tax notes international - blueskydesignny.com€¦ · Correspondents Africa: Zein Kebonang, University of Botswana, Gaborone Albania: Adriana Civici, Ministry of Finance, Tirana Angola:

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Captive Insurance Arrangements —

A Comprehensive Update

by William P. Elliott

Reprinted from Tax Notes Int’l, 19 January 2004, p. 297

tax notesinternational

CorrespondentsAfrica: Zein Kebonang, University of Botswana, GaboroneAlbania: Adriana Civici, Ministry of Finance, TiranaAngola: Trevor Wood, Ernst & Young, LisbonAnguilla: Alex Richardson, Anguilla Offshore Finance Centre, AnguillaAntigua: Donald B. Ward, PricewaterhouseCoopers Center, St. John’sArgentina: Cristian E. Rosso Alba, Hope, Duggan & Silva, Buenos AiresArmenia: Suren Adamyan, Association of Accountants and Auditors of Armenia, YerevanAustralia: Graeme S. Cooper, University of Sydney, Sydney; Richard Krever, DeakinUniversity, Melbourne.Austria: Markus Stefaner, Vienna University of Economics and Business Administration,ViennaBahamas: Hywel Jones, Canadian Imperial Bank of Commerce Trust Company (Bahamas) Ltd.,NassauBangladesh: M. Mushtaque Ahmed, Ernst & Young, DhakaBarbados: Patrick B. Toppin, Pannell Kerr Forster, Christ ChurchBelgium: Werner Heyvaert, Nauta Dutilh, BrusselsBermuda: Wendell Hollis, Ernst & Young, BermudaBotswana: I.O. Sennanyana, Deputy Director, Tax Policy, Ministry of Finance & DevelopmentPlanning, GaboroneBrazil: David Roberto R. Soares da Silva, Farroco & Lobo Advogados, São PauloBritish Virgin Islands: William L. Blum, Solomon Pearl Blum Heymann & Stich LLP, St.Thomas, USVI and New YorkBulgaria: Todor Tabakov, Interlex, SofiaCameroon: Edwin N. Forlemu, International Tax Program, Harvard University, CambridgeCanada: Brian J. Arnold, Goodmans, Toronto, Ontario; Jack Bernstein, Aird & Berlis, Toronto,OntarioCaribbean: Bruce Zagaris, Berliner, Corcoran, and Rowe, Washington, D.C.Cayman Islands: Timothy Ridley, Maples & Calder Asia, Hong KongChile: Macarena Navarrete, Ernst & Young, SantiagoChina (P.R.C.): David D. Liu, Sidley & Austin, Shanghai; Jinyan Li, York University, Toronto;Lawrence Sussman, O’Melveny & Myers LLP, BeijingCook Islands: David R. McNair, Southpac Trust Limited, RarotongaCroatia: Hrvoje Zgombic, Zgombic & Partners, ZagrebCyprus: Theodoros Philippou, PricewaterhouseCoopers, NicosiaCzech Republic: Michal Dlouhy, White & Case, PragueDenmark: Thomas Froebert, Philip & Partners, CopenhagenDominican Republic: Dr. Fernándo Ravelo Alvarez, Santo DomingoEastern Europe: Iurie Lungu, Graham & Levintsa, ChisinauEgypt: Farrouk Metwally, Ernst & Young, CairoEstonia: Helen Pahapill, Ministry of Finance, TallinnEuropean Union: Joann M. Weiner, Facultés Universitaires Saint-Louis, BrusselsFiji: Bruce Sutton, KPMG Peat Marwick, SuvaFinland: Marjaana Helminen, University of Helsinki in the Faculty of Law, HelsinkiFrance: Marcellin N. Mbwa-Mboma, Baker & McKenzie, New YorkGambia: Samba Ebrima Saye, Income Tax Division, BanjulGermany: Jörg-Dietrich Kramer, Ministry of Finance, Berlin/Bonn; Rosemarie Portner, MeilickeHoffmann & Partner, Bonn; Klaus Sieker, Flick Gocke Schaumburg, FrankfurtGhana: Seth Terkper, Chartered Accountant/Tax Expert, AccraGibraltar: Charles D. Serruya, Baker Tilly, GibraltarGreece: Alexandra Gavrielides, AthensGuam: Stephen A. Cohen, Carlsmith Ball LLP, HagatnaGuernsey: Neil Crocker, PricewaterhouseCoopers, St. Peter PortGuyana: Lancelot A. Atherly, GeorgetownHong Kong: Colin Farrell, PricewaterhouseCoopers, Hong KongHungary: Daniel Deak, Budapest University of Economics, BudapestIceland: Indridi H. Thorlaksson, ReykjavikIndia: Nishith M. Desai, Nishith Desai Associates, Mumbai; Sanjay Sanghvi, RSM & Co., Mumbai;Homi Mistry, Deloitte, Haskins & Sells, MumbaiIndonesia: Freddy Karyadi, Karyadi & Co Law and Tax Office, Jakarta

Iran: Mohammad Tavakkol, Maliyat Journal, College of Economic Affairs, TehranIreland: Kevin McLoughlin, Ernst & Young, DublinIsle of Man: Richard Vanderplank, Cains Advocates & Notaries, DouglasIsrael: Joel Lubell, Teva Pharmaceutical Industries, Ltd., Petach Tikva; Doron Herman, S. Friedman& Co. Advocates & Notaries, Tel-AvivItaly: Alessandro Adelchi Rossi and Luigi Perin, George R. Funaro & Co., P.C., New York;Gianluca Queiroli, Cambridge, MassachusettsJapan: Gary Thomas, White & Case, Tokyo; Shimon Takagi, White & Case, TokyoJersey: J. Paul Frith, Ernst & Young, St. HelierKazakhstan: Robert M. Ames and Erlan B. Dosymbekov, Andersen, AlmatyKenya: Glenday Graham, Ministry of Finance and Planning, NairobiKorea: Chang Hee Lee, Seoul National Univ. College of Law, Seoul, KoreaKuwait: Abdullah Kh. Al-Ayoub, KuwaitKyrgystan: Ian Slater, Arthur Andersen, AlmatyLatin America: Ernst & Young LLP, MiamiLatvia: Andrejs Birums, Tax Policy Department, Ministry of Finance, RigaLebanon: Fuad S. Kawar, BeirutLibya: Ibrahim Baruni, Ibrahim Baruni & Co., TripoliLiechtenstein: Reto H. Silvani, Coopers & Lybrand, LiechtensteinLithuania: Nora Vitkuniene, International Tax Division, Ministry of Finance, VilniusMalawi: Clement L. Mononga, Assistant Commisioner of Tax, BlantyreMalaysia: Jeyapalan Kasipillai, University Utara, SintokMalta: Dr. Antoine Fiott, Zammit Tabona Bonello & Co., and Lecturer in Taxation, Faculty of Law,University of Malta, VallettaMauritius: Ram L. Roy, PricewaterhouseCoopers, Port LouisMexico: Jaime Gonzalez-Bendiksen, Baker & McKenzie, Juarez, Tijuana, Monterrey, andGuadalajara; Ricardo Leon-Santacruz, Sanchez-DeVanny Eseverri, MonterreyMiddle East: Aziz Nishtar, Nishtar & Zafar, Karachi, PakistanMonaco: Eamon McGregor, Moores Rowland Corporate Services, Monte CarloMongolia: Baldangiin Ganhuleg, General Department of National Taxation, UlaanbaatarMorocco: Mohamed Marzak, AgadirMyanmar: Timothy J. Holzer, Baker & McKenzie, SingaporeNauru: Peter H. MacSporran, MelbourneNepal: Prem Karki, Regional Director, Regional Treasury Directoriate, KathmanduNetherlands: Eric van der Stoel, Otterspeer, Haasnoot & Partners, Rotterdam; Dick Hofland,Freshfields, Amsterdam; Michaela Vrouwenvelder, Loyens & Loeff, New York; Jan Ter Wisch,Allen & Overy, AmsterdamNetherlands Antilles: Dennis Cijntje, KPMG Meijburg & Co., Curaçao; Koen Lozie, DeurleNew Zealand: Adrian Sawyer, University of Canterbury, ChristchurchNigeria: Elias Aderemi Sulu, LagosNorthern Mariana Islands: John A. Manglona, SaipanNorway: Frederik Zimmer, Department of Public and International Law, University of Oslo, OsloOman: Fudli R. Talyarkhan, Ernst & Young, MuscatPanama: Leroy Watson, Arias, Fabrega & Fabrega, Panama CityPapua New Guinea: Lutz K. Heim, Ernst & Young, Port MoresbyPeru: Italo Fernández Origgi, Yori Law Firm, LimaPhilippines: Benedicta Du Baladad, Bureau of Internal Revenue, ManilaPoland: Dr. Janusz Fiszer, Warsaw University/White & Case, WarsawPortugal: Francisco de Sousa da Câmara, Morais Leitao & J. Galvão Teles, LisbonQatar: Finbarr Sexton, Ernst & Young, DohaRomania: Sorin Adrian Anghel, Senior Finance Officer & Vice President, The Chase ManhattanBank, BucharestRussia: Scott C. Antel, Ernst & Young, Moscow; Joel McDonald, Salans, LondonSaint Kitts–Nevis: Mario M. Novello, Nevis Services Limited, Red BankSaudi Arabia: Fauzi Awad, Saba, Abulkhair & Co., DammamSierra Leone: Shakib N.K. Basma and Berthan Macaulay, Basma & Macaulay, FreetownSingapore: Linda Ng, White & Case, Tokyo, JapanSlovakia: Alzbeta Harvey, Principal, KPMG New YorkSouth Africa: Peter Surtees, Deneys Reitz, Cape TownSpain: José M. Calderón, University of La Coruña, La CoruñaSri Lanka: D.D.M. Waidyasekera, Mt. LaviniaSweden: Leif Mutén, Professor Emeritus, Stockholm School of EconomicsTaiwan: Keye S. Wu, Baker & McKenzie, Taipei; Yu Ming-i, Ministry of Finance, TaipeiThailand: Edwin van der Bruggen, Eurasian Structured Finance, Bangkok/Hong KongTrinidad & Tobago: Rolston Nelson, Port of SpainTunisia: Lassaad M. Bediri, Hamza, Bediri & Co., Legal and Tax Consultants, TunisTurkey: Mustafa Çamlica, Ernst & Young, IstanbulTurks & Caicos Islands, British West Indies: Ariel Misick, Misick and Stanbrook, Grand TurkUganda: Frederick Ssekandi, KampalaUkraine: Victor Gladun, Taxware, a division of govONE Solutions, Salem, MA.United Arab Emirates: Nicholas J. Love, Ernst & Young, Abu DhabiUnited Kingdom: Trevor Johnson, Trevor Johnson Associates, Wirral; Eileen O’Grady,barrister, London; Jefferson P. VanderWolk, Baker & McKenzie, LondonUnited States: Richard Doernberg, Emory Univ. School of Law, Atlanta GA.; James Fuller,Fenwick & West, Palo AltoU.S. Virgin Islands: Marjorie Rawls Roberts, Attorney at Law, St. Thomas, USVIUruguay: Dr. James A. Whitelaw, Whitelaw Attorneys, UruguayUzbekistan: Ian P. Slater, Arthur Andersen, AlmatyVanuatu: Bill L. Hawkes, KPMG, Port VilaVenezuela: Ronald Evans, Baker & McKenzie, CaracasVietnam: Frederick Burke, Baker & McKenzie, Ho Chi Minh CityWestern Samoa: Maiava V.R. Peteru, Kamu & Peteru, ApiaYugoslavia: Danijel Pantic, European Consulting Group, BelgradeZambia: W Z Mwanza, KPMG Peat Marwick, LusakaZimbabwe: Prof. Ben Hlatshwayo, University of Zimbabwe, Harare

