Non-Profit & Tax Exempt Entities Tax and Regulatory Issues

1. Cayman Captive Forum 2013 – Pre-Forum Tutorial The Ritz Carlton Grand Cayman, Cayman Islands December 3, 2013 Non-Profit & Tax Exempt Entities Tax and Regulatory Issues Tom Jones, Partner McDermott Will & Emery LLP Rick Irvine, Partner PwC Bermuda

2. Contact Information Tom Jones Rick Irvine PricewaterhouseCoopers Dorchester House 7 Church Street Hamilton, Bermuda Tel: (441) 299-7136 Email: richard.e.irvine@bm.pwc.com McDermott Will & Emery LLP 227 West Monroe Street Chicago, IL 60606-5096 Tel: (312) 984-7536 E-mail: tjones@mwe.com McDermott Will & Emery and PwC technical presentation

3. Circular 230 Disclosure This document was not intended or written to be used, and it cannot be used, for the purpose of avoiding U.S. federal, state or local tax penalties. McDermott Will & Emery and PwC technical presentation

4. Choosing the Right Form FACTORS: Tax Status of Parent/Founder(s) Number and Tax Status of Potential Insureds Related or Unrelated Status of Potential Insureds Homogenous/Divergent Nature of Insureds Activities Earnings Retention Objectives Extent of Experience Rating Desired Flexibility Desired Typical Policyholder Retention Pattern Desire to Minimize Operational Costs Goal to Entrench Founders/Promoters McDermott Will & Emery and PwC technical presentation

5. Captive Legal/Regulatory Issues 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 abuse) Management/governance (directors and committees) Coverage and policy questions Choice of form (stock/mutual/reciprocal) (onshore vs. offshore) McDermott Will & Emery and PwC technical presentation

6. Taxation of Non-Profit Owned Captives The key tax question: Is it treated as insurance? McDermott Will & Emery and PwC technical presentation

7. Tax Definition of “Insurance” No clear-cut definition in tax law Must analyze case law and IRS rulings Captive with tax exempt parent prefers to avoid “insurance company” tax status for itself and for its parent But unrelated voluntary physicians seek premium deductibility McDermott Will & Emery and PwC technical presentation

8. Basic Requirements For insurance treatment, the U.S. Supreme Court held 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” Insurance risk must be present versus “investment” risk Common Notions of Insurance must be present McDermott Will & Emery and PwC technical presentation

9. Onshore Hospital Captives – Tax Status If captive funds risk of only its tax exempt parent and employees, then domestic captive can obtain an IRS “determination letter” granting tax exempt status Easier to obtain if captive formed as a non-profit membership company with no shares issued (VT, HI, DC permit this form) Must file IRS Form 1023 with a description of intended activities – cannot cover non-employed physicians or third parties if “substantial” portion of business (5%-10%) Thus limited scope of captive activities if onshore – covering >10% ineligible parties can cause all income of the domestic captive to become fully taxable If not “tax exempt” then captive may be subject to corporate level tax on investment, unrelated voluntary physicians premiums and other sources of income McDermott Will & Emery and PwC technical presentation

10. Offshore Hospital Captives - Tax Issues No corporate income taxes in the Cayman Islands Offshore captives are not tax-exempt – so they can accommodate addition of non-employed physicians, but there may be tax ramifications Federal excise tax (FET) on premiums (inbound or outbound) Unrelated business taxable income to captive’s U.S. shareholder – on net income from covering “voluntary attending physicians” or non-controlled entities But unlike onshore captives, covering third parties may generate some tax but it does nottaint the entire captive – this is the principal reason most captives owned by tax exempt hospitals are domiciled offshore McDermott Will & Emery and PwC technical presentation

11. Advantages of Non-Insurance Status for Tax Exempt Owner of Offshore Captive Inbound premiums paid generally not subject to a federal excise tax (4% of the premium for direct insurance and 1% for reinsurance or life insurance) Except for premiums from unrelated voluntary physicians Can avoid attribution of any “unrelated business taxable income” to captive’s tax-exempt parent Except for insurance income from unrelated voluntary physicians State premium tax - known as (i) “direct placement” tax or (ii) “self-procurement” tax or (iii)) “independently procured insurance” tax would apply (about 30 states impose this type of tax) with 3% rate typical Note domestic captives must pay low rate of premium tax (< .5%) in most states + DC (but not AZ or UT); no premiums tax in offshore domiciles like the Cayman Islands. McDermott Will & Emery and PwC technical presentation

