insuranceIn yesterday’s post, we provided an overview of captive insurance entities.  Today, we will consider the specific facts of two different so-called captives, and whether or not they qualified as such according to the Tax Court and the IRS, respectively.

The Captive Arrangement in the Tax Court

In Rent-a-Center v. Commissioner, the Court decided that payments made by a subsidiary corporation to the captive formed by its parent corporation were properly deductible as insurance premiums (ordinary and necessary expenses incurred in carrying on a trade or business).

 

The Court found that the captive was a bona fide insurance company, and that the arrangement shifted and distributed risk to constitute “insurance in the commonly accepted sense.”

The captive was formed to reduce premium costs, improve efficiency, and obtain otherwise unavailable coverage. The parent corporation “made a business decision premised on a myriad of significant and legitimate nontax considerations,” and the captive entered into bona fide arm’s-length contracts with the parent, charged actuarially determined premiums, was subject to regulatory control, met minimum statutory requirements, paid claims from its separately maintained account, and was adequately capitalized. The Court concluded that there was indeed risk shifting, and that the captive “was a separate, independent, and viable entity” that “reimbursed [the parent’s] subsidiaries when they suffered an insurable loss.” The Court thus determined that, under the facts and circumstances of these case, the policies at issue were insurance, and the parent was entitled to deduct the premiums as reported on its returns.

The Captive Arrangement in the IRS Ruling

Taxpayer Group manufactured and marketed products and services. Taxpayer Group included a captive insurance company (Captive), which was regulated under state law. Captive provided coverage to the Taxpayer Group for automobile liability, products and general liability workers’ compensation, product warranty, credit guarantee insurance, earthquake damage coverage, retiree medical cost coverage, and guaranteed renewable accident and health insurance.

Because Taxpayer Group conducted business throughout the world, “sales and purchases in currencies other than the U.S. dollar expose [Taxpayer Group] to fluctuations in foreign currencies relative to the U.S. dollar and may adversely affect [Taxpayer Group’s] results of operations and financial condition.”

Taxpayer Group began to explore avenues for mitigating this risk, including the possibility of insuring earnings losses arising from foreign exchange fluctuations through Captive.

Parent entered into contracts with Captive on behalf of various members of the Taxpayer Group regarding the risk arising from fluctuations in the rate of exchange between the U.S. dollar and certain foreign currencies.

Captive agreed to indemnify, up to a stated limit, the participating members of the Taxpayer Group for the amount of “loss of earnings” connected to a decrease in the value of each specified foreign currency relative to the U.S. dollar. Captive also agreed to indemnify the participating members for the amount of “loss of earnings” connected to an increase in the value of each specified foreign currency relative to the U.S. dollar up to a stated coverage limit.

The contracts had many features commonly found in insurance policies. Many members of the Taxpayer Group participated in the arrangement. It was anticipated that no one participant would account for more than 15 percent of the premiums paid to Captive. There was no mention of any parental guarantee, premium loan back, or other aspect of the arrangement that would be inconsistent with a bona fide insurance arrangement.

The IRS’s Position

In general, neither the Code nor the Regulations issued thereunder define the terms “insurance” or “insurance contract” for income tax purposes. Rather, the standard for evaluating whether an arrangement constitutes insurance for federal tax purposes is a nonexclusive facts and circumstances analysis. The courts have described “insurance” as an arrangement involving risk-shifting and risk-distributing of an actual “insurance risk” at the time the transaction was executed.

Cases analyzing “captive insurance” arrangements have described the concept of “insurance” for federal income tax purposes as having the following three elements:

  1. An insurance risk;
  2. shifting and distributing of that risk; and
  3. insurance in its commonly accepted sense.

The test, however, is not a rigid three-prong test.

The predicate of insurance is “insurance risk.” The risk must be the risk of an economic loss. The failure to achieve a desired investment return is an investment risk, not an economic loss giving rise to an insurance risk, at least for tax purposes.

