Many businesses establish insurance companies to primarily insure some of the business risks of the parent company or its operating subsidiaries. These insurance companies are commonly referred to as captive insurance companies since their insurance activities are focused upon, or “captive” to the insurance needs of the parent business or its operating subsidiaries.There are some unique tax items that should be considered with foreign captive insurance companies. Internal Revenue Code section 4371 imposes a federal excise tax (the “FET”) on premiums paid by a U.S. person (or a non-U.S. person engaged in a U.S. trade or business) for insurance policies, indemnity bonds, annuity contracts, and reinsurance contracts with respect to risks located in the United States. The FET rate is four percent on casualty insurance and indemnity bonds; one percent on life, health, and annuity contracts; and one percent on reinsurance.
The Internal Revenue Service has taken the position that section 4371 applies the FET to each policy of insurance or reinsurance covering U.S. risks and that the FET can be applicable to multiple transactions in which the same underlying U.S. risks are insured and reinsured. This is known as the cascading theory. Under the cascading theory, if a foreign insurance company insures or reinsures a U.S. risk that would be subject to the FET, and then obtains reinsurance for that risk from a second foreign insurance company, the FET applies to the reinsurance contract between the two foreign parties, unless a treaty exemption applies. Several income tax treaties provide an exemption from the FET for eligible foreign insurers and reinsurers. However, these exemptions generally do not apply if the foreign insurer or reinsurer, in turn, reinsures the risk with another foreign reinsurer that is not eligible for an exemption from the FET under an applicable treaty.
In recent years, the IRS has significantly increased its audit activity with respect to foreign captive insurance companies and the accurate reporting of the FET. Accordingly, it is important to review FET compliance for any internationally domiciled captive insurance company. Certain penalty mitigation procedures and favorable interest rules may be available for taxpayer’s liable for previously unreported FET if the taxpayer reaches out to the IRS before it reaches out to the taxpayer.