12. Avoiding a U.S. Trade or Business Foreign insurance companies operating offshore generally not subject to direct U.S. taxation Indirect U.S. taxation can occur if captive owned by U.S. shareholders (e.g., Subpart F, PFIC rules) However, a foreign insurer may be subject to direct U.S. tax if it is considered to be engaged in a U.S. business (or has a U.S. “permanent establishment” where a tax treaty is involved) Net income taxed at 35% (determined under U.S. income tax rules) Additional 30% branch profits tax on amount withdrawn from U.S. Total tax rate as much as 54.5%! Or makes an election under IRC §§953(d) or 953(c)(3)(C) Also potential state insurance regulatory problems if captive is conducting an unauthorized business of insurance onshore McDermott Will & Emery and PwC technical presentation

13. Avoiding a U.S. Trade or Business To avoid being engaged in a U.S. trade or business, foreign insurer should: Hold board meetings outside U.S. Execute contracts (including issuance of policies, investment management agreements) outside U.S. Approve asset allocation policy outside U.S. Use only independent agents in the U.S. Avoid having risk management employees as officers or board members of foreign insurer; he/she should present claims report, etc. in capacity of consultant to the board Issue indemnity rather than “pay on behalf of” policies McDermott Will & Emery and PwC technical presentation

14. Offshore Captive Investments All dividends paid on equities (common and preferred shares, ETFs) of U.S. issuers (except American Depository Receipts) No 30% tax on: bond portfolios comprised of individual bonds that meet the portfolio interest exception Tax exempt bonds and U.S. government bonds, notes “Clone” bond funds formed in Ireland (UCITS) or Luxembourg (SICAVs) avoid this tax under applicable U.S. tax treaties (but generally higher fees and commissions) U.S. source capital gains (long term or short term) Certain income of U.S. regulated investment companies, e.g., “RIC’s” or “mutual funds” (exception is due to expire unless re-enacted by Congress on 1/1/14) Avoid investments taking the form in the U.S. as trusts or partnerships which may “throw off” Effectively Connected Income or ECI • A 30% non-recoverable federal “withholding” tax is imposed on certain U.S. investments: McDermott Will & Emery and PwC technical presentation

15. 1996 Federal Income Tax Legislation Applicable toOffshore Captives Owned by Tax Exempt Organizations • Insurance income (e.g., underwriting and investment) generally creates “unrelated business taxable income” to tax exempt owners but does not cause the entire captive to become fully taxable as with domestic captives • IRC §512(b)(17) imposes a “look through” rule invoking IRC §501(m) “commercial type insurance” UBTI on Subpart F allocation of “insurance income” (includes both underwriting and investment income) • Special exemption for offshore group captives formed by exempt hospitals, colleges and universities exclusively using policyholder (not shareholder) dividends McDermott Will & Emery and PwC technical presentation

16. 1996 Federal Income Tax Legislation Applicable toOffshore Captives Owned by Tax Exempt Organizations • Certain tax exempt affiliates are considered within the economic family if “significant common purposes and substantial common ownership” exist • In general, captive’s coverage of “hospital based” physicians (e.g., ED, pathology, radiology, etc.) groups under exclusive contract with hospital do not create UBTI • Note: IRC §512(b)(17) is inapplicable if no “insurance” is present (e.g., most single parent captives are unaffected) McDermott Will & Emery and PwC technical presentation

17. U.S. Tax Compliance – Offshore Captives The captive’s U.S. shareholder(s) ma file annually the following forms: IRS Form 5471: Typical single parent hospital shows captive as an investment rather than an insurance company IRS Form 926: report all transfers to captive as capital contributions Other potential forms for company and/or U.S. shareholders: Treasury Form TD F 90-22.1 IRS Form 1120-F (Protective Filing) IRS Form 720 (Federal Excise Tax or FET) Potential FATCA Foreign Financial Institution agreement and required withholding and informational reporting Form 8938 Foreign Financial Assets (U.S. individuals only) Form 8621 Passive Foreign Investment Company McDermott Will & Emery and PwC technical presentation

