I just returned from my first trip to Las Vegas. Keep in mind I have spent my professional life helping others avoid risks, and I am generally risk averse by nature. However, I couldn't help trying to beat the odds and win against the house (I hope the casino owners enjoy my money).
Looking back on my experience, I am reminded that in the tax world the IRS is the "house," and the odds are in their favor. However, for foreign insurers or reinsurers who want to write business in the U.S. without paying high U.S. income taxes, there is one sure-fire way to turn the house odds in your favor: write your U.S. business through an independent U.S. agent.
Foreign insurers or reinsurers with a "permanent establishment" in the U.S. are taxable. As a foreign insurer or reinsurer, if you conduct your insurance business directly within the U.S., then any resulting profit generally may be subject to U.S. income tax. However, for foreign insurers or reinsurers located in a country where the U.S. has an international tax treaty, such insurer or reinsurer is subject to U.S. income tax only if it generates profits through a "permanent establishment" located in the U.S.
Under most U.S. tax treaties, the term "permanent establishment" means a fixed place of business through which the business of an enterprise is carried on (whether in whole or in part). A permanent establishment specifically includes any place of management, branch or office located in the U.S. It also may include any person operating in the U.S., if that person is acting on behalf of the foreign insurer and has and habitually exercises the authority to conclude contracts in the name of such company. Such a person is often referred to as an "agency permanent establishment" and can be a trap for the unwary. In the most extreme case, visits to the U.S. by a single agent of a foreign insurer or reinsurer to approve policies on U.S. risks potentially creates a taxable agency permanent establishment, subjecting any resulting profit to U.S. income taxation. In fact, during the Federal Bar Association's 22nd Annual Insurance Tax Seminar held this past June in Washington, D.C., attorneys with the IRS Office of Chief Counsel reportedly confirmed the IRS strongly believes "there are PEs being created by the activities of agents" that would readily create a taxable permanent establishment, and such arrangements are being evaluated by the IRS. 1
As a result of the agency permanent establishment concept, many foreign insurers or reinsurers in treaty countries try to avoid all contact with the U.S. -- requiring all underwriting decisions to be made outside the U.S., all policy applications to be signed outside the U.S. and all policies to be issued outside the U.S. However, this approach is impractical if you are trying to reach a broad U.S. market. More importantly, we all know that to get to U.S. business, there must be someone in the U.S. who will shake hands and interact with the insured or potential insured. It is a fact of life.
Fortunately, most U.S. tax treaties provide a solution. Specifically, a foreign insurance company is not deemed to have a permanent establishment if it carries on business in the U.S. through "a broker, general commission agent, or any other agent of an independent status" provided that such person is acting in the ordinary course of their business. 2
Foreign insurers or reinsurers using an "agent of independent status" avoid U.S. income taxes. Using an agent in the U.S. who is "independent" of the foreign insurer or reinsurer is critical to avoiding U.S. income taxes. The primary source for interpreting whether a foreign insurer or reinsurer carries on business through an "agent of an independent status" is Taisei Fire & Marine Ins. Co., Ltd. et al. v. Commissioner, 104 TC 535 (1995), which involved four Japanese reinsurers and a U.S. reinsurance manager who wrote the U.S. business. Under Taisei, so long as the U.S. entity has "legal independence" and "economic independence" from the foreign insurer and otherwise acts in the ordinary course of its business, the agent will be considered an "agent of an independent status" and its business on behalf of the foreign reinsurers will not create a permanent establishment in the U.S. Without a permanent establishment, the foreign insurers and reinsurers are not subject to U.S. income tax on profits related to their U.S. business -- essentially "beating the house" when it comes to paying U.S. income taxes. Although a 1995 decision, Taisei remains the leading interpretive authority in this area and confirms that by using an independent agent in the U.S., a foreign insurer or reinsurer may effectively avoid U.S. income taxation. 3
Practical steps to avoid agency permanent establishments The key to having an independent U.S. agent and avoiding an agency permanent establishment lies in maintaining the U.S. agent's legal and economic independence. To do so, foreign insurers and reinsurers should consider structuring their arrangement with U.S. agents as follows:
- Enter a written agreement with your U.S. agent clearly specifying the terms and conditions.
