The IRS recently released LTR 201609008, in which it found a foreign captive insurer to not be an insurance company exempt from tax under IRC § 501(c)(15). The specifics of the determination were released as a redacted Form 886-A Report of Examination that found the taxpayer did not meet the requirements of IRC § 501(c)(15) because it did not qualify as an insurance company.
Under IRC § 501(c)(15), an insurance company qualifies for tax exempt status if 1) the gross receipts for the taxable year do not exceed $600,000, and more than 50 percent of gross receipts consist of premiums, or 2) in the case of a mutual insurance company, gross receipts do not exceed $150,000, and more than 35 percent of such gross receipts consist of premiums. The gross receipts tests are applied on an annual basis, and depending on its facts and circumstances, a company may satisfy the tests in some years (be treated as exempt) but not in others (treated as taxable).
The taxpayer, formed as a foreign captive insurance company, initially filed a Form 1024 seeking tax exempt status under IRC § 501(c)(15). The taxpayer later withdrew the application and the IRS closed out the file without making any determination as to the company’s status. Further, although the company intended to elect to be taxed as a U.S. corporation under IRC § 953(d), the IRS found no evidence that the election had been approved.
The taxpayer insured three related entities and also served as a reinsurer. During the years in dispute, the company issued the following 14 types of insurance policies: Loss of Services, Product Recall, Weather Related Business Interruption, Regulatory Changes, Tax Liability, Loss of Major Customer, Excess Intellectual Property Package, Expense Reimbursement, Excess Employment Practices Liability, Excess Directors and Officers Liability, Excess Cyber Risk Liability, Legal Expense, Excess Pollution Liability, and Punitive Wrap Coverage.
The taxpayer also participated in two reinsurance arrangements. Under the first arrangement, it participated in a risk pool with several other unrelated insurance companies, generally providing casualty coverage such as credit life and credit disability. Under the second arrangement, the taxpayer assumed vehicle service reinsurance contracts from the entity operating the risk pool.
The IRS’s inquiry focused on whether or not the taxpayer was actually an insurance company providing insurance in the commonly accepted sense. Its analysis of the insurance and reinsurance arrangements generally mirrored its analysis of other small captive insurance company arrangements. That is, the IRS generally focuses on a number of factual issues such as risk shifting, risk distribution, premiums, pricing, underwriting and existing coverages.
The IRS began by examining every policy issued by the taxpayer and determining whether the policy covered insurance risk, or if it simply protected the insured from investment or business risk. Although the IRS did not provide an analysis in making its determination with respect to each of the policies, it did state that it considered the following factors in assessing whether there was insurance risk for a particular policy: ordinary activities of the business enterprise, typical activities and obligations of running a business, whether the action that might be covered by the policy is in the control of the insured within a business context, whether the economic risk involved is a market risk that is part of the business environment, whether the insured is required by law or regulation to pay for the covered claim, and whether the action in question is willful or inevitable.
The IRS found that all but three of the policies only covered investment or business risks. It did, however, find weather related business interruption, excess directors liability and a portion of cyber risk liability (other than coverage for public relations services and other consultants) to cover insurance risk. It also determined that the uninsured defense portion of expense reimbursement coverage might constitute insurance, although further factual development was required. With respect to the reinsurance arrangements, the IRS indicated it did not have good information regarding the risks insured, but based on some information it did have, it was unlikely that the reinsurance pool would contain insurance risks.
Next, the IRS expressed concern that the premiums were not reasonable. The premium amounts were redacted so it is impossible to determine what the actual payments were. However, concerns over premium pricing are not new, as the IRS has repeatedly attacked the reasonableness of premium payments. The IRS ultimately concluded that the premiums were not determined on an actuarial basis and were not reasonable.
The IRS then determined that the taxpayer failed to distribute risk—a requirement for valid insurance. The IRS argued that because most of the risk insured by the taxpayer was under direct written contracts with related parties, the risk was too heavily concentrated in related entities, and therefore not distributed sufficiently. Based on an analysis of the premiums, the IRS stated that two-thirds of the risk involved affiliated business interests, and noted that it was highly probable that any losses paid by the taxpayer were those of affiliated businesses and not unrelated third parties. It claimed that the reinsurance pool did not contain a sufficient number of insureds as required by prior IRS guidance.
Lastly, the IRS held that because the taxpayer is not a valid insurance company, it cannot elect to be treated as a domestic corporation under IRC § 953(d), and should be treated as a controlled foreign corporation subject to Subpart F of the code.
In a separate determination involving slightly different facts but similar types of coverages, LTR 201613016, the IRS addressed the same legal issues described above, and generally reached the same outcomes with respect to the involved coverages.
Because important information was redacted in both determinations, it is impossible to obtain a full view of the IRS’s thought process in these instances. However, although these determinations were made in the section 501(c)(15) exemption setting, they provide important insight into the IRS’s current thinking regarding captive insurance arrangements in general. The IRS has stated its position in regards to captive insurance companies and the types of activities it is focused on, and these determinations help reinforce these previously stated positions. LTR 201609008 can be found by visiting https://www.irs.gov/pub/irs-wd/201609008.pdf.
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