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					Hospital Captive Legalities:
Update on Regulatory, Tax &
Corporate Governance
Developments Affecting Health Care
Provider Captives
June 17, 2008
Thomas M. Jones
McDermott Will & Emery LLP
                 XYZ Bermuda Indemnity, Ltd.

Sample Captive Board Presentation:
          ABC Health Care System
    [Operates Hospitals in Illinois and Iowa]

             Elbow Beach Resort
     Educational Session – March _, 2008
              Thomas M. Jones
         McDermott Will & Emery LLP
                Chicago, Illinois
               Captive Structural/Regulatory

• State insurance laws and regulations
• Federal and state tax considerations
• Securities registration exemption/antifraud disclosure
  (applicable to group captives)
• Other legal considerations (e.g., Medicare fraud and
• Management/governance (directors and committees)
• Coverage and policy questions
• Choice of form (stock/mutual/reciprocal) (onshore vs.
  The Bermuda Regulatory Environment

• Judicious discretion with limited statutory rules
   – Bermuda’s Insurance Act provides the basic
   – The Bermuda Monetary Authority sets financial
     parameters using a holistic approach and “rules of
     thumb” rather than rigid rules – meritorious
     exceptions are granted by the BMA granting a “Sec.
     56 Directive”
   – The captive’s filed business plan, as amended from
     time to time, establishes its responsibilities and
   – Local insurance managers play a contingent but
     important regulatory role
               Directors’ Duties Under Bermuda

• Duty of skill, care and diligence
• Oversight role - duty to adequately supervise competent
  service providers
• Fiduciary duties - directors must act in the best interests
  of the captive and must disclose to other directors any
  material conflict of interest
• Director indemnification - except for dishonesty, willful
  default or gross negligence
  Illinois Insurance Regulatory Issues

• Prohibition against conducting an unauthorized
  business of insurance in IL
• Two potential bases for the position that there is no
  unauthorized insurance in Illinois:
   – Industrial insured exception
   – No insurance
   Illinois Insurance Regulatory Issues

• Exception for IL “industrial insureds” (each of these
  three requirements must be met):
   – At least $100,000 in annual premiums;
   – Access to employed risk manager or contracted
     insurance consultant; and
   – Gross assets over $3 million or gross revenues
     over $5 million or at least 25 full-time employees
     Iowa Insurance Regulatory Issues

• Prohibition against conducting an unauthorized
  business of insurance in IA
• Two potential bases for the position that there is no
  unauthorized insurance in IA:
   – Policy solicited, written & delivered outside IA
   – No insurance
• IA has no industrial insured exception
     IL & IA Insurance Regulatory Issues

• No insurance position:
   – The “business of insurance” requires risk spreading and
     risk shifting
   – Arguably, there is no shifting or spreading of risk within
     an economically integrated group of entities
   – Typically, entities within a corporate system that are
     under common ownership and control of the First
     Named Insured are covered under a single policy
     issued to the First Named Insured
                 IL & IA Insurance Regulatory

 In order to cover affiliates under the same policy and take
  the position that the single policy does not represent
  “insurance”, the covered entities must be under common
  control, i.e., the policyholder must have more than 50%
  control, through ownership or ability to elect the
  governing body
 Independent non-employee medical staff physicians
  constitute third party risk
   Taxation of Healthcare Captives

  The key tax question:

Is it treated as insurance?
                 Tax Definition of “Insurance”

• No clear-cut definition in tax law

• Must analyze case law and IRS rulings

• Captive’s preference is to avoid “insurance company” tax
  status for itself and for its parent

• But voluntary physicians need premium deductibility
                           Two Basic Requirements

For insurance treatment, both risk shifting and risk
  distribution must be present:

• Risk shifting must be to a separate legal entity

• Risk distribution connotes enough independent risks
  pooled to invoke the “actuarial law of large numbers”
           Advantages of Non-Insurance Status
             for Tax Exempt Owner of Offshore

• Premiums paid not subject to a federal excise tax (4% of
  the premium for direct insurance and 1% for reinsurance
  or life)
• Can avoid attribution of any “unrelated business taxable
  income” to captive’s tax-exempt parent
• State premium tax (known as “direct placement” tax or
  “self-procurement” tax) would apply – e.g., IA rate of 2%
  of premium; none in IL
                   Onshore Hospital Captives – Tax