TAX NOTES INTERNATIONALCopyright 2004, Tax Analysts

ISSN 1048-3306

Editor: Cathy Phillips

Special Reports Editor: Alice Keane Putman

Managing Editor: Maryam Enayat

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Captive Insurance Arrangements —A Comprehensive Update

by William P. Elliott

The issues that are of general importance for taxpurposes to most captive insurance arrangements

from a U.S. tax standpoint are: (1) insurance companystatus; (2) controlled foreign corporation status; (3) thedomestic company election; (4) engagement in a U.S.trade or business; and (5) loans to shareholders. Eachshould be discussed in the planning stage for any typeof captive. “Captive Insurance Arrangements: AnOpportunity for Small and Medium-Size Businesses?”1

discussed the various types of captives most commonlyused as well as the concepts of risk shifting and riskdistribution upon which premium deductibility ishinged. It also pursued the evolutionary progression ofcase law defining the parameters for premium deduct-ibility as accentuated by a steady line of IRS pro-nouncements and reviewed the availability of theever-popular domestic company election under U.S.Internal Revenue Code (IRC) section 953(d) to offshorecaptives making them further eligible for favorableU.S. tax treatment.

This article continues the saga of captive insurancearrangements with coverage of renewed IRS activitytoward captives commencing with a single revenueruling in 2001 followed by a flurry of IRS activity in thelatter half of 2002, producing one notice, one revenueprocedure,and a trilogy of revenue rulings further clari-fying, framing, and perhaps frustrating what consti-tutes acceptable captive insurance arrangements.

In the 2001 revenue ruling, the IRS announced thatit will no longer invoke the “economic family” theory,originally set forth in Rev. Rul. 77-316, whenaddressing the premium deductibility issue of captiveinsurance transactions.

I. Captive ReacquaintanceA fundamental technique of international tax

planning, including the use of captivetax-planning instruments, is the shifting ofprofits from a high-tax jurisdiction to a low-taxjurisdiction and,even if profits are shifted withina high-tax jurisdiction, tax advantages can beenjoyed.2

Tax authorities seek to enforce their statutorybeliefs in three different ways. First, they deny deduct-ibility in a high-tax jurisdiction either because apayment is not considered an expense for tax purposesor because the expense is considered too high. Deduct-ibility has also been all or partly denied when thepremium is not considered to be at arm’s length.3 Atthis point, transfer pricing and its complex rulesbecome paramount. Second, they tax the profits of acompany resident in the low-tax jurisdiction in thehands of the shareholders resident in high-taxcountries (tax and fiscal transparency). Last, the taxauthorities in high-tax jurisdictions seek tax jurisdic-tion over the captive resident in the low-tax jurisdic-tion, probably justified by legal authority premised onthe assertion that the captive is legally resident in thehigh-tax jurisdiction for tax purposes. Tax authoritiesfrequently take the position that insurance premiumspaid to a captive insurance company are per se nonde-ductible because intercompany transfers are notconsidered expenses in an economic sense.

From the international tax planner’s point of view,one of the most serious threats is the domestic legisla-tion in many high-tax jurisdictions that allows profitsderived by enterprises in low-tax jurisdictions to be thebasis for taxing the shareholders resident in thehigh-tax jurisdiction. This is due to the installation ofantiavoidance regimes, particularly in the “captive”arena in the form of CFC taxation and, for U.S.taxpayers, subpart F of the IRC. The net effect is thatthe profits of a company in a low-tax jurisdiction areincluded in the taxable income of the shareholders

Tax Notes International 19 January 2004 • 297

Special Reports

William P. Elliott is an international tax part-ner with DECOSIMO, certified public accountantsand consultants, in Chattanooga, Tennessee.

1William P. Elliott and Thomas A. Gavin, Tax Notes Int’l, 14Apr. 2003, p. 153.

2Professor Arvid A. Skaar, Taxation Issues Relating to Cap-tive Insurance Companies, IBFD Publications BV, Amsterdam,The Netherlands, 1998.

3Elliott and Gavin, supra note 1.

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resident in the high-tax jurisdiction. Because theshareholders, not the company, are subject to tax,taxpayers may not have treaty protection, which is thecentral feature of CFC taxation. Although the condi-tions differ greatly in different jurisdictions, they sharecommon threads.4

A captive can be resident for tax purposes in acountry different from its country of formation or incor-poration when domestic law or a bilateral tax treatyprovides that the seat of effective management deter-mines the company’s residence for tax purposes. Mostimportant for a captive insurance company is whetherthe captive has a place of management in the high-taxcountry, since a place of management may constitute apermanent establishment (that is, a fixed place ofbusiness). In this case, the tax authorities may take theposition that the captive is taxable either on all of itsincome, because it is resident for tax purposes, or onsome of its income, because it is deemed to have apermanent establishment in the high-tax jurisdiction.

II. Captive FundamentalsThe concept of insurance has been around for a long

time. It revolves around individuals and businessesforming groups to mitigate their exposure to a widerange of risks. The insurance concept has been imple-mented using several organizational structures thatserve the interests of constituents for a range of riskcoverages and risk mitigations. One organizationalstructure is called a captive insurance companybecause it operates at the behest of, and for the benefitof, a noninsurance parent owner-company or group (amultiple-owner captive). Organizationally, theseentities resemble mutual insurance companiesworking for a limited number of participants. Captivestructures have suffered from an image problembecause they may lack a business purpose or may becreated in jurisdictions whose laws, customs, and taxsystems differ from those of the United States.However, the formation of a special-purpose captiveinsurance company by an affiliate or controlledcompany should not be negatively influenced by thejurisdiction of formation. And, while captives provideinsurance primarily in the areas of general liabilityand workers’ compensation, the structure can be usedto address what once were considered more exoticrisks, such as kidnapping, extortion, ransom, andterrorism.

A captive insurance company is established for theneeds of the owners or members, as opposed to third-party insurance. Although each captive insurance ar-rangement is distinct, there are some common advan-

tages, including: (1) reduced cost of coverage; (2) directaccess to reinsurers; (3) provision of broad or otherwiseunavailable coverage; (4) improved cash flow; (5)improved risk-retention capability; (6) mitigation ofthe market swings of commercial insurance; (7)spreading of risks; and (8) integration of insurancewith an overall risk management plan. Tax advan-tages, oddly enough, are not the principal reason forforming such an arrangement.5

The IRS has viewed captives as tax-avoidanceschemes because insurance premium payments areusually deductible by members of the economiccorporate family — the parent, affiliates, or controlledgroup members. The IRS has taken the position thatpremiums paid to captives are equivalent to self-insurance and, as such, are not deductible. Anexception would be captives writing coverage for thirdparties. To the members of the affiliated economicgroup, the concept of stabilizing losses or strength-ening earnings is more important than the tax deduct-ibility of premiums. The underlying substance of acaptive, as an autonomous entity, is a special-purposeinsurance company that provides basic benefits to theparent owner-company or members of the group, suchas a special coverage form or a special funding plan.

Three general forms of captives appear to exist:purecaptives (those related by ownership), associationcaptives (captives related by a specific area ofcommerce or coverage), and heterogeneous member-ship captives (those possessing a more heterogeneousmembership).Pure captives insure only the risks of theowner or members of an affiliated group of companies.Group captives, an extension of pure captives, havemultiple owners or sponsors that insure the risks of theshareholders or their affiliates, including trade orbusiness groups, comprising unrelated entities thatjoin together for the sole purpose of forming andowning an insurance company.

Association captives focus on association and riskretention via a group of captives. Association captivesare formed by a group of entities within a particularindustry with common insurance needs and similarexposures. For instance, a risk retention group (RRG)is an association or group captive formed in accordancewith the requirements of the Product Liability RiskRetention Act of 1981 for the principal purpose ofassuming and spreading risk for product liabilityexposure.

Heterogeneous membership captives are those leastthought to resemble captive insurers. Examples ofheterogeneous membership captives, those related by

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4Id.

5James W. Blankenship, “Planning Maximum Benefits of aBermuda Insurance Captive,” Journal of International Taxation(March 1995).

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a loose affiliation but drawn together by mutualagreement, include sponsored captives, a near-struc-tural clone of “rent-a-captives.” The latter have beenavailable to many different insured in offshoredomiciles for years. They provide, for a fee, theadvantage of an existing captive, so participants avoidthe costs and procedures of setting up a captive. Thesemore entrepreneurial captives stray from the tradi-tional captives, which insure only the risks of theirowner(s).

Tax advantages are usually not a key goal in theformation of a captive, but they may be available. Forexample, a U.S. company that is self-funding a layer ofexposure for workers’ compensation risks may chooseto provide for that exposure through an associationcaptive. The company could then deduct the premiumspaid to the captive under the self-funding plan untilthe claims are actually paid, rather than deferring thededuction. While tax advantages may be establishedthrough a properly planned captive, many new ownersand members of captives have unrealistic expectationsabout the availability of tax savings from thosecompanies.This may be partly due to the lack of experi-ence and expertise of the potential owner of a captive inthe complex U.S. tax rules relating to insurance and in-ternational taxation. The formation of a captive isusually the owner or member’s first foray into theinsurance business, other than as a policyholder, andmay also be the company’s first involvement in inter-

national business. Therefore, proper planning is espe-cially important to identify and maximize anyavailable tax advantages and to avoid any risks thatmay detract from the many nontax advantages of thecaptive.

Captive insurance companies represent a signifi-cant component of the alternative risk market.Because of their growth, strength, and utility over thepast decade, captive insurance companies are nolonger considered by many insurance professionals tobe a truly alternative insurance market. The use of acaptive is an integral part of general business riskmanagement.Nowhere has the growth and strength ofthe captive insurance industry been more visible thanin Bermuda,which is home to about half of the existingcaptives worldwide and continues to be the choice for50 percent of new captive formations.Although there isno single reason why Bermuda is preferred to othercaptive centers, its popularity is attributable in part tothe same factors that have made it a recognizedoffshore business center. Bermuda possesseshigh-caliber insurance expertise and technicalknowledge through its many captive managementcompanies and brokers. It has a well-developed profes-sional sector, including accountants, attorneys,bankers, and actuaries that specialize in captiveinsurance. Also, Bermuda has a regulatory environ-ment that offers relative freedom to insurers andmaintains a level of governmental involvement


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Illustration 1CAPTIVE ADVANTAGES

Tax advantages are generally not a key goal in the formation of a captive, but advantagesmay be available. This may be partly due to the lack of experience and expertise of the potentialowner of a captive in the rather complex U.S. tax rules relating to insurance and internationaltaxation. Therefore, proper planning is especially important to identify and maximize anyavailable tax advantages and avoid any risks that may detract from the many nontax advantagesof the captive.