18. U.S. Tax Compliance (Continued) • Treasury Form TD F 90-22.1: all U.S. persons must disclose a financial interest in or signatory authority over foreign bank or other financial accounts if balance > $10,000 at any time: • Includes captive’s parent plus any U.S. citizens or residents • Always on calendar year basis • No extensions given • Due June 30 – must be e-filed starting 6/30/14 • Applies to offshore bank “operating” accounts and foreign mutual fund investments (which are available to the general public and have a regular net asset value) • Foreign hedge funds and private equity funds are currently not included as a financial account McDermott Will & Emery and PwC technical presentation 18

19. 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 year 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 McDermott Will & Emery and PwC technical presentation

20. U.S. Tax Compliance (Continued) IRS Form 720 Federal Excise Tax Filing: Quarterly filing to report excise tax on insurance/reinsurance premiums Reinsurance premiums ceded by captive is subject to FET Timely deposit of FET is required Potential IRS Form 8833 treaty-based return position disclosure required for United States risk insured/resinsured with a counter party resident in a treaty country which has entered into a closing agreement with the IRS (obtain copy of the closing agreement for records) to exempt FET Non-insurance company offshore captives incur 4% FET on “reinsurance” purchased from non-treaty protected reinsurers (e.g., Bermuda, Cayman and Barbados) McDermott Will & Emery and PwC technical presentation 20

21. U.S. Tax Compliance (Continued) The captive’s U.S. officer’s and directors must file the following forms: IRS Form 5471 If a “U.S. Shareholder obtains 10% or an additional 10% interest in a foreign corporation McDermott Will & Emery and PwC technical presentation 21

22. Foreign Account Compliance Tax Act (FATCA) • Enacted by Congress in 2010 to detect & prevent offshore tax evasion enforced via a new federal withholding tax; now effective 7/1/14 • 30% tax on payments from U.S. unless Cayman hospital captive, a “Non-Financial Foreign Entity” (NFFE), supplies IRS Form W-8BEN-E to U.S. payers • Cayman hospital captive (holding an insurance license) will be a NFFE, not a “Foreign Financial Institution” (FFI) which under more onerous rules must register with & file reports to IRS to avoid 30% tax • Next step: setting up a plan so hospital captive timely provides Form W-8BEN-E to U.S. payers for 2014 money transfers • Note Cayman announced it will sign an Intergovernmental Agreement (IGA) with the IRS so FFIs can report to Cayman Government which will share data with IRS – but N/A to NFFEs like hospital captives McDermott Will & Emery and PwC technical presentation 22

23. Summary of Offshore Single U.S.Tax Exempt Owner Captive Status Assumes only institutional & employee risks are being funded Not an “insurance company” for tax purposes No federal excise tax imposed on premiums ceded to captive No “unrelated business taxable income” to sole S/H “Premiums” are not deductible for taxable affiliates No violation of state insurance law No captive activity in state where risks are located Self-funding, not true insurance Policyholders representing most of the premium also could qualify as “industrial insureds” in 22 states with favorable statutes Foregoing not changed with coverage of employees or controlled affiliates But major changes if non-employed physician practices are covered in the future McDermott Will & Emery and PwC technical presentation

24. U.S. Healthcare Law Reform – Impact on Captives McDermott Will & Emery and PwC technical presentation

25. The Underlying Law • March 23, 2010: Patient Protection and Affordable Care Act (a/k/a “PPACA” or the “ACA” or “Obama-care”) enacted • Law includes a number of provisions designed to: • Improve the quality of Medicare services • Support innovation • Establish new payment models • Better align Medicare payments with provider costs • Strengthen Medicare’s financial footing McDermott Will & Emery and PwC technical presentation

26. Every Picture Tells A Story • A Graphic Explanation of Health Care Reform … What we had to what we now have ……. McDermott Will & Emery and PwC technical presentation

27. www.mwe.com

28. 28 www.mwe.com

29. The Goal • All sides agreed on reform objectives • Delivery system reform (e.g., Accountable Care Organizations (ACOs)) • Wellness and prevention (e.g., Medical Homes) • Need for cost containment (e.g., Bundled Payments) McDermott Will & Emery and PwC technical presentation

