In this era of corporate inversions, there seems to be a lot of mud-slinging going around. Congress and the current Presidential administration would like to label large multi-national corporations as traitors. Somewhere along the line, the people in government seemed to miss the part about a corporation’s legal obligation to its shareholders. The Republican Party continues to clamor about the need to reduce the corporate tax rate, but it seems to me that most large corporations have already figured out how to win the tax game and have an effective rate that is far lower than their top marginal rate.
I was recently chatting with a friend of mine who is a top international corporate tax attorney that has worked for the largest law firms and served as tax director for Fortune 500 companies about the problem. He told me that the issue is not the corporate tax rate, but rather, the idea of being taxed at all on foreign profits.
According to numbers reported by Reuters in April 2014, the amount of foreign profits held overseas by U.S. corporations doubled from 2008-2013 to top $2.1 trillion. Corporate tax structuring is complex and large corporations and their external professional advisors always seem to be more than a few steps ahead of Uncle Sam. The resolution of the problem by Congress seems to be an unlikely event until after the next Presidential election as a best case scenario. Is there something in the interim that a large corporation with significant overseas profits might implement to repatriate these dollars on a tax-free basis?
Nobody goes to jail? The answer is yes!
The Pete Seeger folk song “The Hammer Song” is an American classic. Personally, I was stunned at his passing recently at his musical and cultural imprint on American culture. My earliest recollection of this song goes back to the first grade. As an Army officer, mechanics in the motor pool joked that the only tool that they needed to fix heavy equipment was a hammer. Of course, the other famous cliché, “When you only have a hammer, every problem looks like a nail”.
In this case Corporate Owned Life Insurance (COLI) is the “hammer”, i.e. the solution, to the problem of the repatriation of the foreign untaxed profits, i.e. the “nail”. Oddly enough, COLI is widely known and used by many of these same large companies with foreign profits. COLI is used to fund supplemental retirement and post-retirement and medical obligations. In most cases, these same corporations own one or more captive insurance companies as part of the corporate risk management program. Increasingly, these same corporations are also using their captive insurers for employee benefit purposes. The Department of Labor has generously issued a number of prohibited transaction exemptions allowing the. COLI and BOLI insurance assets may exceed a trillion dollars.
This article looks at the use of broad-based COLI, but in an unconventional manner to repatriate foreign profits on an income-tax free basis. The optimal solution contemplates the use of the corporation’s captive insurer to underwrite or reinsure life insurance issued by the company’s captive insuring the company’s worldwide employee workforce.
Current Practice in the COLI and BOLI Market
In COLI, the corporation is the applicant, owner and beneficiary of permanent life insurance – whole life, universal life or variable universal life- insuring the lives of corporate employees covered under the program. In many cases, the life insurance is designed for cost recovery to the corporation for the cost of its employee benefit programs. More recently, COLI has emerged as an investment vehicle for large corporations who insure large numbers of employees.
COLI has been a preferred funding vehicle for the Fortune 1000 for funding the corporations’ non-qualified deferred compensation arrangements. The tax advantages of life insurance are very appealing in this regard – (1) Tax-free inside buildup of the cash value (2) Tax-free loans and withdrawals (3) Tax-free death benefits. The typical COLI program has the corporation as the applicant, owner and beneficiary of the policy. Many of these programs are underwritten without medical underwriting – guaranteed issue or simplified issue.
The program is frequently funded on a single premium basis. In most cases, the policy is a modified endowment contract under IRC Sec 7702A. The asset based and insurance costs (Mortality and Expense charge and cost of insurance) along with sales loads easily exceed 1 percent per year. However, the costs are far less than the cost of current taxation at the corporate level on investment income.
State insurance departments have adopted more stringent Consent to be Insured regulations making it more difficult to insure rank and file employees. These changes were triggered by the proliferation of large scale use of COLI by large corporations as a corporate investment vehicle. The size of the investment was only possible as a result of insuring all of the corporation’s employees in what became known as “janitor insurance” because all of the employees were insured under these programs including the company janitor. In many cases, the employees received no benefit from the program. Congress cried “foul”!