PROFESSIONALADVISORS

CAPTIVEINSURANCE

TRADITIONALINSURANCE

COMPLEX

TAX RULES

CONSULTATION/ADVICE

COMPANY

OWNER

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commensurate with the amount and character of theinsurer’s commitments to its policyholders. Because ofthose and other advantages, Bermuda leads the worldin captive insurance company formation andoperation, with the Cayman Islands a strong secondchoice of situs.

III. Taxation of CaptivesSubpart F of the IRC requires every U.S. share-

holder of a CFC who owns stock in the CFC on the lastday of the CFC’s taxable year to include in grossincome a deemed dividend equal to the shareholder’spro rata share of the CFC’s “tainted earnings,” whichincludes “insurance income.”6 Subpart F applies onlyto CFCs. A foreign corporation is a CFC if, on any dayof the corporation’s taxable year,U.S.shareholders ownmore than 50 percent of the combined voting power ofall classes of stock or more than 50 percent of the totalvalue of the foreign corporation.7 Only U.S. share-holders are considered in applying the 50 percent test.For those purposes, a U.S. shareholder is any U.S.resident owning at least 10 percent of the totalcombined voting power of all classes of stock of theforeign corporation.8 Thus, if an offshore captive ar-rangement is a CFC, its U.S. shareholders mustinclude in their taxable income a pro rata share of anysubpart F insurance income of the CFC or captive.

Another rule exists for allocating subpart Finsurance income to U.S. shareholders. A company isan insurance CFC if its 10 percent U.S. shareholdersown more than 25 percent of the vote or value of theoffshore captive.9 Yet another rule applies when allo-cating insurance income derived from the insuring ofrelated parties (related person insurance income orRPII rules); here, all shareholders resident in theUnited States, not just those owning 10 percent ormore, are included for purposes of the 25 percent test.10

Thus, if a foreign captive is a CFC, the shareholdersresident in the United States must include in taxableincome their pro rata share of the CFC’s subpart Finsurance income, thus negating any deferral of thatincome, whether repatriated or not.

A. Domestic Company ElectionCFCs can elect to be considered U.S. domestic

insurance companies under IRC section 367 if theymeet three requirements, thus making the CFC

eligible for the “Domestic Company Election” underIRC section 953(d). First, the entity must be a CFC forpurposes of allocating related-person insuranceincome. Second, the CFC would be taxed as aninsurance company if it were a domestic company.Finally, the CFC must waive all treaty benefitsotherwise available to it.Under this domestic companyelection, the CFC is deemed to have transferred all ofits assets and liabilities to a new U.S. corporation inexchange for that corporation’s capital stock. Also, U.S.shareholders of an electing CFC are required toinclude in gross income untaxed earnings and profits(that is, retained earnings) in gross income, though fora newly formed company there would be no such gain.11

Available under IRC section 367(b) and in tandemwith a domestic company election under section 953(d)is an opportunity made available under the TaxReform Act of 1986, which liberalized IRC section501(c)(15) in two important respects. It allows stockcompanies, as well as mutual insurers, to qualify forexemption in an attempt to create parity between stockand mutual insurance companies. Also, it changes themeasure of the dollar ceiling from a gross-receipts testto a premium-income test. This point is discussed infurther detail below.12

A domestic company election must be filed by thedue date of the corporate return, including any exten-sions. The electing company is required to execute aclosing agreement and post a letter of credit with theIRS.13 The letter of credit is waived if the electingcompany maintains an office or other place of businessin the United States.14 Once the election is made for theoffshore captive under IRC section 367, it may beeligible to elect tax-exempt status under IRC section501(c)(15). That tax-exempt status provides that anonlife insurance company qualifies as tax-exemptunder this section if its net written premiums (or, ifgreater, direct written premiums) for the taxable yeardo not exceed US $350,000 and the insurer satisfiesother requirements. This makes an extremely tax-efficient structure to establish a captive offshorearrangement available to small and medium-size busi-nesses.Premiums of all members of the taxpayer’s con-trolled group (as defined in IRC section 1563) areaggregated for purposes of the US $350,000 test.

To gain tax-exempt status under IRC section501(c)(15) for any given year, an organization’sprimary business must generate or issue insurance


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6IRC section 951(a)(1).7IRC section 951(b).8Rev. Rul. 78-338, 1978-2 C.B. 107.9IRC sections 951 and 953.10Thomas L. Ward and Leah Embry Thompson, “IRC

501(c)(15) — The Blitz Since 1986,” Ins. Tax Rev., Dec. 1993, p.1435.

11IRC sections 367(b), 953(d)(4)(A).12Ward and Thompson, supra note 10.

13The IRS letter of credit is usually for 10 percent of the com-pany’s gross income for the prior year, subject to a minimum ofUS $75,000 and a maximum of US $10 million.

14Blankenship, supra note 5, p. 2.

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contracts or the reinsurance of risks — hence, therequired presence of risk shifting and risk distribution.If the captive, now a domestic exempt insurancecompany, is unable to meet the US $350,000 premiumtest, the tax-exempt status of insurance income is lost.However, as long as net written premiums do notexceed US $1.2 million in the taxable year, the entity istaxed only on its investment income.15

IV. ‘Tax Law’ as Developed by theCourts and IRS

A. Requirement of ‘Risk-Shifting’ &‘Risk-Distribution’ for PremiumDeductibility

Insurance premiums are deductible as ordinary andnecessary business expenses under reg. section1.162-1(a). However, there is no definition of insurancein the IRC or regulations, nor any indication of theproper treatment of payments by parent corporationsto captive insurance companies. The IRS has not char-acterized those payments as insurance premiums.

The regulatory classification of a corporation as aninsurance company is generally irrelevant to its classi-

fication for U.S. tax purposes. Under IRC section816(a), a company is an insurance company if morethan half of its business during the year is issuinginsurance or annuity contracts or reinsuring risksunderwritten by insurance companies. Becausecaptives are generally established and operated solelyto provide insurance coverage, they rarely failinsurance company status because of the predomi-nance of another business activity. A more commonproblem in establishing that status relates to the typeof insurance business written. Not all contractswritten by an insurance company are insurancecontracts that are eligible for the 50 percent test. Oneof the earliest definitions of insurance was provided byHelvering v. LeGierse,16 in which the U.S. SupremeCourt said that “historically and commonly, insuranceinvolves risk shifting and risk distributing.” The Courtsummarized the concept of risk shifting to include apassage of loss from an insured to an insurer, apayment of a premium that is less than the riskinsured, and an insurer that is financially capable ofaccepting the risk.


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15See note 34 and IRC section 501(c)(15).

3. The CFC waives all treaty benefits otherwise available to it.

The CFC is deemed to have transferred all of its assets and liabilities to a new U.S. corporation in exchange for thatcorporation’s capital stock. The U.S. shareholders of such an electing CFC are required to include in gross income certainuntaxed E&P (i.e., retained earnings) in gross income; though, for a newly formed company, there would be no such gain.

Illustration 2Domestic Company Election

Certain CFCs can elect to be U.S. domestic insurance companies, underIRC , if they meet three requirements.section 367

1. The entity is a CFC for purposes of allocating (RPII).related-person insurance income

2. Such CFC would be taxed as an insurance company if it were a domestic company.

U.S.DOMESTICCOMPANY

ELECTIONSFOREIGNCFC

IRC SECTION 953(d)

IRC SECTION 501(c)(15)

Liberalized IRC allowsstock companies to qualify for exemptionto create parity between stock and mutualinsurance companies.

section 501(c)(15)

16312 U.S. 531, 25 AFTR 1181.

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The concept of risk distribution focuses on theinsurer, whereas risk shifting focuses on the insured.Risk distribution is the mechanism through which theinsurer spreads its risks and quantifies its total antici-pated losses. Under LeGierse risk distribution existswhen the insurer has enough exposures for the statis-tical law of averages to function, the exposures presentapproximately the same chance of loss, and theexposures are each separate and distinct. The LeGiersedefinition of insurance has remained intact for morethan 40 years. Although modified and embellished bylater cases and rulings, the cornerstones of risk shiftingand risk distribution are still requirements forinsurance status. Most captive insurance companycases have evolved from those two requirements.

Although most contracts may be viewed as shiftinga risk of some sort, not all contracts that shift anddistribute risk qualify as insurance risk contracts. Todistinguish LeGierse by way of a current example,since 1986 much of the increase in applications forexemption for domestic company captive arrange-ments is attributable to companies that insure orreinsure service warranties or similar arrangements.17

Two similar schools of thought — a “seller’s warranty”rationale and a “service contract” rationale — haveemerged that argue that those contracts are notinsurance contracts.

The seller’s warranty rationale applies to thewarranty of a product by its seller. Insurance lawgenerally provides that when the warranty does notprotect against outside perils but only against inherentproduct defects, the warranty, as such, is not aninsurance contract. Thus, a written warranty repre-senting that the articles sold will give satisfactoryservice under ordinary usage for a specified length oftime and providing for an adjustment in the event offailure from faulty construction or materials is not aninsurance contract because it expressly excludeshappenings not connected with imperfections in thearticles themselves.18 The service contract rationaleapplies when the primary purpose of the contract isservice rather than indemnification, when benefits areprovided in the form of services.19 The typical auto


Special Reports

17Ward and Thompson, supra note 10.

U.S. PARENTCOMPANY

Concept of risk shifting includes:

A passage of loss from an insured to an insurer.A payment of a premium that is less than the risk insured.An insurer that is financially capable of accepting the risk.

CAPTIVE INSURANCECOMPANY

1 OR MORESUBSIDIARIES

RISK SHIFTEDDISTRIBUTED

Concept of risk distribution focuses on the:insurer

The insurer has a sufficient number of exposuresfor the statistical law of averages to function.The exposures present approximately the samechance of loss.The exposures are each separate and distinct.

Helvering v. LeGierse

Illustration 3Helvering v. LeGierse

One of the earliest definitions of insurance was provided by, in which the Supreme Court stated that “historically and commonly, insurance involves

risk shifting and risk distributing.”

Helvering v. LeGierse, 312 U.S. 531 25 AFTR1181

U.S. Supreme Court 1941

RISK MUST BE

ASSOCIATED WITH AN

“IDENTIFIABLE HAZARD”

18Couch on Insurance 2d, section 1:15 (1984), citing State exrel. Herbert v. Standard Oil Co., 138 Ohio St. 376, 35 N.E. 2d 437(1941).

19Rev. Rul. 68-27, 1968-1 C.B. 315.

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service warranty or extended service warranty extendsand reinforces the rationale developed thus far. Theyinvolve a promise to repair or replace defective itemsand are limited only to breakdowns of covered partsbecause of defects in materials or workmanship; theyspecifically exclude losses resulting from outside perilsand the reimbursement of financial losses. Theseshould be viewed as “other than insurance contracts.”However, an insurer’s agreement to indemnify theissuer of that service contract or warranty may be aninsurance contract.20 To add to the confusion, thetypical auto service warranty or extended servicewarranty, while involving a promise to repair orreplace defective items rather than reimbursefinancial losses, covers only breakdowns of coveredparts due to defects in materials or workmanship andspecifically excludes losses resulting from outsideperils. It should be viewed as an “other than insurancecontract.” However, an insurer’s agreement toindemnify the issuer of that service contract orwarranty may be an insurance contract.21

B. Common-Law DoctrinesThe substance-over-form principle has been imbued

into analysis and resolution of tax issues and disputesin the United States since the 1920s. Both the U.S.Supreme Court and lower courts have discussed andincorporated the doctrine in numerous decisions,and ithas been referred to as a cornerstone of the U.S. taxsystem.

