CCA 200125009: Counsel agrees to concede captive insurance premium deductions

Plain-English summary

A domestic corporation deducted premiums paid to an insurance company owned by the same foreign parent. Chief Counsel considered whether this arrangement shifted and spread risk enough to count as insurance under section 162. It noted that courts had allowed premiums in similar arrangements between sibling companies and that the facts presented offered no relevant distinction from one such case. Counsel therefore did not object to Appeals' recommendation to concede the deduction issue. The advice also explains that a captive or its transactions can still fail if they are a sham.

Ruling snapshot

• Question: Should premiums paid to a sibling captive insurer be deductible as insurance expenses?
• Outcome: Advice to concede the deduction issue on the facts presented.
• Key authorities: IRC § 162; Treas. Reg. § 1.162-1(a); Humana, Inc. v. Commissioner, 881 F.2d 247.

Full text (IRS public release)

DEPARTMENT OF THE TREASURY
IN T E R N AL R E V E N U E S E R V IC E W ASHINGT ON, D.C. 20224
March 12, 2001
OFFICE OF
CHIEF COUNSEL

Number: 200125009
Release Date: 6/22/2001
CC:FIP:4
SPR-106911-01
UILC: 162.04-03

INTERNAL REVENUE SERVICE NATIONAL OFFICE FIELD SERVICE ADVICE

MEMORANDUM FOR
NATIONAL OFFICE APPEALS

FROM: Mark Smith, Chief
Branch 4
Associate Chief Counsel (Financial Institutions & Products)

SUBJECT: Premiums paid for captive insurance

This Field Service Advice responds to your memorandum dated January 19, 2001.
Field Service Advice is not binding on Examination or Appeals and is not a final case determination. This document is not to be used or cited as precedent.

DISCLOSURE STATEMENT

Field Service Advice is Chief Counsel Advice and is open to public inspection pursuant to the provisions of section 6110(i). The provisions of section 6110 require the Service to remove taxpayer identifying information and provide the taxpayer with notice of intention to disclose before it is made available for public inspection. Sec. 6110(c) and (i). Section 6110(i)(3)(B) also authorizes the Service to delete information from Field Service Advice that is protected from disclosure under 5 U.S.C. § 552 (b) and (c) before the document is provided to the taxpayer with notice of intention to disclose. Only the National Office function issuing the Field Service Advice is authorized to make such deletions and to make the redacted document available for public inspection. Accordingly, the Examination, Appeals, or Counsel recipient of this document may not provide a copy of this unredacted document to the taxpayer or their representative. The recipient of this document may share this unredacted document only with those persons whose official tax administration duties with respect to the case and the issues discussed in the document require inspection or disclosure of the Field Service Advice.
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LEGEND

Taxpayer =
X
=
Y
=
Country A =
Country B =
Date 1
=
Date 2
=
$a = $
$b = $

ISSUES

Whether Taxpayer is entitled to deduct as “insurance” premiums amounts paid to Y pursuant to a brother-sister captive insurance arrangement?

CONCLUSIONS

We do not object to your recommendation that this issue be conceded.

FACTS

The years at issue are the taxable years ended Date 1 and Date 2. Taxpayer, a domestic corporation, is the wholly owned subsidiary of X, a Country A corporation. X also owns Y, a registered insurance company under the laws of Country B. Thus, Taxpayer and Y are sibling subsidiaries of a common parent.

During the taxable years ended Date 1 and Date 2, Taxpayer was putatively insured through several policies issued by Y. The risks covered by the policies included commercial general liability, products liability, and automobile liability. Taxpayer paid premiums to Y with respect to these policies in the amount of $a during the taxable year ended Date 1, and in the amount of $b during the taxable year ended Date 2. For federal income tax purposes, Taxpayer claimed deductions for the amounts that it paid to Y.