30. Hospitals’ Rush to Hire Physicians:The Future Model All across the country hospital systems are employing physicians at an unprecedented rate. Impacts to be considered include: Financing of tail coverage Increased loss exposure in hospital captives Need for increased attention to underwriting by captives Claim management demands Adjustments to actuarial models Excess market attachment points Reduced commercial market share as physicians leave private practice Increased focus on ART programs as hospital-owned captives grow in numbers and size McDermott Will & Emery and PwC technical presentation

31. % of Physician Practices Owned by Hospitals/Health Systems 2005: 25% 2008: 50% 2015: ????????? Source: Medical Group Management Association McDermott Will & Emery and PwC technical presentation

32. The Existing Structure Medical Staff Employed Physicians Community Physicians Hospital Insurance Source: Commercial, RRGs Insurance Source: Hospital-Owned Captive Reinsurance Market Reinsurance Market McDermott Will & Emery and PwC technical presentation

33. The New Structure Hospital System Physicians ACO Hospital Captive Future Alignment Strategies • Physician employment (including foundation models) • Leasing arrangements with physician groups • Inclusion of unrelated assisted living, rehabilitation, home healthcare, etc. facilities • Management ventures: cardiac care, women’s health, cancer care, etc. • A possible combination of some or all of the above Reinsurance Market McDermott Will & Emery and PwC technical presentation

34. Private Physicians in a Hospital Captive: The Current and Past Model • Historically, professional liability insurance presented an opportunity to align hospital and physician interests in quality improvement, patient safety and risk management through a joint risk funding vehicle • The risk funding vehicle most commonly used is a hospital-owned “captive” insurance company • Inclusion of voluntary physicians (i.e., non-employed physicians) in the hospital’s risk funding vehicle, such as a captive, requires navigation through a number of obstacles, including insurance regulatory, tax and health care fraud and abuse laws • These issues do not apply to hospital employed physicians McDermott Will & Emery and PwC technical presentation

35. Why Cover Non-Employed Physicians in the Hospital’s Captive? • They are largely the hospital’s risk already – vicarious liability and other theories of “deep pocket” liability • Hospitals can improve quality and enhance the hospital’s own risk management program by aligning hospital and physician interests • Physicians sometimes ask for help • High malpractice premiums in many states, including crises in NY and NJ • Carriers leaving the market or suffering ratings downgrades • High cost of “tail” (extended reporting period) coverage if physician moves • MICRA in effect in California since 1975 on the ballot next year • In the past, physicians retired or relocated rather than paying escalating commercial premiums McDermott Will & Emery and PwC technical presentation

36. Overview of Concerns Applicable to Covering Non-Employed Physicians • State insurance regulatory issues • Health care regulatory issues • Financial relationships between hospitals and physicians trigger legal concerns that are unique to the health care arena • Any element of a physician program that can be characterized as subsidizing physicians or providing non-commercially reasonable terms triggers Medicare fraud and abuse issues and, for tax exempt hospitals, private inurement/tax exemption concerns McDermott Will & Emery and PwC technical presentation

37. Covering Independent Physicians – Insurance/Regulatory Issues • Coverage of only a hospital, its employees and controlled affiliates generally is not considered to be the “business of insurance” and does not trigger state insurance regulation • Extending coverage to “voluntary attending physicians” (i.e., non-employed physicians) rather than only a hospital and controlled affiliates generally will be considered the “business of insurance,” triggering insurance regulation issues • Addressing these issues primarily depends on the law of the state where risks being pre-funded are located • Often the only “safe” solution is to engage a fully licensed “fronting” carrier (e.g., CNA or Lexington) to write the physician coverage and reinsure it with the captive (requires providing collateral to the “front”) McDermott Will & Emery and PwC technical presentation

38. Sources of Health Care Fraud and Abuse Legal Guidance • The law: Two key federal fraud and abuse laws affect hospital financial relationships with physicians: • Anti-Kickback Law • Stark Law • The analysis to determine whether an arrangement is permitted for fraud and abuse purposes generally is parallel to the “private inurement” analysis for tax-exemption purposes • Key is to avoid any tax exempt hospital subsidy of private physician premiums McDermott Will & Emery and PwC technical presentation

39. Establishing Absence of Subsidy • Premiums must be actuarially determined • Actuarially determined premiums may be less than commercial premiums, for reasons such as: • Joint defense • Participation in enhanced risk management • Other differences between captive and commercial premium calculation McDermott Will & Emery and PwC technical presentation

