The United States went to war to avoid the red coats' taxes - now corporations are sprinting to the United Kingdom's tax rate.

Author:Pagano, George
 
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  1. INTRODUCTION

    Properly utilized, captive insurance companies greatly help a corporation shield itself from risk; however, many times corporations use them to funnel income out of the United States and out of the jurisdiction of the Internal Revenue Service (IRS). (1) Along with captive insurance companies, offshore tax shelters give U.S. companies the ability to shift taxable income abroad and away from the purview of the IRS. (2) The Foreign Account Tax Compliance Act (FATCA), which Congress enacted in 2010, attempted to stop U.S. citizens and financially significant corporations from hiding money in foreign accounts across the globe. (3) Nevertheless, even with FATCA, the United States is still losing between USD30 billion to USD90 billion per year through offshore tax evasion. (4)

    This Note will investigate offshore tax evasion, the inappropriate use of captive insurance companies as tax shelters, corporate inversion and ways the United States can retain significant tax revenue within its borders. (5) Part II of this Note will focus on the history and creation of captive insurance companies and offshore tax shelters, as well as their use and abuse. (6) Part III of this Note will discuss how these questionable tax practices affect the United States, and how other countries, such as the United Kingdom and Ireland, combat the problem of offshore tax avoidance. (7) Part IV of this Note analyzes three ways the United States can attempt to stem the exodus of tax revenue, and notes the success of other countries in each method. (8) Part V of this Note will conclude with a petition for reform to halt the flow of taxable income to offshore shelters, assisting in the efforts of the United States to remain a global economic powerhouse. (9)

  2. HISTORY

    1. Captive Insurance Companies

      1. Creation of Captives

        Bermuda is a small, sleepy island with beautiful pink sand beaches about 690 miles off the coast of Wilmington, North Carolina. (10) How does a small island with little natural resources, other than a strategic location in the Atlantic Ocean for vacation, become a global financial giant? (11) Bermuda foresaw needs in the insurance market and met the demand for creative risk mitigation options that the U.S. market could not. (12) As a result, Bermuda transformed itself into the offshore financial hub that it is today. (13) The majority of Bermuda's captives are U.S. owned entities, accounting for almost 60% of the island's insurance companies. (14)

        Captive insurance companies are "wholly owned insurance subsidiaries" or insurance companies formed to protect and provide insurance to the parent company that is not in the insurance business. (15) Captives are a form of self-insurance, and once created, they act just like a normal commercial insurer, and "issuing] policies, collecting] premiums and pay[ing] claims," except the captive does not offer insurance to the public. (16) Any corporation can form a captive, but the leading industries with captives include "finance, real estate, construction, and manufacturing," with large growth in the industries of health care and property development in the past several years. (17)

        The origin of captives dates back to the 1500s, where ship owners in London would meet in coffee shops to "retain[], share[] and transfer[] the cost of risk associated with their ships...." (18) Even though the concept of captives has been around for over 500 years, the term "captive" was not coined until the 1950s by Frederic M. Reiss. (19) In 1958, Reiss incorporated American Risk Management to assist corporations in setting up captives insurance companies. (20)

        During this time, U.S. regulations made it extremely expensive to form and operate captives, leading Reiss to look for other jurisdictions where his idea could prosper. (21) Reiss brought captives to Bermuda in 1962, setting up the first modern captive named International Risk Management Ltd. (22) It took time for the captive concept to gain momentum, not gaining popularity until the mid-1980s when a hard commercial insurance market made liability coverage unavailable or unaffordable. (23) As the captive concept grew and prospered, different types of captives germinated, most notably; the single parent or pure captives; group captives; association captive; and rent-a-captive models. (24)

      2. How Captives Function

        At their core, captives are insurance companies; however, since they do not function like normal insurance companies, the government and the IRS have a difficult time classifying them as such. (25) Captives concern the IRS for two related reasons: the ability to view captives as simple accounting mechanisms through the establishment of reserve accounts and not as risk-based insurance products and the uncertain legal definition of insurance. (26) The primary issue in viewing captive insurers as a reserve account is the conceptual overlap between a reserve account and insurance: reserve accounts are non-tax deductible while premiums paid to insurance companies are generally tax deductible, although both do essentially the same job. (27)