• If captive funds risk of only its tax exempt parent
  and employees, then captive can obtain an IRS
  “determination letter” granting IRC Sec. 501(c)(3)
  tax exempt status
• Must file IRS Form 1023 with a description of
  intended activities – can cover non-employed
  physicians or other third parties only if
  “insubstantial” in amount (<5% of premiums)
• Thus limited scope of captive activities if onshore –
  covering any substantial ineligible party causes all
  income of the domestic captive to become fully
                 Offshore Hospital Captives - Tax

• No corporate income taxes in Bermuda
• Offshore captives are not tax-exempt – so they can
  accommodate addition of non-employed physicians, but
  there may be tax ramifications
   – Federal excise tax on premiums
   – Unrelated business taxable income to captive’s U.S.
     shareholder – on net income from covering VAPs or
     non-controlled entities
• But unlike onshore captives, covering third parties may
  generate some tax but it does not taint the entire captive –
  this is the principal reason most captives owned by tax
  exempt hospitals are domiciled offshore
      Hospital Captive with Independent Physician


501(c)(3)                        Owned      Non-
Hospital                         Medical    Employed
                                 Practice   Medical
                  Captive                   Staff
                 Insurance                  Physicians
                       Avoiding a U.S. Trade or

Why? If offshore captive is found to be engaging in a U.S.
 business, it will become subject to U.S. corporate
 income tax on its income effectively connected with the
How to avoid:
• Conduct day-to-day activities outside of U.S.
• Do not qualify to do business in any state
• Utilize offshore management company
• Never sign contracts in U.S.
• Never hold meetings or make official decisions in U.S.
                        Avoiding a U.S. Trade or

• Critical for offshore captives not electing onshore tax
  treatment, but also relevant for compliance with state
  insurance “unauthorized business of insurance” laws
• Potential double taxation - mainstream 35% corporate
  income tax plus additional 30% “branch profits” tax on
  profit repatriations from the U.S.
• Goal - make captive a passive reimburser of already
  paid claims
                        Avoiding a U.S. Trade or

• A factual determination
• Determined anew each tax year
• Main factors are continuity, regularity and substantiality
  of captive’s U.S. activities
• Management situs test - where is captive’s “mind and
• Activity of employees and dependent agents attributed to
  captive; not independent agents
                        Avoiding a U.S. Trade or

Suggested actions to avoid a U.S. business:

   – Prohibit U.S. meetings and contract signing in
     offshore captive’s corporate bylaws (called bye-laws
     in Bermuda)
   – Policy language should allow indemnitee to adjust
     claims with optional participation by captive
   – Parent’s risk manager should not be an officer or
     director of the captive; he/she should present claims
     report, etc. in capacity of consultant to the board
           Bermuda Captive Investments
A 30% non-recoverable federal “withholding” tax is
  imposed on certain U.S. investments:
– All dividends paid on equities (common and preferred
  shares, ETFs) of U.S. issuers (except American
  Depository Receipts)
– U.S. bond funds (3 year exception enacted in 2004
  expired 1/1/08) (but no tax on portfolios comprised of
  individual bonds)
– “Clone” bond funds formed in Ireland (UCITS) or
  Luxembourg (SICAVs) avoid this tax under
  applicable U.S. tax treaties
– Avoid funds formed in the U.S. as trusts or
                        U.S. Tax Compliance

The captive’s U.S. shareholder must file annually the
  following forms:

– IRS Form 5471: show captive as an investment

– IRS Form 926: report all transfers to captive as
  capital contributions

– Treasury Form TD F 90-22.1: all U.S. persons must
  disclose signatory authority over foreign bank
            U.S. Tax Compliance (Continued)
• Making a Protective IRS Form 1120-F Filing
  – A foreign corporation that is engaged in a U.S. trade or
    business is subject to U.S. tax on its net income, not its
    gross income, but ONLY if it files a U.S. return in that
  – If a foreign corporation is found to be engaged in a
    trade or business on audit and has not filed a U.S.
    return for the year in question, it will generally be taxed
    in the U.S. on its gross income (i.e., no deductions or
    credits allowed)
  – A foreign corporation can make a “protective” filing in
    any year even if it does not believe it has a U.S. trade
    or business by filing a Form 1120-F and indicating that
    the form is being filed for protective purposes
  – No need to show numbers; just name, address & FEIN
        Summary of Hospital Captive Status

• Not an “insurance company” for tax purposes
    – No federal excise tax imposed on premiums
    – No “unrelated business taxable income” to sole S/H
    – “Premiums” are not deductible for taxable affiliates
• No violation of Illinois or Iowa insurance law
    – No captive activity in Illinois or Iowa
    – Self-funding, not true insurance
    – Policyholders representing most of the premium also qualify as
      “industrial insureds”
• Foregoing not changed with coverage of controlled affiliates
• But some major changes if non-employed physician practices are
  covered in the future
             Goals of Corporate Governance

1. To provide an overview of ten key 2007-2008 corporate
   governance developments
2. To list underlying factors causing the subtle and ongoing
   shift in board focus from “guidance” to “compliance”
3. To alert attendees of important corporate governance
   developments so they can position themselves to
   anticipate upcoming changes
       Development One: Environment of

• Healthcare providers are operating within an
  increasingly skeptical environment
   – Governmental (federal, state and local)
   – Media (biased?)
   – Patients, residents, families and service recipients
   – Standard setting associations, consumer advocacy
     groups, corporate payer alliances, etc.
   Development Two: Best Practices 2.0

• Governance “best practices” continued to
  evolve in 2007-08, both through actions taken
  by leading nonprofit organizations and by report
  released by the Panel on the Nonprofit Sector’s
  “Principles for Good Governance and Ethical
 Development Three: Conflict Avoidance

• Closer emphasis on proper board and key
  committee (compensation, audit, compliance)
  composition generated by legislatures,
  regulators, media and public interest groups
• Elimination of incestuous financial relationships
  created difficult decisions in the nominating
  process and narrowed the field of eligible
  independent candidates knowledgeable about
  the industry
Development Four: Conflicts Management
  • Issues associated with proper handling of
    existing director conflicts of interest and lack of
    independence continued to surface in 2008,
    placing boards under increasing pressure to
    address legislative/regulatory concerns with the
    integrity of the board’s decision-making process
                Development Five: Executive
• Matters relating to executive compensation paid
  by nonprofit, tax-exempt organizations, and the
  board’s role in approving such compensation,
  continued to be the source of close regulatory
  attention in 2008
  Development Six: IRS and Governance
• The IRS has dramatically increased its level of
  attention to the corporate governance practices
  of tax-exempt organizations, as manifested in
  multiple different ways
• 2007-08 witnessed several important
  developments relating to the ability of nonprofit
  hospitals and health systems to qualify for both
  local (property tax) and federal (income) tax
     Development Seven: Legal Controls

• 2007 was particularly notable for a series of
  events which emphasize the importance of
  legal controls, and of a strong internal/general
  counsel function, within the organization
       Development Eight: Quality of Care
• A growing expectation of the board to exercise
  an increasing degree of oversight regarding
  quality as it relates to service performance,
  measurement tools and reporting requirements
  emerged during 2007
Development Nine: Financial Irregularities
  • An important 2007 development which “flew
    under the radar” is the dramatic increase in
    reported cases/allegations of financial
    impropriety involving corporate management of
Development Ten: Proper Role of Board
• The foregoing developments collectively
  contribute to a particularly significant shift in the
  role of the board from “guidance” to
                              The Guidance Board
• Traditional approach
• Focused principally on providing management
  with strategic guidance
• Advice and support versus direct oversight
• Supportive of entrepreneurial spirit
                          The Compliance Board
• Focused principally on organizational
  compliance with laws and regulations
• Responsive to increasing legal/public opinions
• Mentality of “constructive skepticism”
• Appreciation of enhanced oversight obligation
• “Vigorous oversight” of corporate affairs
           Emerging Governance Concerns

• How far should corporate accountability
  extend? Cost/benefit analysis?
• Do executives suffer from less direct expression
  of vision from the board?
• Decline in “informed risk taking”?
• Are boards becoming too reactive; too focused
  on regulation, compliance, whistle-blowing
Thank You

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