40. PPACA Impact on Offshore Captives 39 • Because more physicians are becoming hospital employees to support integrated clinical services and financial incentives • Legal reason for a captive may disappear since an onshore trust legally can fund the institutional & employed physician liability risks • But strong counter-arguments for keeping captive include access to reinsurers & focus on patient safety due to captive’s enhanced RM • Offshore captives could especially benefit from ACO risk funding (which involves covering unrelated partners, JVs, etc.) • Onshore captives can write only 5-10% unrelated risk without being fully taxed • But offshore captives can write up to 50% unrelated risk with only minor taxes

41. Future Speculative Contingencies Providers get fixed fee for an indeterminate amount of care Places providers in a position of incurring “patient utilization” risk Perhaps some of the “downside” exposure of providers can be pre-funded in a captive www.mwe.com 41 McDermott Will & Emery and PwC technical presentation

42. Developments in the Cayman Islands for Captives McDermott Will & Emery and PwC technical presentation

43. Why Cayman? Proven Track Record – Harvard Medical Started in ’78 • Flexible but responsible regulatory regime • Healthcare focus (almost half its captives) • Strong medical malpractice infrastructure/orientation • Major federal tax advantages offshore for U.S. tax exempts McDermott Will & Emery and PwC technical presentation

44. The Cayman Regulatory Environment Judicious discretion with limited statutory rules Cayman’s Insurance Act provides the basic framework The Cayman Monetary Authority sets financial parameters using a holistic approach and “rules of thumb” rather than rigid rules The captive’s filed business plan, as amended from time to time, establishes its responsibilities and undertakings By statute the local insurance managers play a contingent but important regulatory role McDermott Will & Emery and PwC technical presentation

45. Directors’ Duties Under Cayman Law 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 McDermott Will & Emery and PwC technical presentation

46. New Cayman Insurance Law • Enacted in 2010, effective 11/1/12 • Motivators: IMF compliance and Hurricane Ivan domestic property insurance aftermath Key elements: • Greater oversight of Class A license holders (writers of Cayman risks) • Splits Class B into three categories – • B-1: 95% or more related party risk • B-2: > 50% related party risk • B-3: < 50% related party risk • New Class C for SPVs (Special Purpose Vehicles) like “cat” bonds, insurance linked securities and other “transformers” • New Class D for commercial reinsurers • Expands non-compliance penalties & whistle blowing provisions McDermott Will & Emery and PwC technical presentation 46

47. New Cayman Insurance Law Impact on health care captives: • Should have little or no effect on most single hospital parent captives • Main reason is favorable definition of “related party” risk • Measured by the captive’s net written premium (retained/not reinsured) • Includes not just parties under common ownership or legal control of the hospital, but also parties participating in the hospital’s common risk management plan • Thus, most “joint” professional liability insurance programs that include independent (voluntary attending) physicians or joint ventures should remain in the Class B-1 category of license holder McDermott Will & Emery and PwC technical presentation

48. General Background on Cell Captives 47

49. Overview Generic term – “cell” company Developed from inherent weakness in attempted segregation in traditional contractual rent-a-captives Cells are comprised of separately identified and legally segregated assets and liabilities within a single company statutorily “firewalled” from each other Guernsey was the first in 1997; others quickly followed; upwards of 50 jurisdictions today including a number of US states Cayman law enacted in 1998 Cayman: a cell is called a “segregated portfolio” and the entity is called a “segregated portfolio company“ Cayman – 30 September 2013: 137 Segregated Portfolio Companies with 589 cells out of 755 captives September 13, 2010 IRS issues Proposed Regulations which would treat foreign “cells” engaged in an insurance business as separate entities for U.S. tax purposes McDermott Will & Emery and PwC technical presentation

50. Varied Uses of Cell Captives What types of captive programs are in cells? • Hospital/clinics/independent physicians • Combining 2 captives into 1 post-merger • Collaborative efforts by unrelated healthcare providers • Pure/single parent risks (conglomerates) - Separation • By product line • By geographic area • Group and/or association shared risks • Transformers, funds & financial guaranty companies • Agency risk participation • Composite insurers – separating life & non-life lines 49