The IRS conceded in prior rulings that insurance premiums paid between related corporations may be insurance for tax purposes. In one ruling, The IRS held that an arrangement between a licensed insurance subsidiary of parent, and each of the 12 of parent’s operating subsidiaries constituted insurance where, among other factors, no one subsidiary accounted for less than 5 percent nor more than 15 percent of the total risk insured by the insurance subsidiary. In the ruling the insurance subsidiary was adequately capitalized, it charged arm’s length premiums established according to customary industry rating formulas, there was no parental guarantee or premium loan backs, and the parties conducted themselves in a manner consistent with the standards applicable to an insurance arrangement between unrelated parties.

Insurance Risk?

The IRS concluded that the arrangement at issue in the ruling was not insurance because it lacked insurance risk and were not insurance in its commonly accepted sense.

According to the IRS, not all contracts that transfer risk are insurance policies, even where the primary purpose of the contract is to transfer risk. For example, a contract that protects against the failure to achieve a desired investment return protects against investment risk, not insurance risk.

Insurance risk requires a fortuitous event or hazard, and not a mere timing or investment risk. A fortuitous event (such as a fire or accident) is at the heart of any contract of insurance – the risk must contemplate the fortuitous occurrence of a stated contingency, not an expected event.

When evaluating whether an arrangement constitutes insurance for tax purposes, the IRS said, the first inquiry is whether the subject risk is properly viewed as an “insurance risk” or as a risk of another nature, such as investment or “business” risk.

The IRS addressed the question: “What is an investment or business risk?” Someone buys stock with the intent to make a profit. That risk of success is an investment risk. A business owner invests capital in a business enterprise with the intent to make a profit. The IRS noted that a business has an unlimited number of economic risks. Are all of these economic risks insurance risks? Is a business risk an investment risk of a business?

In deciding whether a contract does not qualify as an insurance contract for federal tax purposes because it involves an investment or business risk, the IRS submitted that all of the facts and circumstances associated with the parties in the context of the arrangement should be considered. One should take into account such things as the ordinary activities of a business enterprise, the typical activities and obligations of running a business, whether an action that might be covered by a policy is in the control of the insured within a business context, whether the economic risk involved is a market risk that is part of the business environment, whether the insured is required by a law or regulation to pay for the covered claim, and whether the action in question is willful or inevitable.

The IRS concluded that the risk involved in the arrangement under consideration was an investment-type risk as it was solely the manifestation of currency valuation.

The participants were primarily interested in selling their goods and services at a profit. They had an economic risk that they would not make a profit on the sale of those goods and services (without regard to foreign currency exchange rates). This risk was an economic risk which was an investment (or business) risk.

The existence of foreign currency exchange rate protection did not change the investment risk of making a profit on the sale of goods or services. It only reduced that risk. Thus, the IRS noted, a seller of goods or services can purchase options on the open market to protect against currency fluctuations or enter into a contract arrangement similar to the contracts at issue. The economic effect is the same. The investment risk was not an insurance risk and therefore the contracts were not insurance.

Taxpayer’s obligation did not arise because of an event that damaged or impaired the protected asset or its income stream. The contracts explicitly limited Taxpayer’s liability if there was damage or impairment to the asset commonly associated with a casualty event, such as losses covered under property insurance or business interruption insurance.

The contracts indemnified for the amount of loss of earnings sustained due to an increase (or decrease) in the value of specified foreign currency relative to the U.S. dollar. Various market forces can affect foreign currency exchange rates, but the occurrence of these events was not the casualty event.

Planning Ahead

The ruling and other authorities described above are instructive. They recognize that a captive arrangement may be accepted for tax purposes, provided it is structured and maintained in an arm’s length manner, and it addresses bona fide business-related insurance risks.

Thus, a taxpayer who is genuinely looking to manage its casualty exposure and insurance costs may be well-served in considering the creation of a captive arrangement.

A taxpayer whose primary purpose for utilizing a captive arrangement does not fit within these parameters should think twice before doing so.