Non-Profit & Tax Exempt Entities
Tax and Regulatory Issues
Cayman Captive Forum 2013 – Pre-Forum Tutorial
The Ritz Carlton
Grand Cayman, Cayman Islands
December 3, 2013
Tom Jones, Partner
McDermott Will & Emery LLP
www.mwe.com
Rick Irvine, Partner
PwC Bermuda
www.pwc.com/ky
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Contact Information
Tom Jones
Rick Irvine
McDermott Will & Emery LLP
PricewaterhouseCoopers
227 West Monroe Street
Dorchester House
Chicago, IL 60606-5096
7 Church Street
Tel: (312) 984-7536
Hamilton, Bermuda
E-mail: tjones@mwe.com
Tel: (441) 299-7136
Email: richard.e.irvine@bm.pwc.com
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Circular 230 Disclosure
This document was not intended or written to
be used, and it cannot be used, for the
purpose of avoiding U.S. federal, state or
local tax penalties.
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Choosing the Right Form
FACTORS:
– Tax Status of Parent/Founder(s)
– Number and Tax Status of Potential Insureds
– Related or Unrelated Status of Potential Insureds
– Homogenous/Divergent Nature of Insureds Activities
– Earnings Retention Objectives
– Extent of Experience Rating Desired
– Flexibility Desired
– Typical Policyholder Retention Pattern
– Desire to Minimize Operational Costs
– Goal to Entrench Founders/Promoters
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Captive Legal/Regulatory Issues
 State insurance laws and regulations
 Federal and state tax considerations
 Securities registration exemption/antifraud disclosure (applicable
to group captives)
 Other legal considerations (e.g., Medicare fraud and abuse)
 Management/governance (directors and committees)
 Coverage and policy questions
 Choice of form (stock/mutual/reciprocal) (onshore vs. offshore)
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Taxation of Non-Profit Owned Captives
The key tax question:
Is it treated as insurance?
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Tax Definition of “Insurance”
 No clear-cut definition in tax law
 Must analyze case law and IRS rulings
 Captive with tax exempt parent prefers to avoid
“insurance company” tax status for itself and for its
parent
 But unrelated voluntary physicians seek premium
deductibility
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Basic Requirements
For insurance treatment, the U.S. Supreme Court held both
risk shifting and risk distribution must be present:
Risk shifting must be to a separate legal entity
Risk distribution connotes enough independent risks
pooled to invoke the “actuarial law of large numbers”
Insurance risk must be present versus “investment” risk
Common Notions of Insurance must be present
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Onshore Hospital Captives – Tax Status
 If captive funds risk of only its tax exempt parent and employees,
then domestic captive can obtain an IRS “determination letter”
granting tax exempt status
 Easier to obtain if captive formed as a non-profit membership
company with no shares issued (VT, HI, DC permit this form)
 Must file IRS Form 1023 with a description of intended activities
– cannot cover non-employed physicians or third parties if
“substantial” portion of business (5%-10%)
 Thus limited scope of captive activities if onshore – covering
>10% ineligible parties can cause all income of the domestic
captive to become fully taxable
 If not “tax exempt” then captive may be subject to corporate level
tax on investment, unrelated voluntary physicians premiums and
other sources of income
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Offshore Hospital Captives - Tax Issues
 No corporate income taxes in the Cayman Islands
 Offshore captives are not tax-exempt – so they can accommodate
addition of non-employed physicians, but there may be tax
ramifications
– Federal excise tax (FET) on premiums (inbound or outbound)
– Unrelated business taxable income to captive’s U.S. shareholder –
on net income from covering “voluntary attending physicians” or
non-controlled entities
 But unlike onshore captives, covering third parties may generate some
tax but it does not taint the entire captive – this is the principal reason
most captives owned by tax exempt hospitals are domiciled offshore
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Advantages of Non-Insurance Status for Tax
Exempt Owner of Offshore Captive
 Inbound premiums paid generally not subject to a federal excise tax (4% of
the premium for direct insurance and 1% for reinsurance or life insurance)
– Except for premiums from unrelated voluntary physicians
 Can avoid attribution of any “unrelated business taxable income” to captive’s
tax-exempt parent
– Except for insurance income from unrelated voluntary physicians
 State premium tax - known as (i) “direct placement” tax or (ii) “selfprocurement” tax or (iii)) “independently procured insurance” tax would apply
(about 30 states impose this type of tax) with 3% rate typical
 Note domestic captives must pay low rate of premium tax (< .5%) in most
states + DC (but not AZ or UT); no premiums tax in offshore domiciles like the
Cayman Islands.
