Captive insurer wasn’t “insurance company”
The Tax Court has concluded that the transactions that the taxpayer, a foreign captive insurance company, executed weren’t insurance contracts for Federal income tax purposes and that the taxpayer wasn’t an insurance company exempt under Code Sec. 501(c)(15). As a result, the taxpayer was ineligible to make the Code Sec. 953(d) election to be treated as a domestic corporation. The Court further found that the payments that the taxpayer received for the tax years at issue were subject to the 30% tax imposed by Code Sec. 881(a).
Background. Premiums for insurance against various types of business risks, such as property damage or professional liability, are generally deductible as business expenses. Payments to “captive” insurance subsidiaries or other similar arrangements are not deductible where there’s no true risk-shifting.
Neither the Code nor the regs define the terms “insurance” or “insurance contract”, but the Supreme Court has explained that, for an arrangement to constitute insurance for federal income tax purposes, both risk shifting and risk distribution must be present. Helvering v. Le Gierse, The risk transferred must be risk of economic loss. The risk must contemplate the fortuitous occurrence of a stated contingency, and must not be merely an investment or business risk.
Cases analyzing “captive insurance” arrangements—i.e., ones where a corporate taxpayer places its insurance business with a corporate entity owned by or related to the taxpayer—have described the concept of “insurance” for federal income tax purposes as having the following three elements:
- An insurance risk;
- Shifting and distributing of that risk; and
- Insurance in its commonly accepted sense.
In Rent-A-Center, Inc., the Tax Court concluded that the captive company assumed and pooled premiums for “a sufficient number of statistically independent risks” and achieved risk distribution because it issued policies for its affiliates that covered more than 14,000 employees, 7,100 vehicles, and 2,600 stores in all 50 States. By contrast, in Avrahami, the Tax Court found that the captive company’s issuance of seven types of direct policies covering exposures for four related entities was insufficient to distribute risk.
In Harper Group & Includible Subsidiaries, the Tax Court held that a captive insurer distributed risk because, in addition to insuring affiliated entities, the captive provided coverage to and collected premiums from a relatively large number of unrelated insureds. The Court considered the percentage of the captive’s gross premiums that was derived from unrelated insurance business, and found that approximately 30% of the captive’s business came from insuring unrelated parties. The Court concluded that this fact demonstrated that the captive had a sufficient pool of insureds to provide risk distribution.
Small nonlife insurance companies may qualify for tax exemption if they meet the requirements of Code Sec. 501(c)(15). Nonlife insurance companies (including inter-insurers and reciprocal underwriters) may qualify for tax exemption if
- The company’s gross receipts don’t exceed $600,000, and
- 50% or more of those gross receipts consist of premiums.
For nonlife mutual insurance companies, gross receipts cannot exceed $150,000 and 35% or more of those gross receipts must consist of premiums.
Under Code Sec. 953(d), a foreign corporation may elect to be taxed as a domestic entity if the corporation would qualify under the Code as an insurance company if it were a domestic entity, and it meets certain other requirements.
Code Sec. 881(a)(1) generally imposes a tax of 30% on “fixed or determinable annual or periodical” (FDAP) income received from sources within the U.S. by a foreign corporation if the income is not effectively connected with the conduct of a U.S. trade or business. FDAP income includes interest, dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, and emoluments. Reg § 1.1441-2(b)(1)(i) provides that FDAP includes all income included in gross income under Code Sec. 61, except for items specifically excluded by the regs.
Facts. Reserve was incorporated in Anguilla in 2008 as an insurance company. Its stock was owned 100% by Peak Casualty Holdings, LLC (Peak Casualty), which in turn was owned 50% each by Norman Zumbaum and Cory Weikel. In addition, Zumbaum and Weikel equally co-owned 100% of the membership interests in two limited liability companies which were treated as partnerships for Federal income tax purposes: RocQuest, LLC (RocQuest), and ZW Enterprises, LLC (ZW).
Zumbaum and Weikel contacted Capstone Associated Services, Ltd. (Capstone) which offered insurance-related services, including captive feasibility studies, assistance with regulatory filings, accounting, and other services related to forming a captive insurance company. It offered a “turnkey” administrative program to help small and intermediate size captives overcome transaction costs. Capstone charged Reserve approximately $15,000 a quarter for such services, including disbursements on Reserve’s behalf.
