(EOs) form and operate a captive insurance company.

These organisations include structures like hospitals, health care systems, colleges and YMCAs.

Bermuda is one of the largest US-parented captive domiciles and Bermuda managers and practitioners have to constantly update their knowledge of all tax implications for their clients.

Captive insurance companies are wholly owned subsidiary companies that insure some or all of their parents' risks.

Probably one of the most recently highlighted examples of a Bermuda captive with a US EO parent is the AME church captive but there are many others registered in the Island.

Tom Jones, head of the captive legal/tax team at US lawyers McDermott, Will & Emery, discusses the issues relating to tax considerations for offshore EO captives in this month's issue of `Captive Insurance Company Reports'.

"Ascertaining the proper tax characterisation of the risk funding arrangement as qualifying or failing to qualify as `insurance' for tax purposes is always important,'' said Mr. Jones.

He points out the Internal Revenue Code (IRC) in the US was amended in 1996 to clarify the law on taxation of EOs that own offshore captives. He also noted that although captive domiciles, such as Bermuda, impose no corporate income taxes, captives formed outside the US are ineligible for US EO status.

"Thus, if they do business in the US they will become subject to direct federal income taxation, including the possibility of second tier branch profits tax,'' he said.

He stated that prior to the 1996 amendments, Internal Revenue Service (IRS) private letter rulings consistently concluded that owning a single-parent offshore captive does not adversely affect the exempt status of an EO.

In a 1990 ruling, the IRS allowed an offshore hospital captive to retain its favourable tax status while covering professional and general liability of taxable subsidiaries and controlled tax exempt affiliates of the hospital, employees of any of those entities and professional liability of voluntary medical hospital staff.

Mr. Jones said the IRC amendment should not change the favourable tax results previously obtained by EO captives where risks of only members of the same economic family are being funded.

The amendment narrows the prior interpretation of affiliate so that only EOs can be affiliates. Coverage of a for-profit, non-controlled entity, such as a taxable 50/50 owned joint venture, will generate Unrelated Business Taxable Income (UBTI).

But the amendment allows coverage without UBTI of any tax exempt affiliate of the EO that has "significant common purposes and substantial common membership, or directly or indirectly substantial common direction or control'' with the EO.

"This is broader than under the pre-1996 law where for two tax exempt parties to be considered related they must have had a relationship similar to that of a parent/subsidiary,'' said Mr. Jones.

Multi-owner offshore EO captives were more vulnerable than single-parent captives to causing UBTI in the hands of EO shareholders. Under the terms of the amendment the "look through'' approach is mandated with the result, said Mr. Jones, that unless an exception applies virtually all multi-owner risk-sharing offshore EO captives writing coverage for at least a few unrelated EO owners will generate UBTI in the hands of these owners.

One of the exceptions to these rules is where the EO participants in the offshore multi-owner captive establish separate cells such that no risk-sharing or risk distribution can occur, no insurance income would exist, so favourable single parented EO captive treatment would seem to be warranted.