The tax climate in the United States has never been better for the formation of captive insurance companies, according to a leading tax expert.

Tom Jones, partner at McDermot, Will and Emery, said that the Inland Revenue Service had now taken captives off their hit list - but warned that there could be an "earthquake" in the world of captives if they drew the line between insurance companies and investment vehicles in the wrong place.

Speaking yesterday at the International Captives Congress (ICAP) at the Fairmont Southampton, Mr. Jones told delegates that the IRS was beginning to understand the peculiar way in which captives worked.

And he said that the IRS had to understand that the captive was not set up as a sham offshore in a bid to avoid taxes.

"No captive should be formed to avoid taxes," said Mr. Jones, who regularly advises on formation and structuring of offshore captives, told delegates.

The IRS had been looking into captives to make sure that they are not used for evading taxes. But recently in May 2002, Mr. Jones said that the IRS has "quietly de-coordinated captive insurance issues", which means that a strict list of notes used to regulate the insurance vehicles, had been dropped.

He said: "De-coordination may mean that the IRS is scaling back its efforts to challenge captive insurance arrangements and that, on a going forward basis, captives may be subject to less scrutiny, except in abusive cases."

And he said that this was probably a positive thing for captives in general. "The tax climate in the US is better than it has ever been for captives," said Mr. Jones.

Mr. Jones said that before the IRS had said that if a company wanted to be treated (for tax purposes) like and insurance company,it had to act like an insurance company. But now the IRS was becoming more educated in that the relevant standard in this case was not a commercial insurance company - but there was a huge grey area, especially in the matter of loan back of captive assets to the parent or affiliates.

Mr. Jones said: "The IRS is trying to draw a line in the sand between an insurance company and an investment company. This is going to be difficult - and it could be an earthquake depending on where they draw the line.

"Some innocent insurance companies are going to be labelled and some investment companies are going to be labelled incorrectly as insurance companies."

Catherine Sheridan-Moore, partner at KPMG, who was also a speaker yesterday along with Mr. Jones, said that her company had about 300 calls in regard to a notice put out by the IRS in the fall.

The Notice 2002-70 is a notice in which the IRS may assert that the new company is not an insurance company for US federal income tax purposes.

"This has raised a lot of calls," said Ms Sheridan-Moore.

"We as a firm had 300 calls this year."

Mr. Jones said that this was the so-called Park ruling.

"Right now no one is sure who is in, and who is out."

He pointed to insurance vehicles that used hedge funds and investment companies that used insurance.

"Is it really insurance or is it investment?" he said.