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Avoiding a U.S. Trade or Business
 Foreign insurance companies operating offshore generally not subject to
direct U.S. taxation
– Indirect U.S. taxation can occur if captive owned by U.S. shareholders
(e.g., Subpart F, PFIC rules)
 However, a foreign insurer may be subject to direct U.S. tax if it is considered
to be engaged in a U.S. business (or has a U.S. “permanent establishment”
where a tax treaty is involved)
– Net income taxed at 35% (determined under U.S. income tax rules)
– Additional 30% branch profits tax on amount withdrawn from U.S.
– Total tax rate as much as 54.5%!
 Or makes an election under IRC §§953(d) or 953(c)(3)(C)
 Also potential state insurance regulatory problems if captive is conducting an
unauthorized business of insurance onshore
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Avoiding a U.S. Trade or Business
 To avoid being engaged in a U.S. trade or business, foreign insurer
should:
– Hold board meetings outside U.S.
– Execute contracts (including issuance of policies, investment
management agreements) outside U.S.
– Approve asset allocation policy outside U.S.
– Use only independent agents in the U.S.
– Avoid having risk management employees as officers or board
members of foreign insurer; he/she should present claims report,
etc. in capacity of consultant to the board
– Issue indemnity rather than “pay on behalf of” policies
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Offshore Captive Investments
 A 30% non-recoverable federal “withholding” tax is imposed on certain U.S.
investments:
– All dividends paid on equities (common and preferred shares, ETFs) of U.S. issuers
(except American Depository Receipts)
 No 30% tax on:
– bond portfolios comprised of individual bonds that meet the portfolio interest
exception
– Tax exempt bonds and U.S. government bonds, notes
– “Clone” bond funds formed in Ireland (UCITS) or Luxembourg (SICAVs) avoid this
tax under applicable U.S. tax treaties (but generally higher fees and commissions)
– U.S. source capital gains (long term or short term)
 Certain income of U.S. regulated investment companies, e.g., “RIC’s” or “mutual funds”
(exception is due to expire unless re-enacted by Congress on 1/1/14)
 Avoid investments taking the form in the U.S. as trusts or partnerships which may
“throw off” Effectively Connected Income or ECI
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1996 Federal Income Tax Legislation Applicable to
Offshore Captives Owned by Tax Exempt Organizations
 Insurance income (e.g., underwriting and investment) generally creates
“unrelated business taxable income” to tax exempt owners but does not
cause the entire captive to become fully taxable as with domestic captives
 IRC §512(b)(17) imposes a “look through” rule invoking IRC §501(m)
“commercial type insurance” UBTI on Subpart F allocation of “insurance
income” (includes both underwriting and investment income)
 Special exemption for offshore group captives formed by exempt hospitals,
colleges and universities exclusively using policyholder (not shareholder)
dividends
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1996 Federal Income Tax Legislation Applicable to
Offshore Captives Owned by Tax Exempt Organizations
 Certain tax exempt affiliates are considered within the economic family if
“significant common purposes and substantial common ownership” exist
 In general, captive’s coverage of “hospital based” physicians (e.g., ED,
pathology, radiology, etc.) groups under exclusive contract with hospital
do not create UBTI
 Note: IRC §512(b)(17) is inapplicable if no “insurance” is present (e.g.,
most single parent captives are unaffected)
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U.S. Tax Compliance – Offshore Captives
 The captive’s U.S. shareholder(s) ma file annually the following forms:
– IRS Form 5471: Typical single parent hospital shows captive as an
investment rather than an insurance company
– IRS Form 926: report all transfers to captive as capital contributions
 Other potential forms for company and/or U.S. shareholders:
– Treasury Form TD F 90-22.1
– IRS Form 1120-F (Protective Filing)
– IRS Form 720 (Federal Excise Tax or FET)
– Potential FATCA Foreign Financial Institution agreement and required
withholding and informational reporting
– Form 8938 Foreign Financial Assets (U.S. individuals only)
– Form 8621 Passive Foreign Investment Company
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U.S. Tax Compliance (Continued)
 Treasury Form TD F 90-22.1: all U.S. persons must disclose a financial
interest in or signatory authority over foreign bank or other financial
accounts if balance > $10,000 at any time:
– Includes captive’s parent plus any U.S. citizens or residents
– Always on calendar year basis
– No extensions given
– Due June 30 – must be e-filed starting 6/30/14
– Applies to offshore bank “operating” accounts and foreign mutual fund
investments (which are available to the general public and have a
regular net asset value)
– Foreign hedge funds and private equity funds are currently not
included as a financial account
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U.S. Tax Compliance (Continued)
