If the words “offshore entity” inspire dreams of Caribbean islands and easy compliance because, well, there are hardly any tax or governance rules to comply with—you may want to wake up to reality.
That reality is that there are a dwindling number of benefits to incorporating in offshore tax havens such as Bermuda or the British Virgin Islands, thanks to more muscular and more uniform enforcement from the Internal Revenue Service, the European Union, and other regulators trying to extend their cross-border reach.
“There is really no incentive to set up offshore,” says Jay Adkisson, a partner at the law firm Riser Adkisson.
In fact, there are numerous disincentives. While the IRS and other U.S. regulators don’t strictly oppose the use of offshore jurisdictions, they don’t make it easy to set up shop in tax havens. The paperwork that needs to be filed is onerous, the penalties for late filing severe. Insurance companies in particular—which have long had strong incentives to go offshore—face a 4 percent excise tax.
Perception plays an increasing role in a U.S. company’s domicile decisions as well. The public may see an offshore entity as something not quite right, perhaps even unpatriotic; that may weigh on the mind of a board considering where to establish offshore operations. Offshore jurisdictions made their names and long promoted themselves as exotic tax havens, and now they have to fight their history.
The industry most affected by offshore tax havens is the “captive” insurance business—that is, subsidiaries that insure the risk of some parent company. Because U.S. state insurance laws are so strict, many businesses establish their own insurance subsidiary outside the United States in countries that give favorable legal treatment to such operations.
In recent years, however, the compliance climate has changed for offshore tax havens. Sensing a change in the mood of U.S. regulators, and particularly after passage of the Patriot Act in 2001, the havens have worked to reinvent themselves as full-fledged world-class financial centers. Secrecy was downplayed, while infrastructure and regulation was increased to match that found in New York or London.
But in doing so, the havens lost much of what had set them apart and became almost indistinguishable from that which exists in the onshore world.
Levinson
“At some point you ask: Why exactly am I over there?” says Kenneth Levinson, a partner at Faegre & Benson.
The numbers seem to bear this out. Bermuda, the world’s largest captive insurance jurisdiction, had a net gain of only two new captive insurance companies in 2006 over 2005, reaching 989. Cayman Islands, the second-ranked captive center, added seven for a total of 740.
In the United States, however, states that are favorable to captive insurers saw their business expand much more rapidly. Vermont, the largest jurisdiction in the country, added 21 captive insurers, bringing its total to 563. Nevada gained 39 captive insurers, bringing its total to 97.
Setting Up a Captive Shop, at Home and Abroad
Operating onshore in one of the 20-plus states with captive insurance regulation is not necessarily any easier. A domestic captive insurer still faces a long list of rules, a large body of law, and some guiding principles.
“At some point you ask: Why exactly am I over there?”
— Kenneth Levinson,
Partner,
Faegre & Benson
Foremost, a captive insurance entity must meet formidable Internal Revenue Service Standards to be considered an insurance company. If it fails to do so, the premiums are not tax deductible as insurance and the captive subsidiary could be regarded as an investment company and treated as such by tax authorities. In the early 1990s, a number of court decisions set the standards followed today.
To form a captive in Vermont, for example, a company must conduct a feasibility study, hire a state-authorized captive management firm, be reviewed by the commissioner of banking, insurance, and securities, and undertake an actuarial review. A captive then must be audited annually by an approved public accountant (including an evaluation of internal controls), must submit an annual report, and must have reserves certified by an approved actuary.
Crouse
“It all starts with a face-to-face meeting,” says Len Crouse, deputy captive insurance commissioner of the state of Vermont. “We want to make sure it makes sense. We want to make sure the premium is correct. We want to make sure the methodology is correct.”
Some observers wonder whether those standards are enough. While jurisdictions like Vermont and Bermuda may have good controls in place—such as requiring their captives to limit the range of investments that can be made—newer or less-regulated jurisdictions might allow more aggressive investment of the captive’s funds. Indeed, an inherent conflict-of-interest exists between the captive insurer and its parent company: The higher the returns on investments made by the captive, the lower the cost of insurance for the parent. The owners have an incentive to push risk and may find themselves entering dangerous territory in doing so.
Innocent but dangerous investment mistakes can also occur. A technology company, for example, may find itself investing its captive’s assets in technology stocks because that is the sector the parent company understands. Even though no laws have been broken, a tech-sector slump could result in simultaneous trouble at the parent and at the subsidiary that is supposed to be insuring it.
Shareholder Support … Usually
The question also arises of whether shareholders fully understand what they are getting when a company creates an insurance subsidiary. An investment in a captive may look like a valuable asset on the books of the company, and the company may seem fully insured. But the asset and the insurance are the same, and a catastrophic claim could make the value of the asset fall considerably.
“You have to be careful,” says Adkisson. “Are you really telling the shareholder what the risks are?”
The possibility of malfeasance exists as well. Conceivably, a company executive could create an insurance structure that enriches inside management at the expense of shareholders. This is a particular problem in so-called “fronting” relationships, where a large known insurance company issues the insurance and then sends most of the premiums, and risk, to another insurance company. If that other insurance entity is controlled by parent company executives, it can be used to generate hidden compensation through excessively high premiums or in the underwriting of risks for which claims are unlikely.
Adkisson
While many lawyers are skeptical that such structures could be created in today’s stronger jurisdictions, offshore or otherwise, Adkisson says he has been asked to create insurance vehicles designed to take money out of a parent. (He declined.)
“Captives provide a tempting mechanism for looting the company. No auditor is astute enough to figure it out,” he contends. “I promise you, we will see some scandal.”
“The captive insurance business is like the Wild West,” he adds. “It’s like the hedge fund world. There’s not a lot of thought about controls.”
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