- Grant the U.S. agent complete discretion and control to conduct its insurance or reinsurance business in the U.S., subject only to certain objective, clearly specified limitations. Ideally, the limitations should be restricted to: (1) maximum underwriting authority (for example, the U.S. agent has authority to bind coverage up to a maximum net liability on a single policy of $5,000,000) and (2) maximum claims authority (for example, the U.S. agent may handle and dispose of all claims for amounts less $1,000,000 without approval from the foreign insurer or reinsurer).
- The U.S. agent's limitations should be high enough that decisions made by the foreign insurer or reinsurer will be extraordinary and not a substitute for day-to-day management or underwriting decisions.
- Do not impose exclusivity on the U.S. agent. To show independence, the U.S. agent should be allowed to act for other companies. Better yet, it is helpful to choose an agent who already provides services for other insurance companies. Alternatively, the foreign insurer or reinsurer should consider having multiple U.S. agents.
- Under the written agreement with the U.S. agent, allow either party to cancel the arrangement without cause. The cancellation may require some reasonable advance notice. In Taisei, the Japanese reinsurers or the U.S. reinsurance agent could cancel for any reason with six months advance notice.
- Be careful to ensure there is no common ownership (either directly or indirectly) between the foreign insurer or reinsurer and the U.S. agent.
- Compensation to the U.S. agent should be clearly defined, readily measurable by a third party and reasonable relative to the market. For example, remuneration might include compensation based on management fees (i.e., a fixed percentage of gross earned premium), contingent commissions (based on the profitability of business underwritten) and override commissions.
- The U.S. agent should have real operations in the U.S. While a specific number of employees is not required, the U.S. agent should have at least one employee, should have all appropriate insurance licenses and generally should follow good business practices, such as maintaining regular accounting records and owning or renting office space, where such agent pays its own rent, property insurance, salaries and other operating expenses.
- The U.S. agent may be required to regularly report results to the foreign insurer or reinsurer. The U.S. reinsurance agent in Taisei provided its reinsurers quarterly accounting reports, including unpaid losses, reserves for IBNR losses and a narrative summary of overall underwriting results.
- The U.S. agent should file U.S. federal and state income tax returns, reporting all profit and loss from its operations (and, if applicable, paying its own U.S. income taxes).
In assessing the agent's independence, the IRS will view all the facts together to determine both legal and economic independence of the agent. While no single item above is determinative, exercising too much control over the U.S. agent's operations and decisions, or inconsistent compliance with one's own guidelines, may allow the IRS to successfully challenge the arrangement as a taxable permanent establishment. As a result, careful planning and consistent implementation are critical to the foreign insurer or reinsurer's success.
In a world where the tax authorities often have the odds in their favor, eliminating or avoiding U.S. income tax can be a challenge. However, for foreign insurers or reinsurers located in a tax treaty country, writing your U.S. business through an independent agent in the U.S. is an effective way to eliminate income tax on profits from U.S.-based risk.
Footnotes
1. See Kristen A. Parillo, "Agency Permanent Establishments Do Exist Says IRS Official," Tax Analysts Tax Notes Today, June 7, 2010 edition.
2. See e.g. Article 5 of the U.S.-Barbados Income Tax Treaty; Article 3, paragraph 6 of the U.S.-Bermuda Income Tax Treaty; and Article 5, paragraph 6 of the U.S.-U.K. Income Tax Treaty.
3. Foreign insurers and reinsurers still remain subject to the federal excise tax on premium income under Section 4371 of the U.S. Internal Revenue Code of 1986, as amended. This tax equals approximately 4% of gross premium paid for property and casualty risks located in the U.S., and 1% of gross premium paid for life, health and reinsurance policies covering U.S. risks.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.