 Making a Protective IRS Form 1120-F Filing:
– A foreign corporation that is engaged in a U.S. trade or business is
subject to U.S. tax on its net income, not its gross income, but
ONLY if it files a U.S. return in that year
– If a foreign corporation is found to be engaged in a trade or
business on audit and has not filed a U.S. return for the year in
question, it will generally be taxed in the U.S. on its gross income
(i.e., no deductions or credits allowed)
– A foreign corporation can make a “protective” filing in any year
even if it does not believe it has a U.S. trade or business by filing a
Form 1120-F and indicating that the form is being filed for
protective purposes
– No need to show numbers; just name, address & FEIN
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U.S. Tax Compliance (Continued)
 IRS Form 720 Federal Excise Tax Filing:
– Quarterly filing to report excise tax on insurance/reinsurance
premiums
– Reinsurance premiums ceded by captive is subject to FET
– Timely deposit of FET is required
– Potential IRS Form 8833 treaty-based return position disclosure
required for United States risk insured/resinsured with a counter party
resident in a treaty country which has entered into a closing
agreement with the IRS (obtain copy of the closing agreement for
records) to exempt FET
– Non-insurance company offshore captives incur 4% FET on
“reinsurance” purchased from non-treaty protected reinsurers (e.g.,
Bermuda, Cayman and Barbados)
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U.S. Tax Compliance (Continued)
 The captive’s U.S. officer’s and directors must file the following forms:
– IRS Form 5471
– If a “U.S. Shareholder obtains 10% or an additional 10% interest in
a foreign corporation
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Foreign Account Compliance Tax Act
(FATCA)
– Enacted by Congress in 2010 to detect & prevent offshore tax evasion
enforced via a new federal withholding tax; now effective 7/1/14
– 30% tax on payments from U.S. unless Cayman hospital captive, a
“Non-Financial Foreign Entity” (NFFE), supplies IRS Form W-8BEN-E
to U.S. payers
– Cayman hospital captive (holding an insurance license) will be a
NFFE, not a “Foreign Financial Institution” (FFI) which under more
onerous rules must register with & file reports to IRS to avoid 30% tax
– Next step: setting up a plan so hospital captive timely provides Form
W-8BEN-E to U.S. payers for 2014 money transfers
– Note Cayman announced it will sign an Intergovernmental Agreement
(IGA) with the IRS so FFIs can report to Cayman Government which
will share data with IRS – but N/A to NFFEs like hospital captives
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Summary of Offshore Single U.S.
Tax Exempt Owner Captive Status
 Assumes only institutional & employee risks are being funded
Not an “insurance company” for tax purposes
– No federal excise tax imposed on premiums ceded to captive
– No “unrelated business taxable income” to sole S/H
– “Premiums” are not deductible for taxable affiliates
No violation of state insurance law
– No captive activity in state where risks are located
– Self-funding, not true insurance
– Policyholders representing most of the premium also could qualify as
“industrial insureds” in 22 states with favorable statutes
Foregoing not changed with coverage of employees or controlled affiliates
But major changes if non-employed physician practices are covered in the
future
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U.S. Healthcare Law Reform –
Impact on Captives
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The Underlying Law
• March 23, 2010: Patient Protection and Affordable Care Act
(a/k/a “PPACA” or the “ACA” or “Obama-care”) enacted
 Law includes a number of provisions designed to:
• Improve the quality of Medicare services
• Support innovation
• Establish new payment models
• Better align Medicare payments with provider costs
• Strengthen Medicare’s financial footing
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Every Picture Tells A Story
 A Graphic Explanation of Health Care Reform … What we
had to what we now have …….
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www.mwe.com
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The Goal
 All sides agreed on reform objectives
– Delivery system reform (e.g., Accountable Care Organizations
(ACOs))
– Wellness and prevention (e.g., Medical Homes)
– Need for cost containment (e.g., Bundled Payments)
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Hospitals’ Rush to Hire Physicians:
The Future Model
 All across the country hospital systems are employing physicians at
an unprecedented rate. Impacts to be considered include:
– Financing of tail coverage
– Increased loss exposure in hospital captives
– Need for increased attention to underwriting by captives
– Claim management demands
– Adjustments to actuarial models
– Excess market attachment points
– Reduced commercial market share as physicians leave private practice
– Increased focus on ART programs as hospital-owned captives grow in
numbers and size
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% of Physician Practices Owned by
Hospitals/Health Systems
• 2005: 25%
• 2008: 50%
• 2015: ?????????