For the years at issue (2008 – 2009), Reserve issued direct written insurance policies, with Peak, RocQuest, and ZW as the named insureds on each policy. All of the policies showed one premium price and did not specify amounts to be paid by each insured. All of the policies provided that the coverage was only to be in excess of coverage provided by other policies by other insurance companies. During the tax years at issue, Peak maintained its insurance coverage with its previous third-party commercial insurers.
Reserve issued 13 direct written insurance policies for 2008, and 11 for 2009 and 2010, with Peak, RocQuest, and ZW as the named insureds. Each policy listed PoolRe Insurance Corp. (PoolRe) as the stop loss insurer. Capstone administered PoolRe’s operations and maintained the books and records for PoolRe.
In addition, during the tax years at issue, around 55 Capstone entities executed the same quota share arrangement with PoolRe, under which PoolRe gave stop loss endorsements for the captives’ direct written policies and agreed to assume an excess portion of the risks associated with those policies. Simultaneously, the captives agreed to reinsure, and to receive premiums for reinsuring, a share of blended risk from PoolRe’s stop loss pool. Reserve contended that, pursuant to the quota share arrangement, it “insured hundreds of unaffiliated insureds under hundreds of unaffiliated insurance policies”.
Reserve also contended that it distributed risk through its coinsurance contracts. Under the terms of these contracts, it assumed liability for a fraction of the pool of vehicle service contracts that CreditRe Reassurance Corp., Ltd. (CreditRe) ceded to PoolRe for the tax years at issue. Reserve maintained that the liabilities for these vehicle service contracts were pooled and ceded down a chain of entities, and ultimately CreditRe ceded a portion of the pooled risk to PoolRe. The coinsurance contracts provided that PoolRe ceded portions of its liability for the vehicle service contracts to Reserve.
Because of the payments that PoolRe agreed to make pursuant to the quota share arrangement and the payments called for under the coinsurance contracts, Reserve contended that over 30% of its gross premiums for each of the tax years at issue was from providing insurance to unrelated parties. Citing Harper Group in support, Reserve argued that its percentage of nonaffiliated premium income was sufficient to satisfy the requirements of risk distribution.
Court’s conclusion. The Tax Court determined that Reserve’s transactions were not insurance transactions.
Direct written policies. During the tax years in issue, Reserve issued between 11 and 13 direct written policies for three insureds that covered between $8 and $13 million in potential losses. However, the record showed that the operations of RocQuest and ZW were insignificant and that most or all of the risk of loss was associated with the business operations of just one insured, Peak. The Court concluded that the number of insureds and the total number of independent exposures were too few to distribute the risk that Reserve assumed under the direct written policies. Like the taxpayer in Avrahami, Reserve failed to achieve risk distribution through the policies that it issued for its affiliated entities.
Further, under the stop loss endorsements, PoolRe was liable on claims made under the direct written policies only after a substantial claims threshold was exceeded.
Reinsurance agreements. To determine whether Reserve effectively distributed risk through its reinsurance agreements, the Court first had to determine if PoolRe was a bona fide insurance company. It concluded it was not. As a result, the purported reinsurance agreements between it and Reserve did not allow Reserve to effectively distribute risk.
Quota share arrangement. The Court found that Reserve’s quota share policies with PoolRe were not bona fide insurance agreements. The quota share arrangement involved a circular flow of funds with the end result that, for each tax year, Reserve would receive payments from PoolRe in exactly the same amount as the payments that PoolRe was entitled to receive from Peak and the other insureds for the stop loss coverage. The premiums were not negotiated at arm’s length, as the perfect matching of payments under the corresponding stop loss endorsements and quota share policies (from insureds to PoolRe, and from PoolRe to captives) indicated. Although Peak’s risks that were insured through PoolRe were different from the risks that PoolRe ceded to Reserve under the quota share policies, all the insureds of the participants in the quota share arrangement were obligated to pay the same percentage of premiums to PoolRe. There was no evidence that the premiums Peak and the other insureds were obligated to pay PoolRe and the premiums that PoolRe was obligated to pay Reserve were actuarially determined. The Tax Court found that such a one-size-fits-all rate for all the participants in the quota share arrangement raised concerns. PoolRe’s activities as they relate to those policies were not those of a bona fide insurance company.