Gregory v. Helvering,22 the landmark U.S. SupremeCourt case, litigated within the context and backdropof corporate reorganizations in the 1930s, providedthat a “scheme” (“purportedly a transactional arrange-ment not unlike a sham”), “which involves an abruptdeparture from normal reorganization procedure inconnection with a transaction on which the impositionof a tax is imminent, such as a mere device that puts onthe form of a corporate organization as a disguise forconcealing its real character, and the object and accom-plishment of which is the consummation of a precon-ceived plan having no business or corporate purpose.”The essence of this instructive judicial statement isthat a transaction lacks merit for tax purposes unlessit serves a purpose other than tax avoidance; thus, atransaction principally conceived with tax avoidancemotives may be disregarded as a sham. Alternatively,its form may be recast to reflect economic substance bycollapsing interdependent steps into a single transac-tion to prevent the taxpayers from doing indirectlywhat was prohibited directly.

Four recent decisions,23 unrelated to traditionalcaptive insurance arrangements,have been decided ontheir economic substance and business purpose. Thatshould remind taxpayers of the importance of demon-strating a valid business purpose, not one solely predi-cated on tax benefits, when structuring and affecting acaptive arrangement. If successful at demonstrating avalid business purpose, the taxpayer may also succeedin obtaining deductions for premiums paid to a captiveentity.

C. Economic Family DoctrineThe IRS has not defined insurance contract, but has

ruled on what is not an insurance contract. One of theIRS’s major weapons in denying insurance status to acontract was, until its abandonment in 2001, theeconomic family doctrine, which says an insurancerelationship cannot exist within a group of affiliatedentities. For example, a parent company cannot havean insurance contract with a wholly owned subsidiaryunder this doctrine. It is the IRS’s position that aninsurance relationship cannot exist between these twoparties because any loss incurred by the parent andindemnified by the subsidiary would not be trans-ferred outside the economic family. The loss wouldsimply be transformed from a casualty loss to a lossrelating to the parent’s investment in the captivesubsidiary. The doctrine applied to any related risksthat resided in the captive, even if they were fronted byone or more unrelated insurers.

The IRS position that there can be no insurancewhen premiums are paid to an insurance subsidiarywas first announced in Rev. Rul. 77-316.24 The IRSargued that the element of risk transfer could not bepresent when the risk was transferred amongmembers of a single economic family.Risk transfer hadbeen held to be a requirement for the presence ofinsurance since the U.S. Supreme Court in LeGiersesaid that “historically and commonly insuranceinvolves risk shifting and risk distributing.” Whenapplied to insurance subsidiaries that insured nounrelated risks, the IRS’s position — albeit not alwaysthe economic family theory — had been sustained.25


Special Reports

20IRS Technical Advice Memorandum (TAM) 9251007.21Id.22293 U.S. 465 (1935).

23United Parcel Service of America Inc., T.C.M. 1999-268;ACM Partnership, 82 AFTR 2d. 98-6682, 157 F3d 231, 98-2USTC; Winn-Dixie Stores Inc., 110 T.C. 291; Saba Partnership,T.C.M. 1999-359.

241977-2 C.B. 553.25Mobil Oil Corp., Cls. Ct., 19850801; Carnation Co., 47 AFTR

2d 81-997, 640 F2d 1010, 81-1 USTC para. 9263; Beech AircraftCorp., 58 AFTR 2d 86-5548, 797 F2d 920, 86-2 USTC para. 9601;Stearns-Roger Corp., 56 AFTR 2d 85-6099, 774 F2d 414, 85-2USTC para. 9712; Clougherty Packing Co., 59 AFTR 2d 87-668,811 F2d 1297, 87-1 USTC para. 9204; Gulf Oil Corp., 66 AFTR 2d90-5552, 914 F2d 396, 90-2 USTC para. 50496.

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Historically, the IRS has made a sharp distinctionbetween risk shifting and risk distributing.Recall fromthe earlier discussion that the concept of risk shiftingrequires that risk move from the insured to theinsurer; risk distributing requires pooling by theinsurer of several independent risks, especiallyregarding captives. As evidenced in LeGierse, the ruleis well established that a business cannot simply setaside a fund as an insurance reserve and claim anordinary and necessary business expense forinsurance premiums paid under IRC section 162.Self-insurance arrangements are not insurance and donot involve risk shifting or risk distributing.

In Rev. Rul. 77-316,26 the IRS addressed whether asubsidiary was an insurance company for tax purposesif it “insured” only the risks of its parent and subsid-iaries. The IRS concluded that the contractual ar-rangement between the domestic parent andsubsidiaries and the insurance subsidiary did notqualify as insurance for federal income tax purposesbecause the insurance subsidiary insured no otherparties and was wholly owned by the parent.

In Moline Properties Inc. v. Commissioner,27 the U.S.Supreme Court recognized each insurance subsidiaryas an independent corporate entity in light of itsbusiness structure and activity. Moline concluded thatthe economic reality of the insurance agreement witheach subsidiary was to indirectly obtain a deduction forits parent and subsidiaries that would be denied ifsought directly. Though separate corporate entities,the parent, its insurance subsidiary, and its othersubsidiaries represented one economic family,and,as aresult, the ultimate burden of economic loss was borneby the same persons who suffered the loss. The MolineProperties case established the separate entitydoctrine in the United States and its key point is that acompany must be considered a separate taxable entityif (1) the purpose of the corporation is to performbusiness or (2) the actual activity of the corporation is abusiness activity. Moline Properties has been invokedby taxpayers in all the captive cases in the U.S.,resulting in a great deal of confusion as the lowercourts have in the past attempted to rule in accordancewith both Moline Properties and the IRS’s economicfamily doctrine. In fact, in many captive cases, the U.S.Tax Court employed the “substance over form”argument as a general device applicable when thecourt felt uncomfortable with the taxpayer’s taxplanning.28 Thus, no economic shifting or distributing

of risk of loss resulted because the risks were notshifted to an unrelated insurance company.

In direct contrast to Rev. Rul. 77-316, Rev. Rul.78-33829 illustrates a case with a diluted ownershipstructure. Here, insurance contracts existed via adomestic corporation owning an interest,along with 30unrelated shareholders, in a foreign corporation thatinsured the risks of its shareholders and their subsid-iaries and affiliates. No shareholder owned a control-ling interest, and no shareholder’s individual riskexceeded 5 percent of the total risks insured. Still, theIRS concluded that the taxpayer failed to demonstrateits case.

Following Rev. Rul. 77-316, several cases30 examinedwhether amounts paid to a captive insurance arrange-ment are deductible. That in turn forced analysis as towhether the contracts were for “insurance.”The courts,in these cases, have usually upheld the IRS’s positionthat they are not insurance contracts throughreasoning similar to that found in the revenue ruling.However, no court appears to have expressly adoptedthe economic family doctrine.31

V. Captives Insuring Unrelated RisksWhen the insurance subsidiary insures unrelated

risks, the IRS initially agreed that the question was avery different one. An internal IRS National Officememorandum in 1979 rejected expansion of theeconomic family argument given birth in Rev. Rul.77-316 and agreed with the arguments advanced bytaxpayers and later adopted by the courts. The memo-randum was not revoked until 1984. Only two weeksbefore the close of briefing in the first of the U.S. TaxCourt cases to address the issue — The Harper Group32

(for which the decision would come almost three yearslater) — the IRS attempted to expand the economicfamily approach to cases involving unrelated insuredsby issuing Rev. Rul. 88-72.33

Taxpayers have won several cases on fact patternsfalling between those of Rev. Rul. 77-316 and Rev. Rul.78-338. Several courts have ruled, contrary to Rev. Rul.88-72, that a substantial insurance business with


Special Reports

261977-2 C.B. 53.27319 U.S. 436 (1943).28Skaar, supra note 2.

291978-2 C.B. 107.30See Clougherty Packing Co. v. Comm., 59 AFTR 2d 87-668

(811 F. 2d 1297), 03/03/1987; Carnation Co. v. Comm., 71 T.C.400, 12/26/1978.

31Ward and Thompson, supra note 10.3296 T.C. 45 (1991).331988-2 C.B. 31, O.M. 19167, forwarded by GCM 38136, 10/

12/79, GCM 39247, 6/20/84. Because that ruling included state-ments directly contradicting the government expert’s position attrial, and the error was called to the attention of the Tax Court bythe taxpayer in a way unhelpful to the Service’s cause, the rulingwas “clarified” by Rev. Rul. 89-61, 1989-1 C.B. 75.

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unaffiliated insureds creates a pool allowing for riskshifting as well as risk distribution for premiumpayments by a parent to its insurance subsidiary.34

In Clougherty Packing Co. v. Commissioner,35 thecourt defined a captive “as a corporation organized forthe purpose of insuring the liabilities of its owner.”Clougherty Packing was one of the first cases in whicha so-called “balance sheet” test was expressly recog-nized by the court and depicts a simple example ofvertical insurance fronted by an unrelated insurancecompany, which reinsured 92 percent of the risk withClougherty’s wholly owned captive insurance company.

The Tax Court denied deductions for premiums paid tothe captive arrangement as risk of sustaining losseswas not shifted to unrelated parties in exchange forinsurance premiums because the premiums were paidto the wholly owned subsidiary of its wholly ownedsubsidiary. Thus, Clougherty’s consolidated balancesheet was unaffected by the arrangement, with thecourt expressly requiring, in this instance, that therisks must be shifted to unrelated parties, to fulfill the“essence” of the IRS’s economic family doctrine.

At one extreme is the case presented here,where theinsured is both the sole shareholder and the onlycustomer of the captive. There may be other permuta-tions involving less than 100 percent ownership andmore than a single customer, although at some pointthe term “captive” is no longer appropriate. In OceanDrilling & Exploration Co,36 the court held that in


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34See Ocean Drilling & Exploration Co. v. United States, 988F. 2d 1135 (Fed. Cir. 1993) (44-66 percent unaffiliated business)and Sears Roebuck & Co. v. Commissioner, 972 F. 2d 858 (7th Cir.1992) (99 percent unaffiliated business), et al.

35811 F. 2d 1297 (9th Cir. 1987). 36988 F. 2d 1135, 71 AFTR 2d 93-1184 (CA-F.C., 1993).

Illustration 4Moline Properties Inc. v. Commissioner

The rule is well established that a business cannot simply set aside a fund as an insurance reserve andclaim an “ordinary and necessary” business expense for insurance premiums paid under IRC .