•
Source: Medical Group Management Association
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The Existing Structure
Medical Staff
Community
Physicians
Employed
Physicians
Hospital
Insurance Source:
Insurance Source:
Commercial, RRGs
Hospital-Owned
Captive
Reinsurance
Market
Reinsurance
Market
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The New Structure
Hospital
System
Hospital
Captive
ACO
Physicians
Future Alignment Strategies
- Physician employment (including foundation models)
- Leasing arrangements with physician groups
Reinsurance
Market
- Inclusion of unrelated assisted living, rehabilitation, home
healthcare, etc. facilities
- Management ventures: cardiac care, women’s health,
cancer care, etc.
- A possible combination of some or all of the above
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Private Physicians in a Hospital Captive:
The Current and Past Model
 Historically, professional liability insurance presented an opportunity to
align hospital and physician interests in quality improvement, patient
safety and risk management through a joint risk funding vehicle
 The risk funding vehicle most commonly used is a hospital-owned
“captive” insurance company
 Inclusion of voluntary physicians (i.e., non-employed physicians) in the
hospital’s risk funding vehicle, such as a captive, requires navigation
through a number of obstacles, including insurance regulatory, tax and
health care fraud and abuse laws
 These issues do not apply to hospital employed physicians
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Why Cover Non-Employed Physicians
in the Hospital’s Captive?
 They are largely the hospital’s risk already – vicarious liability and other
theories of “deep pocket” liability
 Hospitals can improve quality and enhance the hospital’s own risk
management program by aligning hospital and physician interests
 Physicians sometimes ask for help
– High malpractice premiums in many states, including crises in NY and NJ
– Carriers leaving the market or suffering ratings downgrades
– High cost of “tail” (extended reporting period) coverage if physician moves
– MICRA in effect in California since 1975 on the ballot next year
 In the past, physicians retired or relocated rather than paying escalating
commercial premiums
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Overview of Concerns Applicable to Covering
Non-Employed Physicians
 State insurance regulatory issues
 Health care regulatory issues
– Financial relationships between hospitals and physicians trigger legal
concerns that are unique to the health care arena
– Any element of a physician program that can be characterized as
subsidizing physicians or providing non-commercially reasonable
terms triggers Medicare fraud and abuse issues and, for tax exempt
hospitals, private inurement/tax exemption concerns
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Covering Independent Physicians –
Insurance/Regulatory Issues
 Coverage of only a hospital, its employees and controlled affiliates
generally is not considered to be the “business of insurance” and does
not trigger state insurance regulation
 Extending coverage to “voluntary attending physicians” (i.e., nonemployed physicians) rather than only a hospital and controlled affiliates
generally will be considered the “business of insurance,” triggering
insurance regulation issues
 Addressing these issues primarily depends on the law of the state where
risks being pre-funded are located
 Often the only “safe” solution is to engage a fully licensed “fronting”
carrier (e.g., CNA or Lexington) to write the physician coverage and
reinsure it with the captive (requires providing collateral to the “front”)
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Sources of Health Care Fraud and
Abuse Legal Guidance
 The law: Two key federal fraud and abuse laws affect hospital financial
relationships with physicians:
– Anti-Kickback Law
– Stark Law
 The analysis to determine whether an arrangement is permitted for fraud
and abuse purposes generally is parallel to the “private inurement”
analysis for tax-exemption purposes
 Key is to avoid any tax exempt hospital subsidy of private physician
premiums
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Establishing Absence of Subsidy
 Premiums must be actuarially determined
 Actuarially determined premiums may be less than commercial
premiums, for reasons such as:
– Joint defense
– Participation in enhanced risk management
– Other differences between captive and commercial premium
calculation
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PPACA Impact on Offshore Captives
• Because more physicians are becoming hospital employees to support integrated
clinical services and financial incentives
– Legal reason for a captive may disappear since an onshore trust legally can
fund the institutional & employed physician liability risks
– But strong counter-arguments for keeping captive include access to reinsurers
& focus on patient safety due to captive’s enhanced RM
• Offshore captives could especially benefit from ACO risk funding (which involves
covering unrelated partners, JVs, etc.)
– Onshore captives can write only 5-10% unrelated risk without being fully taxed
– But offshore captives can write up to 50% unrelated risk with only minor taxes
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Future Speculative Contingencies
– Providers get fixed fee for an indeterminate amount of care
– Places providers in a position of incurring “patient utilization” risk
– Perhaps some of the “downside” exposure of providers can be pre-funded in a
captive
www.mwe.com
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Developments in the Cayman Islands
for Captives
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Why Cayman?
