Foreign micro-captive payments may face FDAP tax adjustment

Plain-English summary

Chief Counsel addressed abusive micro-captive arrangements involving a foreign entity that had elected domestic treatment under Section 953(d). If the arrangement was not insurance, the captive was not an insurance company and its domestic election was invalid. The advice said an examiner may treat payments reported by the captive as United States-source fixed or determinable annual or periodical income subject to the 30-percent tax under Section 881 unless the captive proves an exclusion or exception. That adjustment may be proposed alongside denial of the insured's deduction and a withholding-tax assertion, with relief to prevent duplicate collection when one liability is paid.

Ruling snapshot

• Question: May an examiner impose Section 881 FDAP tax on payments to a foreign abusive micro-captive whose Section 953(d) election was invalid?
• Outcome: advice given
• Key authorities: IRC §§ 816, 831, 881, 953(d), 1442; Treas. Reg. §§ 1.864-2, 1.1463-1; Reserve Mechanical Corp. v. Commissioner

Full text (IRS public release)

          Office of Chief Counsel
          Internal Revenue Service
          memorandum
          Number: 202422010
          Release Date: 5/31/2024
          CC:INTL:B01
          POSTS-120376-20

 UILC:    881.00-00, 953.06-00

  date:   April 8, 2024

    to:   Edwin Herrera
          Area Counsel (Small Business & Self-Employed)

          Justin Scheid
          Associate Area Counsel (Large Business & International)

  from: Branch 1, ACCI


subject: Proposed FDAP Tax Adjustment in Abusive Foreign Micro-captive Cases

          This Chief Counsel Advice responds to your request for assistance. This advice may not
          be used or cited as precedent.

          Facts

          In an abusive micro-captive arrangement involving a foreign entity, the following facts are
          present:1

          •   In Year 1, a foreign regarded entity (“Captive”) made a § 953(d) election to be
              treated as a domestic corporation.

          •   In Year 1 and following years,

                   •   A domestic entity (“Insured”) directly or (when Captive is claimed to be a
                       reinsurer) indirectly made payments to Captive that were claimed to be
                       deductible insurance premiums;
                   •   Insured (and intermediary, when Captive purports to be a reinsurer in the
                       arrangement) did not deduct or withhold any tax under § 1442 (requiring
                       withholding on payments of fixed or determinable annual or periodical

          1
           The facts presented here are exemplary of abusive micro-captive arrangements involving foreign
          entities, but particular abusive fact patterns may differ from those described in this memorandum.
POSTS-120376-20                                    2

               (“FDAP”) income) on the payments made to Captive pursuant to the
               arrangement;
           •   Captive filed a U.S. Federal income tax return as a domestic insurance
               company (Form 1120-PC); and
           •   Captive reported the payments received pursuant to the arrangement as
               income on its Form 1120-PC and excluded the payments from taxable
               income under § 831(b).

As a result of examinations of Insured and Captive, neither established that payments to
Captive were insurance premiums (because the arrangement lacked insurance risk, risk
distribution, or risk shifting, or was not insurance in its commonly accepted sense) and a
revenue agent denied Insured’s claimed deduction. Because the payments to Captive
were not for insurance, more than half of the business of Captive was not insurance,
meaning that Captive did not qualify as an insurance company under § 831(c) and 816(a)
and was ineligible to make a § 953(d) election.

Law

Under § 881(a), foreign corporations generally are subject to a 30-percent tax on amounts
of FDAP income received from sources within the United States that are not effectively
connected with the conduct of a trade or business in the United States. In general,
whether a foreign corporation is treated as engaged in a trade or business within the
United States “shall be determined on the basis of the facts or circumstances in each
case.” Treas. Reg. § 1.864-2(e). Absent evidence that shows that payments received by
a foreign corporation are not FDAP income subject to the 30-percent tax under § 881(a),
the Tax Court has sustained the IRS’s proposed § 881(a) tax liabilities on a purported
captive insurer. 2 In Reserve Mechanical Corp. v. Commissioner, the purported insured
made payments to a foreign entity that purported to be a captive and made an election
under § 953(d) to be treated as a domestic corporation. 3 The Tax Court found that (1) the
captive was not an insurance company, (2) the captive was therefore ineligible to make
an election under § 953(d), and (3) the premiums received by the captive were U.S.-
source FDAP income taxable under § 881.4 The Tax Court held that the captive could
not meet its burden to show that premiums received from the insured were not U.S.-
source FDAP income required to be reported on Form 1120-F.5 Having failed to meet that

2
 See Reserve Mechanical Corp. v. Commissioner, T.C. Memo. 2018-86, aff’d, 34 F.4th 881 (10th Cir.
2022).
3
    Reserve, T.C. Memo. 2018-86, at *28-29.
4
  Id. at *62-66. Accord Keating v. Commissioner, T.C. Memo. 2024-2, at *71-73 (holding that a § 953(d)
election is invalid in any year in which the electing entity is not an insurance company); Swift v.
Commissioner, T.C. Memo. 2024-13, at *44 (holding that the captives’ § 953(d) elections were invalid
because the captives were not insurance companies, and noting that, as a result, the “captives must
recognize the premiums they received as income for the years at issue”).
5
    Reserve, T.C. Memo. 2018-86, at *62-66.
POSTS-120376-20                                     3

burden, the captive was liable for tax on FDAP income under § 881.6 In an opinion
echoing the Tax Court’s reasoning, the Tenth Circuit affirmed. 7