LAW AND ANALYSIS

Generally, premiums paid for insurance are deductible under I.R.C. § 162(a) if directly connected with the taxpayer’s trade or business. Treas. Reg. § 1.162-1(a). Although the Internal Revenue Code does not define the term “insurance,” the 3
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United States Supreme Court has explained that to constitute “insurance,” a transaction must involve "risk shifting" (from the insured to the insurer) and “risk distribution” (by the insurer). Helvering v. Le Gierse, 312 U.S. 531, 539 (1941). In this regard, amounts set aside by a taxpayer as a self-insurance reserve for anticipated losses are not deductible “insurance” expenses because risk is not shifted from the taxpayer. Therefore, these amounts are not deductible until the taxpayer actually pays or accrues the anticipated loss. United States v. General Dynamics Corp., 481 U.S. 239, 243-244 (1987).

In Rev. Rul. 77-316, 1977-2 C.B. 53, three situations were presented in which a taxpayer attempted to seek insurance coverage for itself and its operating subsidiaries through the taxpayer’s wholly-owned captive insurance subsidiary. The ruling explained that the taxpayer, its non-insurance subsidiaries, and its captive insurance subsidiary represented one “economic family” for purposes of the risk-shifting analysis. The ruling concluded that the transactions were not insurance to the extent that risk was retained within the economic family. Therefore, the premiums paid by the taxpayer and its non-insurance subsidiaries to the captive insurer were not deductible.

No court has fully accepted the economic family theory as set forth in Rev. Rul. 77-

316. Particularly, both the United States Court of Appeals for the Sixth Circuit and
     the United States Court of Federal Claims have held that payments to a captive insurer by its sibling subsidiary were deductible as insurance premiums. Humana, Inc. v. Commissioner, 881 F.2d 247 (6th Cir. 1989); Kidde Industries, Inc. v. United States, 40 Fed. Cl. 42 (1997). In both Humana and Kidde, the captive in question insured risks only within its related group. Both courts reasoned that sufficient risk shifting existed with respect to the brother-sister transactions because a loss incurred by the insured subsidiary did not diminish the assets reflected on that subsidiary’s balance sheet when the captive paid claims. The court in Humana explained that brother-sister transactions should be considered insurance for federal income tax purposes unless either the captive entity or the transaction itself is a sham. Humana, 881 F.2d at 255.

In Malone & Hyde v. Commissioner, 62 F.3d 835 (6th Cir.1995), the Sixth Circuit applied Humana to a brother-sister insurance transaction and concluded that the captive insurer was a sham, and that the payments at issue were therefore not deductible as insurance premiums. In Malone, the taxpayer and its operating subsidiaries purchased insurance from a commercial insurer, which then reinsured a significant portion of those risks with the taxpayer’s captive insurance subsidiary. The commercial insurer retained a portion of premiums received from the taxpayer, and paid the remainder to the captive subsidiary as a reinsurance premium. The taxpayer claimed deductions for the insurance premiums paid to the commercial 4
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insurer. In determining that the captive insurance company was a sham corporation, the court in Malone noted that the parent “propped up” the captive by guaranteeing its performance, that the captive was thinly capitalized, and that the captive was loosely regulated by the locale in which the captive was incorporated (Bermuda). Id. at 840.

In addition to the factors set forth in Malone, other possible factors to consider in determining whether a captive insurance transaction is a sham include: whether the parties that insured with the captive truly faced hazards; whether premiums charged by the captive were based on commercial rates; whether the validity of claims was established before payments were made on them; and whether the captive’s business operations and assets were kept separate from its parent’s. Ocean Drilling & Exploration Co. v. United States, 24 Cl. Ct. 714, 728-729 (1991), aff’d, 988 F.2d 1135 (Fed. Cir. 1993).

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS:

All of the premiums at issue are attributable to brother-sister captive insurance transactions. Given the opinions in Humana and Kidde, it is unlikely that a court in this case would invalidate these transactions on the basis of the economic family theory set forth in Rev. Rul. 77-316. Your submission further indicates that there are no relevant distinctions between the facts in this case and the facts set forth in Humana.

Accordingly, we do not object to your recommendation to concede this issue.

Please call if you have any further questions.

Lon B. Smith
Acting Associate Chief Counsel
(Financial Institutions and Products)
By: MARK SMITH, CHIEF
Branch 4