneficial owners when a new license application is submitted. CIMA takes time to carefully analyze each application to make sure a genuine business purpose is present.  

US Tax Reform – moving forward

Most of the conversation around U.S. tax reform has centered on captives that are already incorporated and have been operating for a numbers of years. The general feedback from these entities has been that they have established practices that work well form them, and the vast majority have decided not to make any changes to how they operate from a U.S. tax perspective. Board members have cited a couple of reasons for this. One is that the current structure is the most tax efficient both under pre-2018 tax rules and post U.S. tax reform. Others have modeled the tax effects of income projections and see a potential tax savings if they make an IRC section 953(d) election, assuming the projections hold true. However, before making any hasty decisions, they are weighing the pros and cons of making the election to determine if the effort and cost would be worth the potential tax savings. In cases where the potential tax savings are nominal, most captives are opting against making the irrevocable IRC Section 953(d) election for the sole reason of saving a few dollars of tax. Since the 953(d) election is permanent, there are several other factors besides anticipated future tax liabilities that should be analyzed before making the final determination regarding whether it is the best solution for the future of the captive, its beneficial owners, and its insured parties. The stability of the U.S. political climate, or lack thereof, has been raised as a concern by both mature captives and those in the formation phase. There is some skepticism that the corporate rate will stay at its 2018 level for the foreseeable future, particularly with influential elections looming in November, 2018. This has further amplified the apprehensiveness to make an irrevocable tax election. 

Some discussion should be directed toward captives that were in the various stages of formation but delayed the final push until there was more certainty in the U.S. political environment and clarity about whether U.S. tax reform would actually materialize and how those potentially sweeping changes would affect a Cayman captive insurance company. A captive that has been in the formation stages for a long period of time, at least since early to mid-2017, should re-consider how it wants to proceed from a U.S. tax standpoint. Does it want to make an IRC Section 953(d) election to be taxed as a U.S. corporation, or do its members prefer to treat the captive as a CFC? New captives are advised to seek the advice of a tax expert to assist in making these decisions. It’s very possible that the final decision will not change solely because of U.S. tax reform. However, the sharp reduction of the U.S. corporate tax rate will definitely change the economics of the structure. The assumptions and inputs entered into the original feasibility study should be updated and re-analyzed to confirm any conclusions previously drawn, because the ultimate choice can have numerous implications on the parties involved. 

One of the major attractions of domiciling a captive insurance company in Cayman is the concentrated wealth of knowledge this tiny island has to offer. Legend has it that a coconut never falls from a tree without hitting someone from the financial services industry. There are thousands of professionals from tax accountants, auditors, actuaries, captive managers, investment managers, attorneys, advisory professionals, etc. who are knowledgeable in various facets of financial services and able to assist in their capacity as specialists. If someone physically in Cayman cannot assist, the wider global network of these professionals is also just a phone call or email away. This is particularly important in years when tremendous changes occur. In 2016 it was IRS Notice 2016-66, aimed at IRC Section 831(b) micro captives. In 2017 it was U.S. tax reform. In both instances there were many questions that needed to be answered, and Cayman was armed with professionals who could make sense of it all and find solutions for their clients.  

Contrary to popular belief, the professionals in Cayman have built their careers in one way or another on helping clients maintain compliance, not avoid it. The ability to hire and trust Cayman professionals to ensure their Cayman companies are staying compliant with various legal, regulatory, and tax matters is what allows beneficial owners of those Cayman companies to thrive in their own chosen fields of expertise. It is a flawed argument to suggest that Cayman exists solely to help beneficial owners dodge tax and regulatory requirements. Successful business owners know the best way to achieve growth is to provide a quality product to customers. Negative reviews proliferate among potential customers faster than positive ones, which makes it difficult to maintain a successful business over the long term.  

The “Captive International” interview with Ruwan Jayasekera goes on to point out that Cayman has been the leading jurisdiction for healthcare captives for a number of years, with more than half of its registered captives hailing from the healthcare sector. Mr. Jayasekera acknowledges this is a core competency of the Cayman captive industry. “The expertise is hard to match,” he says. “Every time healthcare is mentioned Cayman comes to mind.” Even though it would be easy for his team at CIMA to hang their hat on this distinction and rely on it to attract future formations, they realize Cayman needs to strive for continuous improvement to stay at the forefront of an ever-evolving market. They are making a concerted effort to assess what improvements, such as making the licensing process more efficient or tweaking certain pieces of legislation, will go farthest in making Cayman an even more desirable jurisdiction.   

Cayman has a history of over 40 years in the captive insurance industry and IMAC recently hosted the 25th annual Cayman Captive Forum, which was the largest on recordThe strength with which Cayman closed out the 2017 year, combined with the results of the IMAC survey conducted in 2018 and CIMA’s concerted efforts to seek continuous improvement, do not indicate its momentum will slow down in 2018 as the various aspects of U.S. tax reform begin to take effect. 

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