Proven Track Record – Harvard Medical Started in ’78
– Flexible but responsible regulatory regime
– Healthcare focus (almost half its captives)
– Strong medical malpractice infrastructure/orientation
– Major federal tax advantages offshore for U.S. tax
exempts
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The Cayman Regulatory Environment
Judicious discretion with limited statutory rules
– Cayman’s Insurance Act provides the basic framework
– The Cayman Monetary Authority sets financial parameters using a
holistic approach and “rules of thumb” rather than rigid rules
– The captive’s filed business plan, as amended from time to time,
establishes its responsibilities and undertakings
– By statute the local insurance managers play a contingent but
important regulatory role
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Directors’ Duties Under Cayman Law
 Duty of skill, care and diligence
 Oversight role - duty to adequately supervise competent service
providers
 Fiduciary duties - directors must act in the best interests of the captive
and must disclose to other directors any material conflict of interest
 Director indemnification - except for dishonesty, willful default or gross
negligence
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New Cayman Insurance Law
 Enacted in 2010, effective 11/1/12
 Motivators: IMF compliance and Hurricane Ivan domestic
property insurance aftermath
Key elements:
 Greater oversight of Class A license holders (writers of Cayman risks)
 Splits Class B into three categories –
– B-1: 95% or more related party risk
– B-2: > 50% related party risk
– B-3: < 50% related party risk
 New Class C for SPVs (Special Purpose Vehicles) like “cat” bonds,
insurance linked securities and other “transformers”
 New Class D for commercial reinsurers
 Expands non-compliance penalties & whistle blowing provisions
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New Cayman Insurance Law
Impact on health care captives:
 Should have little or no effect on most single hospital parent captives
 Main reason is favorable definition of “related party” risk
– Measured by the captive’s net written premium (retained/not
reinsured)
– Includes not just parties under common ownership or legal control
of the hospital, but also parties participating in the hospital’s
common risk management plan
– Thus, most “joint” professional liability insurance programs that
include independent (voluntary attending) physicians or joint
ventures should remain in the Class B-1 category of license holder
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General Background on Cell Captives
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Overview
 Generic term – “cell” company
 Developed from inherent weakness in attempted segregation in
traditional contractual rent-a-captives
 Cells are comprised of separately identified and legally segregated
assets and liabilities within a single company statutorily “firewalled”
from each other
 Guernsey was the first in 1997; others quickly followed; upwards of 50
jurisdictions today including a number of US states
 Cayman law enacted in 1998
 Cayman: a cell is called a “segregated portfolio” and the entity is
called a “segregated portfolio company“
 Cayman – 30 September 2013: 137 Segregated Portfolio Companies
with 589 cells out of 755 captives
 September 13, 2010 IRS issues Proposed Regulations which would
treat foreign “cells” engaged in an insurance business as separate
entities for U.S. tax purposes
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Varied Uses of Cell Captives
What types of captive programs are in cells?
 Hospital/clinics/independent physicians
 Combining 2 captives into 1 post-merger
 Collaborative efforts by unrelated healthcare providers
 Pure/single parent risks (conglomerates) - Separation
– By product line
– By geographic area
 Group and/or association shared risks
 Transformers, funds & financial guaranty companies
 Agency risk participation
 Composite insurers – separating life & non-life lines
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General Background on Incorporated
Cell Captives
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Latest Development – ICC’s
ICC = Incorporated Cell Company
Originated in Jersey (Not New Jersey)
Legislation enacted in Cayman
Bermuda considering
By statute, each cell is a distinct legal entity and can have
its own governing body (cell walls “higher and thicker”)
Addresses cell participants’ demand for intra-cell contracts
and diverse governance input
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Latest Development – ICC’s (Cont’d)
ICC tax status is clearer than PCCs – each cell is a
separate entity for U.S. tax purposes
Insolvency law status also is clearer – each cell is a
separate juridical person
Usual rules to apply creditor hierarchy but only within
the incorporated cell entity
Must apply “piercing the corporate veil” case law to cut
through an IC wall
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Enabling ICCs: Next Logical Step for Cayman
 “Regular” segregated cell is not a separate legal entity
 This creates drawbacks
– Intra-cell contracting not possible in Cayman
– Uncertain federal tax status of unincorporated cells
– Restricted to a single board at the core level
 Enter the “portfolio insurance company” (“PIC”)
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Recently Enacted Cayman PIC Law
 Wording of PIC enabling law (passed 3/25/13) is user
friendly
 Insurance specific – part of the Insurance Law
 An SPC’s board can choose to incorporate one or more of
its cells by the cell’s establishing a wholly owned
subsidiary PIC
 The PIC is an “exempted” company beneath a cell which,
generally, “replaces” the cell
 Thus, the legal relationship between the core and its cells
is that of a parent/subsidiary
 PIC board chosen by core board but can be comprised of
different persons
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Questions
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