The facts indicated that Reserve did not enter into the quota share arrangement with the intention of distributing its risk. For each of the tax years in issue, the arrangement cycled a portion of the premiums that Peak paid under the direct written policies from one controlled entity to another, that is, to Reserve, which was not taxed on the income pursuant to Code Sec. 501(c)(15). The only purpose PoolRe served through the quota share arrangement was to shift income from Peak to Reserve.
Coinsurance contracts. The Tax Court concluded that the coinsurance contracts were not bona fide reinsurance agreements. Reserve failed to show that vehicle service contracts, which formed the basis for the reinsurance that PoolRe re-ceded in the coinsurance contracts, actually existed. And even if the Court agreed with Reserve about the validity of the coinsurance contracts, any actual risk that PoolRe had in connection with the vehicle service contracts was de minimis because PoolRe assumed liability for a small, blended portion of the overall pool of vehicle service contracts, and it re-ceded most or all of that liability to the Capstone entities. The amount ceded to Reserve was also de minimis.
Insurance in the commonly accepted sense. While Reserve was organized and regulated as an insurance company and satisfied the regulatory requirements of its domicile jurisdiction, the Tax Court determined that Reserve was not operated as an insurance company in the commonly accepted sense. The parties to Reserve’s insurance transactions did not participate in structuring or executing these transactions; little or no due diligence was performed with respect to the direct written policies or the reinsurance agreements; and for all of the tax years in issue, only one claim was filed under Reserve’s policies, and that claim was handled in an irregular manner. Capstone directed Reserve’s activities and directed a series of transactions between its managed entities so that Reserve appeared to be engaged in the business of issuing insurance contracts.
There was no legitimate business purpose for the policies that Reserve issued for the insureds. The facts did not reflect that Peak had a genuine need for acquiring additional insurance during the tax years in issue. There was no significant history of losses that would justify such a drastic increase in insurance coverage. The direct written policies increased Peak’s insurance coverage and expenses for the tax years at issue, while it also continued to hold policies with third-party commercial insurers. And, the direct written policies were valid only after insurance coverage from other insurers was exhausted, and Peak had never come close to exhausting the policy limits of its third-party commercial insurance coverage. The Court found that no unrelated party would reasonably agree to pay Reserve the premiums that Peak and the other insureds did for the coverage provided by the direct written policies. Although Capstone calculated Reserve’s premiums using objective criteria and what appear to be actuarial methods, the absence of a real business purpose for Reserve’s policies led the Court to conclude that the premiums paid for the polices were not reasonable and not negotiated at arm’s length.
Exempt status. As the Court found that Reserve didn’t issue insurance or reinsurance contracts, it did not receive more than 50% of its gross receipts from insurance premiums and didn’t qualify under Code Sec. 501(c)(15). Because Reserve was not an insurance company, it was not eligible to make an election under Code Sec. 953(d) (which only applies to a foreign company which would qualify as an insurance company under subchapter L of the Code if it were a domestic corporation). As a result, Reserve was to be treated as a foreign corporation.
Subject to 30% tax. For each of the tax years in issue, Reserve reported the gross premiums for the direct written policies and the reinsurance agreements as program service revenue, as well as revenue from investment income, and for 2009 and 2010, it reported “other revenue”. The Court, rejecting Reserve’s contention that the amounts it received during the tax years at issue were capital contributions or nontaxable deposits, found that Reserve failed to produce evidence to show that the income it received was not FDAP income. The Tax Court sustained IRS’s determination that Reserve had FDAP income from sources within the U.S. which was subject to the 30% tax under Code Sec. 881.
In addition, the Court determined that Reserve failed to prove its entitlement to any deductions. Even if Reserve established that it had reasonable cause for incorrectly filing Forms 990 (Return of Organization Exempt From Income Tax) as a supposedly exempt insurance company, rather than Forms 1120-F (U.S. Income Tax Return of a Foreign Corporation), the Court stated that it could not conclude that Reserve was entitled to deductions. Reg § 1.882-4(b)(1) provides that deductions are allowed to a foreign corporation only to the extent they are connected with gross income which is effectively connected, or treated as effectively connected, with the conduct of a trade or business in the U.S., and Reserve failed to establish that it was engaged in or received income treated as income effectively connected with a trade or business within the U.S.
Source: Thomson Reuters Checkpoint Newsstand 6/21/18