“Self-insurance” arrangements are not insurance and do not involve risk shifting or risk distributing.section 162

U.S. Supreme Court 1943

In Rev. Rul. 77-316, the Service concluded that the contractual arrangementbetween the domestic parent and subsidiaries and the “insurance” subsidiary didnot qualify as insurance for federal income tax purposes since the “insurance”subsidiary insured no other parties and was wholly owned by the parent.

Moline Properties Inc. v. Commissioner recognized each “insurance” subsidiaryas an independent corporate entity in light of its business structure and activity,but concluded that the economic reality of such “insurance agreement” with eachsubsidiary was to obtain, by indirect means, a deduction for its parent andsubsidiaries that would be denied if sought directly.

CAPTIVECO.

WHOLLY OWNEDSUBSIDIARY

SELF-INSURANCE

FUND

MOLINE

PROPERTIES

XSAME “ECONOMIC FAMILY”

PARENTCO.

1. PURPOSE=TOPERFORM BUSINESS;

2. ACTUAL ACTIVITY=BUSINESS ACTIVITY

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determining whether payments to captive insurers aredeductible, it had to follow LeGierse and Moline Prop-erties, holding that an arrangement between a parentand its subsidiary can constitute insurance when theparent’s premiums are pooled with those of unrelatedparties, assuming as in Ocean Drilling, (1) insurancerisk is present, (2) risk is shifted and distributed, and(3) the transaction is of the type that is insurance in thecommonly accepted sense.

Finally, in Kidde Industries Inc,37 the U.S. Court ofFederal Claims held that a corporation could deductpremiums paid to a captive insurance company onbehalf of a subsidiary, but not on behalf of a division,which, unlike a subsidiary, is not an entity separatefrom the parent corporation. (Note:This applies as wellto disregarded entities of their parents under IRS“check-the-box” rules as well as to U.S. qualifiedsubchapter S subsidiaries (QSSS/Q-Subs).)

In Rev.Rul.88-72,38 clarified by Rev.Rul.89-61,39 theeconomic family analysis was used to find insufficientrisk shifting even when a preponderance of the whollyowned subsidiary’s business was with unrelatedinsureds. The IRS ruled that although there may havebeen sufficient risk distribution, there was no riskshifting between the “insurance” subsidiary andparent and other subsidiaries. Rev. Rul. 88-72 alsoexplained the distinction between risk shifting andrisk distributing. Risk shifting occurs when a risk ismoved away from a corporate parent and its subsid-iaries; risk distributing occurs when an insurancecompany accepts many independent risks, therebytaking advantage of a statistical phenomenon knownas the law of large numbers — although as thepotential loss exposure increases, the average lossincurred becomes increasingly unpredictable.

The IRS conceded the issue by temporarily aban-doning its economic family reasoning when it lost inthe U.S. Tax Court trilogy of The Harper Group, SearsRoebuck & Co.,40 and AMERCO,41 by a decisive 12-3majority. The IRS lost all of the appeals as well, appar-ently settling the status of insurance subsidiaries thatinsure both related and unrelated risks at the sametime. (A unanimous Seventh Circuit affirmed Sears.42

AMERCO43 and Harper Group44 were argued together

and affirmed by the Ninth Circuit in unanimousdecisions rendered less than 30 days after oralargument.)

In Sears the unrelated insureds comprised 99.75percent of Allstate’s insurance business. In AMERCOunrelated insurance comprised more than 50 percent ofthe pool for each year, ranging from 52 to 74 percent. InHarper Group the insurance subsidiary received approx-imately 30 percent of its premiums from unrelatedinsureds during the years at issue. The Tax Courtrejected the proposition that a parent corporation cannever obtain insurance from an insurance companyrelatedbyownership.It explainedthat theTaxCourthasrepeatedly rejected the IRS’s economic family theory.Instead, it developed a facts-and-circumstances testconsisting of three prongs, each of which must besatisfied: (1) the arrangement must involve the existenceof an insurance risk; (2) there must be both risk shiftingand risk distribution; and (3) the arrangement must befor insurance in its commonly accepted sense.

In AMERCO the purpose of the three-pronged testwas explained as providing a proper framework,ratherthan a definition, to address the existence of insurancefor federal tax purposes, in which each prong informsthe others and, to the extent not fully consistent,confines their excesses. The existence of an insurancerisk was present because each insured faced substan-tial potential liability that it had transferred toanother upon payment of a premium. Unlike illusoryself-canceling arrangements, such as in CarnationCo.,45 in which the parent agreed to make capitalcontributions to the insurance subsidiary, the transferof risk was real. Risk shifting occurred because theinsurance subsidiary had an existence separate andapart from its parent, was not a sham, was financiallycapable of satisfying the claims made against it, andactually paid claims. The court found risk distributionin AMERCO because the business was diverse andmultifaceted, and most of the money in the pool wasfrom unrelated insureds.

The court found risk distribution in Harper Groupbecause a relatively large number of unrelatedinsureds comprised a sufficient pool of insureds. Thefacts satisfied the third prong of the test, requiring thatthere be insurance in its commonly accepted sense,because each company was organized and operated asan insurance company, was adequately capitalized,was regulated as an insurance company,and each usedvalid and binding insurance policies that resulted fromarm’s-length transactions.

The first decision in the IRS’s appeals of the TaxCourt trilogy came from the Seventh Circuit in Sears.Aunanimous court observed that no judge of the Tax


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37Fed. Cl. Ct., 31 December 1997, 81 AFTR 2d 98-315.381988-2 C.B. 31.

391989-1 C.B 75.

4096 T.C. 61.

4196 T.C. 18.

4270 AFTR 2d 92-5540, 972 F2d 858, 92-2 USTC para. 50426.

43979 F.2d 162 (1992).

44979 F.2d 1341 (1992). 4547 AFTR 2d 81-997, 640 F2d 1010, 81-1 USTC para. 9263.

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Court had ever embraced the IRS’s economic familytheory, which it characterized as hard to reconcile withthe doctrine of Moline Properties Inc., which respectsthe separateness of corporations, emphasizing ineffect, “form over substance.” The court downplayedthe importance of risk transfer because, in commercialinsurance,devices such as experience rating and retro-spective rating mean that — at least over the long run— corporate insureds will bear all of their own risks.Risk distribution, the result of convergence throughpooling, was the important aspect. On that basis, itfound that the Tax Court must be affirmed because thetransactions between Sears and Allstate had at leastsome substance independent of tax effects. Thepayment of premiums increased the size of the pool toreduce the ratio between expected and actual losses,put the insurance company’s reserves at risk, andassigned claims administration to persons withcomparative expertise.

The opinions of the Ninth Circuit in AMERCO andHarper Group likewise downplayed risk transfer. Theyemphasized both the importance of risk distributionand the substance of the insurance transactions inde-pendent of tax effects. The AMERCO opinion rejectedthe IRS argument that risk transfer requires that allpossible risk be transferred — some risk alwaysremains in mutual companies and retrospectivelyrated policies, both undeniably insurance. It affirmedand restated the Tax Court conclusion that risk distri-bution had occurred, given a majority of outsidepremiums in the pool and the diverse and multifacetedcharacter of risks. In the Harper Group opinion, theNinth Circuit added that there is a point when theamount of outside business is so insubstantial thattrue insurance does not exist, but found that the TaxCourt committed no error in finding that point ofinsubstantiality had not been reached. In effect, theNinth Circuit pointed to the Harper Group trial courtas the one place in which the question of “how muchunrelated insurance is enough?”had been considered.

The Harper Group was the only case in the TaxCourt trilogy involving less than 50 percent unrelatedpremiums. The Tax Court in Harper Group found thatunrelated insureds had supplied 29 percent, 32percent, and 33 percent of gross premium revenues inthe three years before the court. It explained that therelatively large number of unrelated insureds (2,500annually) paid approximately 30 percent of thepremiums, a level of insurance that constituted a suffi-cient pool of insureds to provide risk distribution.

The Ninth Circuit Court of Appeals noted that itwas not considering brother-sister premiums asunrelated insureds, as had the Sixth Circuit inHumana Inc.46 By holding that insurance was present

in a pool consisting solely of the brother-sisterinsurance premiums, the Sixth Circuit found riskdistribution even without financially unrelatedinsureds. That point was not supported by thetestimony presented to the Tax Court or by theanalysis of the Tax Court sustained by the appellatecourts in the Sears-AMERCO-Harper Group trilogy.

The Tax Court rejected 2 percent unrelatedinsurance in Gulf Oil47 as de minimis, albeit withoutthe benefit of expert testimony to demonstrate theeffect of risk distribution. Because the effect would besmall, that conclusion appears correct. The Tax Courtsustained 29 percent in Harper Group, bracketing thetarget. The relative risk measurements above stronglysuggest the answer to the question “how much isenough?” At the 15 percent level of unrelatedinsurance, much — nearly most — of the effect ofadding unrelated insureds has been felt. Thatreduction should be viewed as meaningful, and itwould seem inappropriate to disregard the effect as deminimis. Such a meaningful reduction should demon-strate substance apart from tax effects and should beheld sufficient for risk distribution to occur.

Thus, the courts have agreed that unrelatedinsurance makes a difference, whether by causing riskdistribution or by occasioning a difference of substanceindependent of tax effects so that the form of theinsurance arrangements must be respected. But theyhave provided no basis on which to determine howmuch unrelated insurance is enough. The presenta-tions underlying the Tax Court decision in the HarperGroup case provide substantial guidance. The resultsupports a principled determination that 15 percent(although 30 percent appears a more relevantthreshold in light of the Service’s 2002 ruling of 50percent as an acceptable lower level, as below)unrelated insurance provides a meaningful reductionin relative risk that, as a general rule, should be suffi-cient for risk distribution and for there to be substanceapart from tax effects of the arrangement.

VI. Recent Case LawIn Kidde Industries Inc.48 the U.S. Court of Federal

Claims held that a corporation could deduct premiumspaid to a captive insurance company on behalf of asubsidiary, but not on behalf of a division (which,unlike a subsidiary, is not an entity separate from theparent corporation). The taxpayer conducted businessthrough 15 operating divisions and 100 wholly ownedsubsidiaries. Divisions and subsidiaries both had theoption of participating in the taxpayer’s master


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4664 AFTR 2d 89-5142, 881 F.2d 247, 89-2 USTC para. 9453.

4766 AFTR 2d 90-5552, 914 F.2d 396, 90-2 USTC para. 50496.48Fed. Cl. Ct., 31 December 1997, 81 AFTR 2d 98-315.

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insurance policy (Travelers) or obtaining alternatecoverage.49 There has been extensive litigation onthese points,one case of which was binding on the courtin Kidde.

In Ocean Drilling & Exploration Co.,50 unlike Kidde,the parent corporation made its payments directly to awholly owned captive insurance subsidiary. In Kiddethe parent made payments to a third-party insurer,

which then reinsured with the parent’s wholly ownedcaptive insurance subsidiary. In Ocean Drilling thecourt said that in determining whether payments tocaptive insurers are deductible, it had to followLeGierse and Moline Properties Inc. In LeGierse theSupreme Court said insurance involved “risk shiftingand risk distributing.” Moline Properties held thatunless, for example, a sham arrangement exists, acorporation generally should be treated as a taxableentity separate from its shareholder.