Analysis

In the arrangement described in the above facts, a revenue agent may properly assert
that Captive has the burden to prove that payments Captive received and reported as
income on its Form 1120-PC are of a type excluded from income (e.g., capital
contribution, loan proceeds) or otherwise of a type not subject to tax under § 881 (e.g.,
income from sources without the United States, income effectively connected with a
§ 864(b) U.S. trade or business). Absent facts allowing Captive to meet this burden, it is
appropriate for the revenue agent to propose an adjustment to include the payments in
U.S.-source FDAP income subject to the 30-percent gross tax under § 881 (“FDAP
Adjustment”).

The revenue agent may propose the FDAP Adjustment to Captive even if a denial of
Insured’s claimed deduction for the same payments has been asserted. 8 It is also
appropriate for the revenue agent to propose the FDAP Adjustment even if a § 1442
withholding tax liability, as described in CCA 202134017, has been asserted against
Insured (or intermediary, when Captive purports to be a reinsurer) with respect to the
same payments. Insured (or intermediary) against whom withholding tax has been
asserted would, however, be entitled to relief from its withholding tax liability to the extent
Captive pays its FDAP liability (and vice versa). See Treas. Reg. § 1.1463-1. For
purposes of completing Form 886-A, Explanation of Items, as part of a notice of proposed
adjustment, sample language for the FDAP Adjustment is provided below. If, however,
the facts differ from those described above in any manner other than Captive’s receipt of
payments from multiple Insureds, or if Captive asserts an alternative characterization of
the payments, the agent should contact counsel for assistance.

Sample Language

As a result of an examination, it has been determined that the amounts Insured paid were
not insurance premiums for Federal tax purposes because for [INSERT TAX YEARS],

6
    Id.
7
    Reserve, 34 F.4th at 917-19.
8
  If an arrangement between a captive and an insured does not constitute insurance, it is appropriate to
impose an income-related adjustment, such as the FDAP Adjustment, as well as denying deductions
claimed by the insured. See Syzygy v. Commissioner, T.C. Memo. 2019-34, at *48 (“Petitioners also argue
that if the payments to Syzygy are not deductible they should not be taxable to Syzygy. While [Rev. Rul.
2008-8 and Rev. Rul. 2005-40] suggest the possibility that an arrangement that purports to be an insurance
contract may instead be characterized as a deposit arrangement, a loan, a contribution to capital, or
otherwise, there is no evidence that any such recharacterization is appropriate.”). Further, any argument
by Captive that the payments constitute income effectively connected with a U.S. trade or business of a
foreign corporation would be inconsistent with its § 953(d) election.
POSTS-120376-20                             4

the arrangements failed to meet [LIST RELEVANT FACTORS: the risk shifting
requirement, risk distribution requirement, insurable risk requirement, and/or the
insurance in the commonly accepted sense requirement] and that Captive did not
qualify as an insurance company for Federal tax purposes for [INSERT TAX YEARS].
Further, Captive has failed to establish that it ever qualified as an insurance company for
Federal income tax purposes. As a result, Captive never met the requirements of § 953(d)
to be treated as a domestic corporation and as such, for Federal income tax purposes,
Captive was at all times a foreign corporation.

Under § 881(a), foreign corporations generally are subject to a 30-percent tax on amounts
of fixed or determinable annual or periodical (“FDAP”) income received from sources
within the United States. Captive has not established that it meets any exception to this
rule. In Reserve Mechanical Corp. v. Commissioner, 34 F.4th 881 (10th Cir. 2022), the
Tenth Circuit affirmed the Tax Court’s holding that a foreign entity that purported to be a
captive was not an insurance company for Federal income tax purposes, and therefore
had made an invalid § 953(d) election and was liable for tax on FDAP income under § 881
with respect to the purported premiums it had received. The Tax Court found that the
captive had not met its burden to show that premiums reported as income from the
insured were not U.S.-source FDAP income required to be reported on Form 1120-F, and
the Tenth Circuit agreed. See Reserve Mechanical Corp. v. Commissioner, T.C. Memo.
2018-86, aff’d, 34 F.4th 881 (10th Cir. 2022).

Captive has failed to establish that the payments it received in [INSERT TAX YEARS]
and reported as income on Form(s) 1120-PC were the kind of payments that would not
be subject to tax under § 881. Because Captive did not establish that fact, Captive is
liable for a § 881 tax of [INSERT 30 percent OF AGGREGATE PAYMENTS MADE TO
CAPTIVE IN ALL TAX YEARS AT ISSUE].