Congress also jumped into the act by adopting IRC Sec 101(j) which was adopted in August 2006. The provision potentially changes the taxation of the COLI and BOLI death benefit from tax-free to taxable unless certain notice and consent rules are met before the policies are issued. The corporation has record keeping requirements. The policy death benefit is taxable for the amount of death benefit in excess of cumulative premiums if the requirements are not met.
An employee must provide consent to be insured after employment is terminated. Exceptions to the adverse tax treatment exist for meeting the notice and consent requirements who are employed within a twelve month period at the time of death or were highly compensated employees as defined under the pension rules (IRC Sec 414(q) and IRC Sec 105(j).
The regulatory and tax trends for COLI and BOLI tend to be negative. Many regulators at the state and federal level unfairly see COLI and BOLI as a corporate tax shelter. With the national deficit being what it is, it may not be the worst thing to consider other alternatives. It could very well turn out that the alternative is as good or better as the original solution.
As it turns out, it may not even be necessary to issue a U.S. tax compliant product in order to implement this strategy.
Insurance Law and Tax Considerations
IRC Sec. 7702 is the U.S. tax law definition of life insurance. The tax laws require that a contract be considered “life insurance” under the insurance laws that apply to the contract. The applicable law may be the insurance laws and regulations of a particular U.S. state or the laws of a foreign jurisdiction.
Normally, the applicable law governing a policy will be the law of the jurisdiction to which the Insurer is subject, which is generally the laws of the jurisdiction in which the company resides. Typically, the policy will expressly specify which jurisdiction (Bermuda, Cayman Islands, Puerto Rico) is the law governing the policy. In this case, a large corporate captive insurer which is frequently located in Bermuda might serve as life reinsurer or direct insurer.
Presumably, an insurer is licensed and regulated in the jurisdiction, will issue and deliver the policy in, and administer the policy from the jurisdiction where the life insurer is domiciled. The jurisdiction of the insurer is the law that controls the policy's issuance and the legal interpretation of its terms.
If the Policyholder is a non-U.S. person, there should be no U.S. tax consequences during the lifetime of the Insured. Since the Carrier is a non-U.S. any income that the Policy might be considered to generate during this period would be income that is derived from non-U.S. sources. The U.S. should not impose federal income taxes on a non-U.S. person deriving non-U.S. source income.
In the event the Policyholder is a U.S. person, and the Policy is a “life insurance contract under applicable law,” but fails the legal requirements of IRC Sec 7702 to qualify as a “life insurance contract,” the Policyholder should be subject to tax on the “income on the contract” under the rules of section 7702(g).
IRC Sec. 7702(g) sets forth the U.S. income tax rules for “any contract which is a life insurance contract under the applicable law (but) that does not meet the definition of a life insurance contract under subsection (a) IRC Sec. 7702 (which states that the policy has to meet the cash value accumulation test or the guideline premium and cash value corridor requirements).
IRC Sec 7702(g) provides that if a contract is a life insurance contract, but does not meet the tax law definition of life insurance of IRC Sec. 7702, then the policyholder is taxable each year on the “income on the contract,” which is defined to mean the sum of (i) the increase of the net surrender value of the contract during the taxable year, and (ii) the cost of life insurance protection provided under the contract during the taxable year, over the premiums paid during the contract year
If a policy violates the U.S. tax law definition but is considered life insurance in the jurisdiction where the policy is issued, the death benefit will continue to receive income tax-free treatment under IRC Sec 101(a). If the program insures a number of U.S. lives, specialty products such as Frozen Cash Value Life Insurance contract may be used to mitigate the current taxation on the increase in cash value while preserving the tax-free status of the death benefit.
Foreign jurisdictions frequently allow a much lower death benefit corridor than the U.S. tax law definition of life insurance allows. This difference should make it easier to underwrite and issue for the captive insurer.
From an insurance law standpoint, some offshore jurisdictions have modified their insurance interest and consent to be insured laws making it pretty straight-forward for an offshore life insurer or captive to issue coverage on the employees of the parent company. Effectively, the foreign subsidiary is using the company’s captive which is also tax-favored to pass foreign profits back to the parent as an income tax-free death benefit. Profits are reallocated as life insurance premiums paid to the company’s captive.