Bringing those two decisions together, the court inOcean Drilling said the parent and its captive companymust be considered separate entities in determiningwhether there was risk shifting and risk distribution.Even if the parent and the captive insurer wereseparate entities, if the parent retained the risk of thelosses against which it insured (that is, no risk shifting),the premiums paid amounted to a reserve for losses andthe parent could not deduct them from taxable income.The court found that the arrangement between Kidde,the multinational’s subsidiaries, and the captiveinsurance company was not a sham and was consistentwith “commonly accepted notions of insurance.” Theagreements allocated risks so that “one party would faceuncertain and variable claims against it.”

Risk shifting and risk distribution were present inthe payments made on behalf of Kidde’s subsidiaries,but not on behalf of its divisions.As to the divisions, thecourt found that Kidde shifted no risk to the captiveinsurer. Therefore, the premiums paid on behalf of thedivisions were merely a reserve for future claims and,based on Ocean Drilling and LeGierse, werenondeductible.


Special Reports

49In 1976 the taxpayer’s product liability policy was cancelledfor 1977. The taxpayer later incorporated its own wholly owned(captive) insurance company in Bermuda with US $1 million andpurchased insurance through a multinational insurance conglom-erate’s subsidiaries. Those subsidiaries entered into reinsuranceagreements with the captive, under which the captive assumedthe risk of paying the first US $2.5 million of each product’s liabil-ity. The taxpayer allocated premiums paid to the multinational’ssubsidiaries approximately 60 percent to the taxpayer’s subsid-iaries and 40 percent to its divisions. The captive insurance com-pany had no clients other than the taxpayer during 1977. From1978 to 1980 it had one additional insurance client, whose premi-ums totaled less than 1 percent of premium income for thoseyears. It did not seek third-party reinsurance business until 1980.By 1985 its third-party business was over 50 percent of total pre-mium income. In 1977 and 1978 the taxpayer paid premiums ofUS $25.3 million to the subsidiaries of the insurance conglomer-ate. US $21 million of this amount was ceded to the captive for re-insurance. The taxpayer filed its returns on a consolidated basis,including all divisions and subsidiaries, for 1977 and 1978 anddeducted the entire US $25.3 million. The IRS allowed a deduc-tion for the US $4.3 million retained by the multinational’s sub-sidiaries and for actual payments to the taxpayer’s divisions andsubsidiaries to satisfy claims, but it disallowed the remainingpayments by the taxpayer to the multinational that were ceded tothe captive for reinsurance during 1977 and 1978.

50988 F.2d 1135, 71 AFTR 2d 93-1184 (CA-F.C., 1993).

Illustration 5Economic Family Analysis

Rev. Rul. 88-72

Rev. Rul. 88-72

, clarified by Rev. Rul. 89-6, the economic family analysis was used to find insufficient even wherea preponderance of the wholly owned subsidiary’s business was with unrelated insureds. The Service ruled that while theremay have been sufficient , there was no risk shifting between the “insurance” subsidiary and parent and othersubsidiaries.

also explained the distinction between and

occurs when a risk is moved away from a corporate parent and its subsidiaries.

occurs when an insurance company accepts a large number of independent risks, thereby taking advantage of astatistical phenomenon known as “the law of large numbers” — although as the potential loss exposure increases, the averageloss incurred becomes increasingly unpredictable.

risk shifting

risk distribution

risk shifting risk distributing:

Shifting

Distributing

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VII. Recent IRS GuidanceBeginning in 2001, after a noticeable hiatus during

which the IRS worked the courts, the IRS began what is,with relatively short hindsight, a proliferation ofresponse, limited guidance, and warnings in the captiveinsurance area.The IRS began with Rev.Rul.2001-31,51

in which it announced that it would no longer invoke theeconomic family theory, originally set forth in Rev. Rul.77-316,52 when addressing the premium deductibilityissue of captive insurance transactions, thus aban-doning its long-evoked doctrine of reason in favor of“facts and circumstances,” and reserving the right tocontinue to challenge captive insurance arrangementsbased on the facts and circumstances of each case. Thisreservation increases the probability that the IRS willcontinue to challenge parent-subsidiary arrangementswhen a captive covers only the risks of its parent,although the economic family theory, an IRS mandateddoctrine, apparently will no longer be reserved as astaple in the IRS litigation arsenal.

Several recent field service advices from the IRSindicate that it will not challenge bona fidebrother-sister (controlled group) cases.53 That couldprovide substantial benefits to members of the con-trolled group. Those benefits are a function of thenumber of control group members, their size, and howhard the external insurance market has becomevis-à-vis the risk. It is noteworthy that Rev. Rul.2001-31 is silent as to whether insurance exists andwhether premiums are deductible, when a captiveinsures specified amounts of unrelated risk, inaddition to insuring related-party risk.54

In Notice 2002-70, the IRS examined taxpayers,generally service providers and retailers, who offercustomers coverage for repairs or replacement if aproduct is broken, stolen, or damaged,and coverage forpayment obligations if the customer dies or becomesdisabled or unemployed. The transaction is structuredso that the taxpayer, acting as an agent for anunrelated insurance company, offers insurance aspreviously described and then collects and remits apremium, less a sales commission retained by thetaxpayer, to the insurance company (typically similarto arrangements used in the recent past by automobileand other new and used vehicle dealerships). Also, thetaxpayer forms a wholly owned corporation, frequentlyreferred to as a producer-owned reinsurance company

(PORC), to reinsure the policies the taxpayer sold. Thetaxpayer remits the reinsurance premiums receivedfor the insurance company to the PORC. That takesadvantage of the benefits of IRC section 501(c)(15) orIRC section 831(b), which allow a qualifying company,whose net written premiums are between US $350,000and US $1,200,000, to elect to be taxed solely on invest-ment income. The practical impact of this recentpronouncement is to add such a transaction to the U.S.“corporate tax shelter blacklist,” requiring formaldisclosure of the arrangement to the IRS on thetaxpayer’s tax return in any year in which the effects ofsuch a transaction are contained. The IRS said it isquestionable whether the wholly owned PORC is aninsurance company; the IRS looks at actual activitiesof the entity during the year, including types of trans-actions and sources of income. Questions as to whetherthe transaction is a sham in substance are resolved byconsidering economic substance apart from tax conse-quences and business purpose.55

Although still relatively opaque, the issue of whatconstitutes an acceptable captive arrangement for taxpurposes has been expanded by a recent trilogy ofrevenue rulings, coupled with multiple revenue proce-dures, notices, and the first TAM in years. Those cameon the heels of Rev. Proc. 2002-75,56 which says the IRSwill now consider requests for rulings on the proper taxtreatment of captive insurance arrangements.The IRScautions, however, that the unique facts and circum-stances surrounding those arrangements probablynecessitate the taxpayer contacting the IRS, beforepreparing a request, with questions as to whether thetransaction is a sham in substance being resolved byconsidering economic substance apart from tax conse-quences and business purpose. According to Rev. Proc.2002-75, the IRS will now consider ruling requestsregarding the proper tax treatment of a captiveinsurance company. However, some questions arisingin the context of a captive ruling request are so inher-ently factual that the IRS should be contacted beforepreparing the request to determine whether it willissue the ruling.Accordingly, the IRS said that sections4.01(11) and 4.01(41) of Rev. Proc. 2002-357 have beendeleted. Those sections provided that the IRS ordi-narily will not rule on the application of IRC sections162 and 816 to insurance arrangements.

The IRS relies on, but refines, the previous discus-sion on risk shifting and risk distributing in Rev. Rul.2002-89.58 It holds that when the premiums earned


Special Reports

512001-26 IRB 1348.521977-2 C.B. 53, IRC section 162.53FSA 200130032; FSA 200125009; FSA 200125005.54Randall L. Hahn and William Bailey, “Captive Insurance

Companies: More Viable Than Ever?” Journal of Corporate Taxa-tion, WG&L, September 2002 Preview Edition.

55Both of these concepts were discussed earlier in this article.562002-52 IRB 997, 12/10/2002, IRC section 162.572002-1 IRB 117.582002-52 IRB 984.

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and risk borne by the captive constitute 90 percent ofthe parent-to-subsidiary premium ratio and risk ratio,respectively, the arrangement lacks sufficient riskshifting and risk distributing to warrant treatment asinsurance for federal income tax purposes. Therefore,payments by the parent to the subsidiary are not de-ductible as insurance payments. Alternatively, thepremiums are considered insurance payments for taxpurposes when the premium- and risk-borne ratios areless than 50 percent, because the premiums and riskborne by the parent are pooled with unrelated insuredsin sufficient quantities to meet requisite risk shiftingand risk distribution. In that case the parent-to-subsidiary insurance premium payments are deemedtax-deductible.

In factual situations presented in the revenueruling, when the premiums earned and risk borne bythe captive constitute 90 percent of the parent-to-subsidiary premium ratio and risk ratio, respectively,the arrangement lacks sufficient risk shifting and riskdistributing to warrant treatment as insurance forfederal income tax purposes. Accordingly, payments bythe parent to the sub are not deductible as insurancepayments. However, when the premium- and risk-borne ratios are less than 50 percent, the premiumsand risk borne by the parent are pooled with unrelatedinsureds in sufficient quantities to meet requisite riskshifting and risk distribution so as to be consideredinsurance for tax purposes; the parent-to-sub insur-ance premium payments are deemed tax-deductible.This leaves a wide gap between no unrelated risks andhalf unrelated risks, with practitioners seeming togravitate toward at least 30 percent of net written

premiums (net of reinsurance) as an acceptable norm,although well below the safe harbor of 50 percentprovided in the ruling.

Situation 1 of Rev. Rul. 2002-89 involves a domesticcorporation that enters into an annual arrangementwith its wholly owned domestic subsidiary wherebythe subsidiary “insures” the professional liability risksof the parent either directly or as a reinsurer. Thesubsidiary is regulated as an insurance company ineach state where it does business. The amounts thatthe parent pays to its subsidiary under the arrange-ment are established according to customary industryrating formulas. In all respects the parties conductthemselves consistently with the standards applicableto an insurance arrangement between unrelatedparties. The parent does not provide any guarantee ofits subsidiary’s performance, and all funds andbusiness records of the parent and the subsidiary aremaintained separately. While the subsidiary alsoenters into insurance contracts with unrelatedentities, the premiums that it earns from its parentconstitute 90 percent of its total premiums earnedduring the tax year on both a gross and net basis. Theliability coverage that the subsidiary provides to itsparent accounts for 90 percent of the total risks borneby the subsidiary.Situation 2 in the revenue ruling hasthe same fact pattern as Situation 1 except that thepremiums that the subsidiary earns from the arrange-ment with its parent constitute less than 50 percent ofits total premiums earned during the tax year on agross and net basis. The liability coverage that thesubsidiary provides to its parent accounts for less than50 percent of the total risks borne by the subsidiary.


Special Reports

Illustration 6Revenue Ruling 2002-89

CAPTIVE INSURING ‘UNRELATED’ RISKS

Relying on but refining the previous discussion on risk shifting and risk distributing…

This leaves moderately aggressive captive planners contemplating a safe harbor of 30 percent.

The Service holds that when the premiums earned and risk borne by the captive constitute 90 percent of the parent-to-subpremium ratio and risk ratio respectively, the arrangement lacks sufficient risk shifting and risk distributing to warranttreatment as insurance for federal income tax purposes. Therefore, payments by the parent to the sub are not deductible asinsurance payments.