        This leads to the second issue, the uncertain legal definition of insurance. (28) In 1943 the Supreme Court of the United States defined insurance as comprising of both risk shifting and risk distribution, but has yet to provide any further expansion on that definition. (29) With unclear guidelines, the IRS has frequently found bona fide captives to be reserve accounts, making premiums paid non-tax deductible. (30)

        All captives must comply with three essential criteria: (1) the existence of an "insurance risk"; (2) both risk shifting and risk distribution; and (3) a valid purpose for "insurance" in its commonly accepted sense. (31) To put the first and third points more simply, captives must function as do normal commercial insurance companies. (32) The second point is more complicated for captives, but is a key factor to benefit from the IRS's special treatment of qualifying captives. (33)

        Risk shifting transfers risk from the insured to the captive, for example when the insured pays the captive a premium to cover an identified risk, the risk transfers to the captive. (34) In risk distribution the insurer spreads risk over a sufficient number of resources, ensuring that the risk is sufficiently diversified to manage the exposure. (35) One way to achieve risk distribution is through the use of reinsurance, also known as a safe harbor, representing one of the largest benefits of captives. (36) Reinsurance is known as the "insurance for insurance companies," allowing companies to spread out risk in diversified portfolios. (37)

      3. Internal Revenue Code [section] 831(b)

        To take advantage of tax benefits under I.R.C. [section] 831(b) U.S. entities are creating smaller captives or "micro-captives." (38) I.R.C. [section] 831(a) explains that a tax will be imposed on the taxable income of any insurance company. (39) I.R.C. [section] 831(b) provides that insurance companies whose total annual premiums are below USD1.2 million will not pay taxes on that income for that year. (40) I.R.C. [section] 831 provides a significant tax benefit for small companies and has spurred a large growth of micro-captives in the past few years. (41) The IRS has identified the potential for abuse within the I.R.C. [section] 831(b) tax benefit and is cracking down on violators. (42)

    2. Off Shore Tax Evasion

      1. Definition of a Tax Haven

        There is a misconception that tax havens and offshore financial centers are one in the same, but while closely related, there are distinctions. (43) There are a variety of tax haven definitions and these varying definitions are generally based on choice of domicile. (44) The most commonly adopted definition was advanced by the Organization for Economic Co-operation and Development (OECD). (45) According to OECD's definition there are four factors in identifying tax havens, the first of which requires that the country have no or only nominal tax rates. (46) A jurisdiction with low tax rates alone is insufficient to qualify it as a tax haven, primarily because many countries with high tax rates pass legislation to reduce the tax rates for specific industries. (47) Tax havens use no or nominal tax rates as a means to attract capital, while countries with industry specific tax rates usually construct these arrangements to allow specific industries to remain competitive within their borders. (48)

        The second factor to qualify as a tax haven under the OECD definition is "ring fencing" of regimes, meaning there is a two-part tax system, subjecting residents and foreign investors and companies in the same jurisdiction to different tax structures. (49) Different jurisdictions tend to be havens for different types of taxes and for different categories of people or companies. (50) Notably, many tax havens require that investors may not be domiciled or have any operating business within the jurisdiction. (51) The purpose of ring fencing is to create laws and other measures that can be used to evade or avoid tax laws or regulations of other jurisdictions and thereby offer non-residents the opportunity to shield assets from high tax rates in their resident country. (52)

        The third OECD requirement is "lack of transparency in the operation of the legislative, legal or administrative provisions...." (53) The absence of transparency is a broad concept according to OECD, and "includes ... favourable [sic] application of laws and regulations, negotiable tax provisions, and a failure to make widely available administrative practices." (54) The OECD recognized the "broader challenge in today's interdependent globalized economy: how to respond to countries and territories that seek to profit from tax dodging by residents of other jurisdictions." (55)

        The fourth and final requirement under the OECD definition is that the tax haven has a lack of effective information exchange with tax authorities in other countries...

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