Captive Insurance Considerations
Eighty percent of the S&P 500 companies own one or more captive insurance companies. Most of these captives have been traditionally used for property and casualty risk management purposes. Increasingly, these companies are using captives as part of solution to manage and control employee benefit costs. The challenges of under-funded pension benefits and post retirement employee benefits have increasingly forced large corporations to consider the use of their captive to extract meaningful costs savings. The Department of Labor has provided companies with prohibited transaction exemption for this purpose.
A number of these captive insurers have integrated the use of the captive with the corporate self-funded health insurance plan and also to reinsure group term life and disability benefits. The interesting point of law here is that from a risk shifting and risk distribution benefit, the analysis allows each employee to be considered as a separate risk where they receive some benefit. Alternatively, a fronting company might be used to issue the life insurance coverage on worldwide employees.
The tax rules provide that an insurer that has over half of its reserves connected to life and health related coverage is a life insurance company for tax purposes. The investment income associated with the life insurance reserves would continue to accrue on a tax-deferred basis.
Building or Buying the Hammer
The basic idea contemplates the purchase of life insurance on the non-U.S. employees. A variation of the idea can also contemplate the inclusion of the U.S. employees into the insured pool. The corporation may structure an offshore trust to structure the purchase of the life insurance.
Revenue Ruling 2004-15 while focused on employee benefits for a U.S. corporation may serve as a general template as to how the arrangement can be structured. A VEBA arrangement purchased insurance from the company’s captive. The coverage insured the employees of the company. The coverage was considered unrelated to the company for risk shifting and distribution purposes. Revenue Ruling -92-93 provides that coverage underwritten is unrelated to the captive since it insured employees.
The foreign subsidiary of the multi-national corporation is the settlor of the employee benefit trust with the parent corporation as the beneficiary of the trust. The program will be designed so that each insured employee will receive some personal benefit under the coverage in the event the captive underwrites the coverage. The trustee of the employer trust will be applicant, owner and beneficiary of policies insuring the worldwide employee base.
The Irish or foreign-based subsidiary may contribute will contribute the premium to the Trust and may receive a death benefit equal to the lesser of its premium payments or the aggregate cash value of the policies. The parent corporation through the trust will receive the aggregate initial death initial plus the aggregate death benefit income tax-free. Insured employees will each receive a small percentage of the coverage. This version of the strategy models the well-known strategy known as split dollar life insurance.
The coverage may be actuarially and medically underwritten on a guaranteed issued basis by the captive. In a certain respect, it is almost more advantageous for the cost of coverage to be conservatively priced in order to direct more premiums out of the foreign subsidiary through the captive back to the parent corporation as an income tax-free death benefit. In the event U.S. employees are underwritten, a fronting company may be utilized or alternatively, the employees may be underwritten by the Bermuda-based captive. Bermuda has relaxed its insurable interest rules to include the employees of the parent company.
The proposed arrangement can provide for the tax-deferred growth on foreign profits repositioned as life insurance premiums along with the ability to access these assets through policy loans and withdrawals. Ultimately the funds are repatriated to the parent company as an income tax-free death benefit.
Question #1 may be who is doing this? The answer – No one! This phenomenon has more to do with the problem of specialization and professional advisors focusing on the solutions within their respective technical “silos” as well as the lack of exchange of information between these professionals.
Congress is heavily focused on the Sub-part F implications of the foreign profit problem, and looking to close access to access to loopholes such as using short-term, arms-length intra-corporate loans. In the meantime, on a less troublesome front, the use of captive insurance companies for both property and casualty and employee benefits purposes has become very mainstream.
It should not be much of a technical stretch to understand how these “dots might be connected” in order to maximize the tax-free treatment of life insurance to maintain tax-deferral and the tax-free distribution of these foreign profits to the parent company. Most of these corporations already have significant exposure to life insurance in the Mothership, i.e. the parent company.
If we can show companies how to connect these dots, maybe we can finally create some new jobs in America. Who knew that life insurance might be the solution to the shortage of jobs?