Alternatively, when the premium and risk borne ratios are less than 50 percent, the premiums and risk borne by the parentare pooled with unrelated insureds in sufficient quantities to meet requisite risk shifting and risk distribution so as to beconsidered insurance for tax purposes; the parent-to-sub insurance premium payments are deemed tax-deductible as such.

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The IRS, in the revenue ruling, reasons that underreg. section 1.162-1(a), insurance premiums againstfire, storms, theft, accident, or other similar losses in abusiness are deductible business expenses.Neither theIRC nor the regulations define insurance or insurancecontract. However, the U.S. Supreme Court in LeGierseexplained that for an arrangement to constituteinsurance for federal income tax purposes, both riskshifting and risk distribution must be present. Nocourt has held that a transaction between a parent andits wholly owned subsidiary satisfies the requirementsof risk shifting and risk distribution if only the risks ofthe parent are “insured.” However, courts have heldthat an arrangement between a parent and its subsid-iary can constitute insurance when the parent’spremiums are pooled with those of unrelated parties if:(1) insurance risk is present; (2) risk is shifted anddistributed;and (3) the transaction is of the type that isinsurance in the commonly accepted sense. InSituation 1 of Rev. Rul. 2002-89, because the liabilitycoverage that the subsidiary provides to its parentaccounts for 90 percent of the total risks borne by thesubsidiary, the arrangement lacks the requisite riskshifting and risk distribution to constitute insurancefor federal income tax purposes, and payments by theparent to its subsidiary are not deductible as insurance

premiums. In Situation 2, because the liabilitycoverage that the subsidiary provides to its parentaccounts for less than 50 percent of the total risksborne by the subsidiary, the premiums and risks of theparent are pooled with those of the unrelated insureds.Thus, the requisite risk shifting and risk distributionto constitute insurance for tax purposes are present,and the payments by the parent are deductible asinsurance premiums.

Rev. Rul. 2002-9059 examines the situation of adomestic holding company that owns all of the sharesof 12 domestic professional service subsidiaries as wellas a wholly owned insurance subsidiary. The holdingcompany’s wholly owned insurance subsidiary directlyinsures the professional liability risks of the 12operating subsidiaries in the group. The insurancesubsidiary charges the 12 subsidiaries arm’s-lengthpremiums that are established according to customaryindustry rating formulas. None of the operatingsubsidiaries have liability coverage for less than 5percent or more than 15 percent of the total risk


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592002-52 IRB 985, 12/10/2002, IRC section 162.

Illustration 6Continued

Revenue Ruling 2002-89‘Safe Harbor’

PARENTCOMPANY

RELATEDRISKS

UNRELATEDRISKS

1 OR >SUBS

CAPTIVE

50% OR LESS

SAFE PASSAGE PREMIUM DEDUCTIBILITY

50% OR MORE

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insured by the insurance subsidiary. The insurancesubsidiary retains the risks that it insures from the 12operating subsidiaries. In all respects the partiesconduct themselves consistently with the standardsapplicable to an insurance arrangement betweenunrelated parties. The insurance subsidiary does notprovide coverage to any entity other than the 12operating subsidiaries. Although the captive’sinsurance business is limited to the 12 subsidiaries,traditional industry rating formulas are used, and riskshifting and risk distributing are demonstrated by thefact that no subsidiary has less than 5 percent or morethan 15 percent of the total risk insured by the captive,with the captive retaining the risk that it insures thesubs. Pooling exists — the insured loss suffered by onesub is covered by the premiums paid by the other subs.The payments are deemed to meet the insurancecriteria and are deductible.

Similar to Rev. Rul. 2002-89 above, Rev. Rul 2002-90focuses on the requirement that both risk shifting andrisk distribution must be present for an arrangementto constitute insurance. It cites several cases that holdthat arrangements between an insurance companysubsidiary and other subsidiaries of the parent qualifyas insurance because the requisite risk shifting andrisk distribution are present. In the case described inthe ruling, the professional liability risks of the 12operating subsidiaries are shifted to the insurancesubsidiary. Further, the premiums of the operatingsubsidiaries, determined at arm’s length, are pooled sothat a loss by one operating subsidiary is bornesubstantially by the premiums paid by others. Accord-ingly, the IRS concludes that the arrangementsbetween the insurance subsidiary and each of the 12operating subsidiaries constitute insurance for federalincome tax purposes and premiums paid for profes-sional liability coverage are deductible.

In Rev. Rul. 2002-91,60 the IRS reasons that IRCsection 831(a) provides that taxes are imposed for eachtax year on the taxable income of every insurancecompany other than a life insurance company. Underreg. section 1.801-3(a) an insurance company is “acompany whose primary and predominant businessactivity is the issuing of insurance or annuity contractsor the reinsuring of risks underwritten by insurancecompanies.” Factors considered in determiningwhether a captive insurance transaction is insuranceinclude: (1) whether the parties that insured with thecaptive truly face hazards; (2) whether premiumscharged by the captive are based on commercial rates;(3) whether the validity of claims was establishedbefore payments are made;and (4) whether the captivebusiness operations and assets are kept separate fromthe business operations and assets of its shareholders.

In Rev. Rul. 2002-91, a small group of unrelatedbusinesses involved in a highly concentrated industryform a group captive to provide insurance coverage forstated liability risks. The captive provides insuranceonly to members of the group. The business operationsof the captive are separate from the business operationof each member. No member owns more than 15percent of the captive, and none has more than 15percent of the vote on any corporate governance issue.Also, no member’s individual risk insured by thecaptive exceeds 15 percent of the total risk.The captiveissues insurance contracts and charges premiums forthe insurance coverage provided under the contracts.It uses recognized actuarial techniques, based in parton commercial rates, for similar coverage, to determinethe premiums to be charged to a member. The captivepools all premiums that it receives in its general funds,from which it pays claims. It conducts no businessother than issuing and administering insurancecontracts. Although only providing coverage to groupmembers, the captive’s assets and operations areseparated from those of the members. Also, whilelosses might be expected to exceed premiums remittedto the captive, refunds are not given to members whenlosses are less than premiums. Here, the substance ofthe structure and the transactions support the ar-rangement as insurance. Therefore, in this ruling, theIRS deems the premiums deductible for tax purposes.

In Rev. Rul. 2002-91, the group members face trueinsurable hazards. Although the group is small, thereis a real possibility that a member will sustain a loss inexcess of the premiums that it paid. No individualmember is reimbursed for premiums paid in excess oflosses sustained by that member and the members areunrelated. Therefore, the contracts issued by thecaptive are insurance contracts for federal income taxpurposes and the premiums paid by the members aredeductible business expenses under IRC section 162.Also, as the captive’s only business activity is thebusiness of insurance, it is taxed as an insurancecompany under IRC section 831.

Technical Advice Memorandum (TAM) 20032302661

concerns amounts paid by a parent corporation and itssubsidiaries to a related captive insurance company,aswell as to an unrelated insurance company thatreinsures the risks with the related captive insurancecompany. This TAM holds that the amounts paid arenot deductible under IRC section 162 as insurancepremiums because the facts do not support a finding ofinsurance for federal income tax purposes. The IRS,after stating that no single fact or factor is determina-tive, evaluates several factors that support its conclu-sion. The insurance subsidiary is initially capitalizedwith 1/20th of the amount recommended by the inde-


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602002-52 IRB 991, 12/10/2002, IRC section 162. 6106/06/2003, IRC section 162.

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pendent firm that prepared the feasibility study. Therelatively small amount of surplus in relation to theamount potentially at risk in even a single incidentdemonstrates that there is little expectation that theinsurance subsidiary could honor the terms of itspolicies in the event of a large pollution incident in asingle location. The degree of informality that theparties accord the insurance subsidiary weighsagainst treating the arrangements as insurance.Thereis only limited risk distribution among the parent andthe captive as a result of the arrangements.

In the TAM the parent is a holding company whoseoperating subsidiaries are engaged in manufacturingbusinesses in the United States. All of the parent’sstock is owned by its foreign parent, which is incorpo-rated in a foreign country. In year 1, in response toconcern over exposure to pollution liabilities, theparent commissions a feasibility study to consider theformation of a captive insurance company and receivesa recommendation that the proposed captiveinsurance company be initially capitalized with US$10,000. In August of year 2, the foreign parent formedan insurance subsidiary with a capitalization of US$500 under the laws of a foreign country. It is intendedthat the insurance company would have a fiscal yearbeginning 1 July and ending 30 June and that thepollution policies are issued on a 1 July to 30 Junebasis. The foreign parent also issued a letter offinancial support addressed to the insurance subsid-

iary, in which the foreign parent guarantees paymentof any claims in excess of the insurance subsidiary’sshare capital and retained earnings.

The insurance subsidiary is issued an insurancelicense on 11 August of year 2. During the last quarterof year 2, premiums totaling US $1,000 are paid to theinsurance subsidiary for the first policy year. Thepollution insurance policies were not formallyexecuted until 10 September of year 4. The policies are“claims made” policies with a policy year running from1 July of year 2 to 30 June of year 3. The insurancesubsidiary pays no claims for that policy period. As of30 June of year 3, the insurance subsidiary’s capitaland surplus are approximately US $1,500. In year 3the parent and its captive subsidiary enter intoinsurance contracts with a fronting company forworkers’ compensation risks. Effective 1 August ofyear 3, the fronting company enters into a reinsurancearrangement with the insurance subsidiary for theunderlying workers’ compensation risks of the parentand captive. Under the agreement, the insurancesubsidiary receives only a token amount in premiumincome. For the policy years in question (years 2, 3, and4), the insurance subsidiary pays no pollution claims.As to the reinsurance of the underlying risks of theworkers’ compensation risks of the parent and captive,the insurance subsidiary reports nominal losses andexpenses for years 2, 3, and 4, and parent and captive


Special Reports

Illustration 72003 TAM

Technical Advice Memorandum 200323026

Amounts paid by a parent corporation and its subsidiaries to a related captive insurance company, as well as to anunrelated insurance company that reinsured the risks with the related captive insurance company, and holds thatsuch amounts paid are not deductible as insurance premiums.

Facts do not support a finding of insurance for federal income tax purposes, and amounts paid under thesearrangements are therefore not deductible as insurance premiums.

The insurance subsidiary was initially capitalized with 1/20th of the amount recommended by the independentfirm that prepared the feasibility study.

The relatively small amount of surplus in relation to the amount potentially at risk in even a single incidentdemonstrated that there was little expectation that the insurance subsidiary could honor the terms of its policies inthe event of a large incident in a single location.

The degree of informality that the parties accorded the insurance subsidiary weighed against treating thearrangements as insurance. There was only limited risk distribution among P and the captive as a result of thearrangements.

Technical Advice Memorandum 200323026, 06/06/2003, IRC Sec(s). 162

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deduct amounts paid to the insurance subsidiary asinsurance premiums under IRC section 162.

