State and international tax aspects of "captives".

• Author: McGrath, Jr., Clinton N.

Besides addressing significant U.S. tax issues when forming and operating a captive insurance company (captive), significant state and international tax issues must also be discussed. (For background on the key U.S. tax aspects of captives, see McGrath, Tax Clinic, "Using Captives to Manage Risk," TTA, July 2004, p. 419.)

State Tax Aspects

Nexus: For a state to have taxing authority over a captive, the latter must have sufficient nexus with the state such that taxation does not violate the U.S. Constitution. This determination depends on the facts and circumstances; see, e.g., State Bd. of Ins. v. Todd Shipyards Corp., 370 US 451 (1962); Dow Chemical Co. v. Carol Keeton Rylander, Comptroller of Pub. Accts. of the State of TX, 38 SW3d 741 (TX Ct. Apps. 2001); and Quill Corp. v. North Dakota, 504 US 298 (1992).

In this context, an unsettled issue involves a state's claim of taxing authority over a captive neither located nor licensed to do business in that state. The question is whether the captive is to be taxed as an insurance company, although not regulated as such in that state, or as an out-of-state corporation. Resolution depends on the state's laws, as well as on an analysis of the company's facts and circumstances.

Premium taxes: Generally, states may subject insurance companies to the following taxes: real and personal property, franchise, income, license and capital-based. However, the most significant (and common) tax imposed by states on insurance companies, often in lieu of all other taxes except real property taxes, are premium taxes.

In general, premium taxes are based on an insurer's gross written premiums, as reflected in its annual statement (net of allowable deductions such as return premiums, reinsurance premiums and policyholder dividends). Although the premium tax rate varies by state, the average rate is slightly less than 2% (e.g., CA-2.35%; HI-4.265%; IL-5%; NE-1%; and NYC (life)-0.8%).

Although captives are insurance companies, they typically are licensed to do business in only one state, because they typically insure very specific risks or insureds. As states generally provide for much lower premium tax rates on captives (typically, 0%-0.4%, such as DE-0.1%-0.7% and VT-0.075%-0.6%) than on ordinary insurance companies, the premium tax burden on captives generally will be relatively insignificant in the state tax context.

Income taxes: Currently, seven states (FL, IL, MS, NE, NH, NY (only life) and OR) presently...