Use of Protected Cell Company and Series LLC Structures – the Basics

American Conference Institute’s 2nd Advanced Forum on CAPTIVE INSURANCE

April 24-25, 2014 - The Carlton Hotel Madison Avenue, New York, NY

Use of Protected Cell Company and Series LLC Structures – The Basics

Thomas M. Jones McDermott Will & Emery LLP [email protected] (312) 984 7536

Cell Company Structure

POOLED LAYER - CORE CAPITAL

Cell A Cell B Cell C Cell D

2 Offshore Cell Captive World (>20)

. Segregated Accounts Company (SAC) Bermuda SAC Act 2000

. Separate Accounts Company

Bermuda Private Acts of Parliament – since 1991

. Protected Cell Company (PCC) Gibraltar Protected Cell Companies Act of 2001 Guernsey Protected Cell Company Ordinance 1997

. Segregated Portfolio Company (SPC) Cayman Islands Companies Law 2000 (Revised 2006) British Virgin Islands Business Companies Act (Revised 2005)

3 Onshore Cell Captive World (>14)

. Sponsored Cell Captives - Vermont Special Insurer Act of 1999

. Sponsored (formerly Leased Capital) Cell Captives - Hawaii Hawaii Revised Statutes 2000

. Protected Cell Captive Insurers - DC Captive Insurance Company Act of 2004

. Protected Cell Companies - SC Protected Cell Insurance Company Act of 2000

4 Varied Uses of Cell Captives

What types of captive programs are in cells? . Pure/single parent risks (conglomerates) - Separation – By product line – By geographic area . Group and/or association shared risks . Transformers, funds & financial guaranty companies . Hospital/clinics/independent physicians . Agency risk participation . SPVs – securitization; XXX life insurance . Composite insurers – separating life & non-life lines

5 “General Account”

. Also called “core capital” . Corresponds with general assets and liabilities in standard balance sheet of an ordinary company . Open issue depending on PCC domicile – Can core contract with a cell? Can one cell contract with another?

6 “Segregated Account”

. Generically called a “cell” . Identifiable assets segregated or distinguished from other assets of company for the purposes of creditor protection whether in a solvent situation or insolvency proceeding . “Open” Cell – Assets of core available (at least to a specified amount) to satisfy creditor of cell . “Closed” Cell - Assets of core not available to satisfy creditor of cell

7 Will Cells’ Separateness Be Respected?

. Concept of separating assets and liabilities in self- contained cells seems valid, but has not yet been judicially tested . Two key factors to enhance success: – Governing law/venue must be the domicile – Cell assets (i.e., custody of investments) should be located in the domicile . Reason: contrary to insolvency principle of horizontal “equitable distribution” (pari passu) of assets to creditors; cell structure is a vertical distribution only within the cell 8

Experience in Bermuda

. SAC mutual fund litigation in Bermuda Supreme Court – Tensor Endowment Limited vs. New Stream Capital Fund Limited – Segregation a peripheral issue, but efficacy upheld (9/23/10) . Litigation involving wind up (liquidation) of SAC cell – Matter of CAI Master Allocation Fund Ltd. (2011) – Judge described the cell wall as a “statutory iron curtain” – But left open its breach if used as an instrument of fraud

9 AMBAC Insolvency in Wisconsin

. Pending mortgage guaranty insurance cell insolvency litigation in Wisconsin – See Plan of Rehabilitation for the Segregated Account of Ambac Assurance Corporation filed by the Wisconsin Office of the Commissioner of Insurance on 10/8/10 at http://ambacpolicyholders.com; plan approved by Dane County Circuit Court on 1/26/11 – Cell formed on 3/24/10 to sequester certain assets and liabilities under long standing Wisconsin law – Issue was whether the IRS & other Ambac creditors could pierce the cell wall – The Segregated Account reached a compromise with the IRS & Ambac creditors without breaching the cell walls – approved by the federal bankruptcy court on 5/1/13 10 Key U.S. Tax Issues – Insurance or Self Funding?

. Premium deductibility by policyholder? . Loss reserve deductibility by company? . Controlled foreign corporation status? . How is shareholder taxed under Subpart F? . Possible passive foreign investment company (PFIC) treatment? . Applicability of federal excise tax?

11 Tax Authorities Supporting a Single Company

. Life insurance company “separate asset accounts” - see, e.g., Rev. Rul. 74-4 and TAM 9807001 . Taxation of “regulated investment companies” (mutual funds) – see, e.g., Union Trusteed Funds, 8 TC 1130 (1947) and Rev. Rul. 56-246 . PFIC statutory rule re classes of stock – see IRC §1298(b)(4) . Moline Properties separate corporate existence doctrine

12 Tax Authorities Supporting a Single Company

13 Authorities Supporting “Multi-Corporations”

. Legislative history to 1997 IRC amendments states that use of “separate accounts” will be respected to prevent risk sharing . Federal Bank Holding Company Act of 1977 regulations concluding that each cell of a rent-a-Captive type structure should be considered a separate corporation . Possible impact of future budget proposals regarding public company subsidiary “tracking stock”

14 Factors Influencing Multiple “Mini-Corporations” Outcome . Is core capital at risk? Must it be replaced via assessing other cells? . Does company-wide or cell-by-cell governance prevail? (Cell statutes specify only 1 governing board) . Is primary/stop-loss/excess coverage and collateral for “front” on a company-wide or cell-by-cell basis? . Are each cell’s assets invested on a separate or commingled basis? . Are cell owners risking significant capital? . Separate or composite GAAP financial accounting treatment?

15 2008 IRS Cell Captive Guidance

16 Rev. Rul. 2008-8

General Account Y

X Cell X Cell Y Preferred Shares Insurance Insurance Policy Policy Covering 1 12 Brother/Sister Group

. No Insured except for X . Adequate capital . No guarantee of Cell X obligations . No subsidiary < 5% nor >15% . Adequate capital . No loans . No loans . No guarantees by Y or Y1 → Y12 of Cell Y obligations . Annual policy . No other insurance contracts

. Homogeneous risk

. Annual policy

Rev. Rul 2008-8

– Look to existing rules; apply on cellular basis • Risk shifting • Risk distribution – Arrangement between X and Cell X akin to a parent and wholly-owned subsidiary. Rev. Ruls. 2002-89 & 2005-40 – Arrangement between Y and Cell Y characterized as brother/sister insurance. Rev. Rul. 2002-90 – Should have been a 3rd situation in which Cell Z owned by Z wrote > 50% unrelated risk with holding of insurance under Rev. Rul. 2002-89

18 IRS Notice 2008-9 Proposed Guidance

. Cell of a PCC would be treated as an insurance company separate from any other entity if: – Assets and liabilities segregated – Based on facts and circumstances cell would be classified as an insurance company . Tax Effect – Elections at cell level – Cell must apply for FEIN if subject to U.S. tax – Cell activities not taken into account in characterizing PCC’s “general account” (core) – Cell (or parent, if consolidated) responsible for filing returns and paying tax – PCC does not include income items with respect to cell 19

IRS Notice 2008-19 Comment Period

– To implement this guidance, taxpayer comment requested by 5/5/08 regarding: • Transitional rules • Reporting, if any, necessary to ensure PCC has needed information • Special rules regarding foreign entities (including CFCs) • Treatment of PCCs and cells under consolidated return rules • How to handle segregated arrangements not involving insurance – Note no inference on tax status of PCC core or its non-insurance cells – Effective date would be for tax years beginning more than 12 months after this guidance is finalized

20 IRS Proposed Regulations Issued 9/13/10 – Not Yet Finalized

21 Prop. Treas. Regs – General Rules

. Regs explicitly state they do not address the proper tax characterization or filing requirements of the core . If a cell is classified as a separate corporate entity, then it will be treated like any other corporation, including the ability to make stand alone tax elections . Regs will not override general tax law principles – for example, if a cell has no business purpose other than tax avoidance, it still will be disregarded as a “sham” . Regs indicate that ownership of a cell will be determined to be whomever “bears the economic burdens and benefits of ownership” of the cell (shares = contracts?) 22

Prop. Treas. Regs – Domestic Cell Captives

. Every cell will be treated as a separate taxpayer, except for segregated asset accounts of a life insurance company . The fact that state law does not consider the cell to be a separate entity is not important . Regs cite Vermont and South Carolina cell captive provisions, but this same rule should apply to cell captives formed in all other domestic domiciles with similar laws, including the District of Columbia

23 Prop. Treas. Regs – Domestic Cell Captives

. The cell's separate entity status will be respected even if the cell fails to comply with statutory record keeping requirements negating the limitation of liability . The cell's separate entity status will be respected even if, through an arrangement such as guarantees, the debts and liabilities of a cell are enforceable against assets of another cell

24 Prop. Treas. Regs – Foreign Cell Captives

. Regs state they do not address the proper tax characterization or filing requirements of a foreign cell company or its cells . But an important exception exists for a foreign cell that conducts an insurance business . Thus, if the foreign cell’s business would qualify it as an insurance company for federal tax purposes had it been a domestic entity, then it will be a stand alone foreign corporation . Regs cite Guernsey, Cayman and Bermuda cell captive provisions, but the same rule should apply to other offshore domiciles with similar laws

25 Example – Foreign Insurance Cell

. Assume Foreign CellCo establishes Cell A for a U.S. taxpayer . Assume more than half of Cell A's business is issuing insurance or reinsurance contracts . Under the Regs, Cell A will be treated as a separate taxpayer . Because Cell A qualifies as an insurance company, it will be classified as a foreign corporation . Cell A’s U.S. owner will report Subpart F income using insurance tax accounting (e.g., loss reserve deductions) because he/she bear the burdens & benefits of cell ownership . Cell A also will be eligible to make tax elections, including under IRC §953(d) and §831(b), on a stand alone basis 26 Example – Foreign Non-Insurance Cell

. Assume Foreign CellCo establishes Cell B for a U.S. taxpayer . Assume less than half of Cell B's business is issuing insurance or reinsurance contracts . Regs state that they don’t address Cell B’s tax status due to the "novel federal income tax issues" raised . So presumably Cell B, if associated with a non-CFC cell captive, will report only investment income when repatriated . Cell B will not be eligible to make tax elections, including under IRC §953(d) and §831(b), on a stand alone basis . Treas. official Mark Smith on 9/24/10: IRS feared foreign series could be used to separate foreign income from related foreign tax credit and IRS didn’t have a “firm enough grasp” of foreign “series statutes” 27 Transitional Rules

. Cells (domestic or foreign) established prior to September 14, 2010 may be eligible to be treated, together with the core, as a single entity . Domestic cells are eligible if: – The cell conducted business or investment activity – No owner of a cell treated the cell as a separate entity – The cell and the core had a reasonable basis for its claimed classification – Neither the cell nor any owner nor the core was notified before September 14, 2010 that the classification of the cell was under examination . This exception ceases to apply if there is a change in ownership of 50% or more of the interests in the core (or the cell) 28 Transitional Rules

. Foreign cells are eligible if: – More than 50% of the business of the cell was insurance business – The cell’s classification was relevant (generally, affects the liability of any person for federal tax or information purposes) and more than half of its business was insurance business – No owner of the cell treated the cell as a separate entity – The cell and the core had a reasonable basis for its claimed classification – Neither the cell nor any owner nor the core was notified before September 14, 2010 that the classification of the cell was under examination . This exception ceases to apply if there is a change in ownership of 50% or more of the interests in the core (or the cell)

29 New Cell Annual Reporting Requirement

. Each cell company and each cell within it will annually file a statement with the IRS containing identifying information "to ensure the proper assessment and collection of tax” . The statement would be a stand-alone filing due March 15 of each year . The IRS is seeking taxpayer written comments by 12/13/10 on this statement requirement and several other issues, including: – whether a cell is a separate entity if it has no assets or conducts no activities – whether a series with no members should still be treated as a 30 separate entity Latest Development – ICC’s

. ICC = Incorporated Cell Company . Originated in Jersey (Not New Jersey) . Adopted by DC in 2009; VT and MT in 2011 . Legislation passed & regs pending in Cayman; Bermuda considering . By statute, each cell is a distinct legal entity and can have its own governing body (cell walls “higher and thicker”) . Addresses cell participants’ demand for governance input where core owners don’t want to share power 31

Latest Development – ICC’s

. Difficult to characterize legal relationship between core and its cells – not a parent/subsidiary (but inter-IC contracts clearly are valid) . Tax status is clearer – each cell is a separate tax-payer, likely eligible to file a consolidated federal tax return with its occupant/participant (if domestic or with an IRC Sec. 953(d) election) . Insolvency law status also is clearer – each cell is a separate juridical person; usual rules to apply creditor hierarchy only within a cell; must apply “piercing the corporate veil” case law to cut through IC wall 32