This TAM is the first private ruling issued after Rev.Rul. 2002-89, Rev. Rul. 2002-90, and Rev. Rul. 2002-91(issued in December 2002).The TAM indicates that theIRS may not focus on any one factor in evaluatingwhether an insurance arrangement will be treated asinsurance for federal tax purposes,but will look at all ofthe facts and circumstances. However, there areseveral factors in the TAM that, in the IRS’s view,support a conclusion that the arrangement is not to betreated as insurance for federal tax purposes. Itremains to be seen whether any one of the factors aloneis sufficient for the IRS to reach the same conclusion.

Rev. Proc. 2003-47 provides newprocedural rules regarding the IRCsection 953(d) election that allowssome foreign insurance companies toelect to be treated as domesticcorporations for U.S. tax purposes.

Rev. Proc. 2003-4762 provides new procedural rulesregarding the IRC section 953(d) election that allowssome foreign insurance companies to elect to be treatedas domestic corporations for U.S. tax purposes. Theprocedure replaces the rules in Notice 89-79.63

Pursuant to it, a CFC that elects under IRC section953(d) will be subject to tax in the United States on itsworldwide income but will not be subject to the branchprofits tax or the branch-level interest tax imposed byIRC section 884. In addition, the excise tax imposedunder IRC section 4371 on policies issued by foreigninsurers will not apply. Rev. Proc. 2003-47 provides anew mailing address for IRC section 953(d) electionsand takes into account the replacement of Form2848-D by Form 8821 (Tax Information Authorization)to designate an authorized representative to receiveconfidential tax information on behalf of the corpora-tion that makes an IRC section 953(d) election. Theprocess of making an IRC section 953(d) election mustbe initiated by filing an original election statement.The electing corporation must attach to its electionstatement a complete list of all U.S. shareholders of theelecting corporation as of a date no more than 90 daysbefore the date the election statement is mailed. Thelist must include the name, address, and tax identifica-tion number of, and ownership percentage for, eachU.S. shareholder. To complete the election, an electingcorporation that does not satisfy the “office”and “asset”

tests (discussed below), either directly or through aU.S. affiliate, must enter into a closing agreement andprovide a letter of credit to secure payment of taxesdue, if any, from the electing corporation. The letter ofcredit must be in an amount equal to 10 percent of theelecting corporation’s gross income, but not less thanUS $75,000 and not greater than US $10 million.

A closing agreement and letter of credit will not berequired if the electing corporation maintains an officeor other fixed place of business in the United States(office test) and owns assets that are physically locatedin the United States with an adjusted basis equal to 10percent of its gross income for the base year (asset test).If, as a result of the IRC section 953(d) election, theelecting corporation is a member of a consolidatedgroup, the electing corporation may satisfy the officeand asset tests based on the office and assets of a U.S.corporation that is a member of the consolidated group(a U.S. affiliate). If the electing corporation chooses tosatisfy the office and asset tests based on the office andassets of a U.S. affiliate, the affiliate must enter into aclosing agreement with the IRS to agree that, in theevent of termination or revocation of the electing corpo-ration’s election, the affiliate will be liable for the excisetax that remains unpaid after the electing corporationhas been issued a statement of notice and demand forthe tax.

The base year is generally the tax year immediatelybefore the tax year for which the election is first made.However, if the electing corporation did not receivegross income in the prior tax year, the base year is thefirst year of the election. If the first year is not a full taxyear, gross income is determined annually.

To satisfy the asset test, a corporation may includean asset only to the extent that any claim of the U.S.government regarding the asset (which may arise fromthe corporation’s failure to pay any tax imposed by theIRC) is not subordinated to the claims of any othercreditor. Intangible personal property will qualify asan asset physically located in the United States only ifthe income from that property is income from sourceswithin the United States, and the evidence ofownership of the property is physically present in theUnited States.

Once approved, the election generally remainseffective for each subsequent tax year in which therequirements are satisfied unless revoked by theelecting corporation with the IRS’s consent. However, ifthe electing corporation fails to timely file a return, paythe tax due, or comply with any other requirement formaking the election, the IRS may terminate the electionas of the beginning of the tax year after the tax yearregarding which the failure occurs.Termination or revo-cation of the election may cause the U.S. shareholders ofthe foreign corporation to be liable for subpart F inclu-sions for tax years when the election is no longer ineffect. It will also cause the corporation to be considered


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622003-28 IRB 55, 06/20/2003, IRC section 953.631989-2 C.B. 392.

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a foreign person for purposes of the excise tax under IRCsection 4371 on premiums for insurance or reinsuranceissued by the foreign corporation.

Notice 2003-3464 warns taxpayers that arrange-ments involving investments in offshore insurancecompanies that invest in hedge funds or investmentsin which hedge funds typically invest, which are beingused to defer recognition of ordinary income or to char-acterize ordinary income as a capital gain, often do notgenerate the claimed federal tax benefits. RelatedNotice 2003-3565 serves as a reminder that an entitymust be an insurance company for federal income taxpurposes to qualify for IRC section 501(c)(15)exemption. The typical arrangement involves anowner, subject to U.S. income tax, investing (directly orindirectly) in the equity of a foreign corporation that isorganized as an insurance company. The foreign corpo-ration issues insurance or annuity contracts orcontracts to “reinsure” risks underwritten byinsurance companies. Some of the contracts do notcover insurance risks; others significantly limit therisks assumed by the foreign corporation through theuse of retrospective rating arrangements, unrealisti-cally low policy limits, finite risk transactions, or othersimilar devices. The foreign corporation’s actualinsurance activities, if any, are small compared to itsinvestment activities. It invests its capital and theamounts that it receives as consideration for its“insurance” contracts in, among other things, hedgefunds or investments in which hedge funds typicallyinvest. As a result, the foreign corporation’s portfoliogenerates investment returns that substantiallyexceed the needs of its “insurance” business. Theforeign corporation generally does not currentlydistribute these earnings to the stakeholder. Thestakeholder takes the position that the foreign corpo-ration is an insurance company engaged in the activeconduct of an insurance business and is not a passiveforeign investment company (PFIC). Therefore, whenit disposes of its interest in the foreign corporation, itwill recognize capital gain rather than ordinaryincome.

IRC section 1297(b)(2)(B) provides an exception topassive income for any income derived in the activeconduct of an insurance business by a corporation thatis predominantly engaged in an insurance businessand that would be subject to tax under subchapter L ofthe IRC if it were a domestic corporation (theinsurance income exception). If the foreign corporationwould not be subject to tax under subchapter L if itwere a domestic corporation, the insurance incomeexception to passive income will not apply, and the

foreign corporation will be subject to the generalincome and asset tests. Even if the foreign corporationwould be subject to tax under subchapter L if it were adomestic corporation, the insurance income exceptionmay not apply to the foreign corporation because theexception applies only to income derived in the activeconduct of an insurance business. The IRS said that itwill scrutinize arrangements and will apply the PFICrules when it determines that a foreign corporation isnot an insurance company for federal tax purposes.

Notice 2003-3566 also reminds taxpayers that anentity must be an insurance company for federalincome tax purposes to qualify as exempt from incometax as an organization described in IRC section501(c)(15). As described above, this section providesthat an insurance company (other than a life insurancecompany) is tax-exempt if its net written premiums (or,if greater, direct written premiums) for the tax year donot exceed US $350,000. For purposes of this annualtest, the company is treated as receiving during the taxyear premiums received during the same year by allother companies within the same controlled group. Foran entity to qualify as an insurance company, it mustissue insurance contracts or reinsure risks under-written by insurance companies as its primary andpredominant business activity during the tax year.Taxpayers and practitioners alike are hereby warnedthat the IRS intends to scrutinize the tax-exemptstatus of entities claiming to be described in IRCsection 501(c)(15) and will challenge the exemption ofany entity that does not qualify as an insurancecompany, regardless of whether the exemption isclaimed under an existing determination letter or on areturn filed with the IRS.

VIII. ConclusionCaptive insurance arrangements continue to be

popular planning tools in the practitioner’s arsenalwhen confronted with the increasingly “hard”insurance markets accompanying the terrorist attackson the United States on 11 September 2001, coupledwith the collateral effects of global recession andabysmal investment returns of late, once the anchor ofpublic insurance company earnings and reserves.Increasingly, the captive concept is moving onshore inthe United States to friendly and progressive jurisdic-tions, including Vermont and South Carolina, as regu-lation decreases and insurance infrastructures becomeprogressive. The prolific use of the domestic companyelection for offshore captives indicates that theprimary reasons for selecting an offshore jurisdictionin the past were the lack of regulation and the innova-tion provided in offshore environments. These offshore


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642003-23 IRB 990, 05/09/2003, IRC section 1297.652003-23 IRB 99. 662003-23 IRB 992, 05/09/2003, IRC section 501.

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jurisdictions for some U.S. captive insurance arrange-ments may become relics of the past as onshore juris-dictions rise to the challenge of the offshorecompetition of Bermuda and Cayman, with anexception for certain arrangements such as Risk-Retention Groups (RRGs) and some other types ofgroup captive arrangements that cannot be writtenfrom an onshore jurisdiction in the U.S. currently, andfor which certain offshore “segregated portfoliocompanies” may be more appropriate, although forwhich U.S. civil law remains quite uncertain as to thelegal status accorded such arrangements in the eventof onshore liquidation.

Most notably, employee benefits are emerging as astaple in the captive portfolio of insured risks as the U.S.Department of Labor (DOL) implements its “expeditedprocess” system of fast-track approval of captives

insuring employee benefits such as group long-termdisability and life insurance for employees of midsizeand larger companies, requiring only 90 days for consid-eration. In November 2003, the DOL approved such afast-track request for International Paper Company.Including employee risks within the captive insuranceportfolio provides such U.S.companies with an essentialelement of premium deductibility — insuring“unrelated” risks — because such employee risks aredeemed unrelated insureds for risk-shifting purposes.

In conclusion, international tax and legal practitio-ners should be aware of one certainty in the uncertainarena of captives — captive insurance arrangementsfor now are here to stay. They make perfect sense inmany situations both economically and from a taxstandpoint if established and maintained carefullyand competently. ✦


Special Reports

Illustration 8EMERGING TRENDS

Increasingly in the U.S., the captive concept is moving onshore to friendly and progressive jurisdictions asregulation decreases and insurance infrastructures become progressive.

Onshore jurisdictions rise to the challenge of the offshore competition of Bermuda and Cayman.

U.S.PARENT

CAPTIVE

CHOICE OF JURISDICTION

VERMONT S.C.

CAYMANBERMUDA

OTHERDOMESTIC

OTHERFOREIGN

JURIS-DICTIONS

SHORELINE

EMPLOYEEBENEFITS

3 RD

PARTYREINSURANCE

= UNRELATEDRISKS FORRISK-SHIFTINGPURPOSES

Employee benefits are emerging as what may be a staple in the captive portfolio of insured risks prospectively asthe DOL implements its “expedited process” system of fast-track approval of captives insuring such employeebenefits as group long-term disability and life insurance for employees, thus providing them with the essentialelement of insuring “unrelated” risks as such employees are deemed for risk-shifting purposes to be unrelated.

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Documents

tax notes international - blueskydesignny.com€¦ · Correspondents Africa: Zein Kebonang, University of Botswana, Gaborone Albania: Adriana Civici, Ministry of Finance, Tirana Angola: