By Steven Miller, former IRS Acting Commissioner and alliantgroup National Director of Tax
On December 9, 2011, the IRS issued Technical Advice Memorandum 201149021, concluding that a residual value insurance contract that ‘insures against market decline is not a contract of insurance for federal income tax purposes.” On September 21, 2015, in R.V.I. Guaranty Co., LTD. & Subsidiaries, v. Commissioner of Internal Revenue, the Unites States Tax Court disagreed, ruling that the IRS was wrong and residual value insurance is insurance for tax purposes.
In the RVI case, the taxpayer provided residual value insurance to unrelated parties on the property they leased. Residual insurance in this case provides protection against the risk that the actual value of the asset would be significantly lower than the expected value when the lease ended. The insured was leasing companies, manufacturers and financial institutions that leased passenger vehicles, commercial real estate and commercial equipment.
“Pure Risk” and “Speculative Risk”
The IRS argued that the contracts were not insurance because the lessors were purchasing protection against an investment risk and not an insurance risk. The Service supported this argument by claiming that insurance risk only covers “pure risk” and not “speculative risk,” stating that pure risk only has two possible outcomes, loss or no loss. According to the IRS’ argument, if there is a chance for a gain, the contract involves speculative risk and not insurance risk.
The court found this argument unpersuasive and explained that even some of the sources cited by the IRS experts did not support the contention that pure risk is the only type of insurance risk. More importantly, the court cited several types of commonly accepted insurance that do not involve pure risk; specifically, mortgage guaranty insurance and municipal bond insurance.
One IRS expert stated the policies differed from typical insurance policies as the risk insured is not a fortuitous “insured event.” The expert argued that the taxpayer did not face any “timing risk” because the taxpayer faced no uncertainty as to when the loss would occur since they knew exactly when the lease would end. The court dismissed this argument, stating that the underlying occurrence that diminished the value of leased property could happen at any time during the lease term, thus having different end dates for the leases contributed to the distribution of risk for the insurer.
The IRS claimed that there was no risk-shifting as the taxpayer was not exposed to any significant loss. The IRS determination was based on a very low loss ratio for the taxpayer in the first four years of providing insurance. This led an IRS expert to opine that the risk of loss was remote. The taxpayer countered this argument by sharing the loss ratios for the next ten years, which amounted to a cumulative loss ratio of approximately 34%, demonstrating that they paid a significant number of claims. The taxpayer further explained that fewer claims would be expected in the early years as the leases had to expire before the claims were made. The court found the taxpayer’s position much more persuasive, comparing the coverage with catastrophic insurance coverage, which insures against low-frequency, high-severity risks. When dealing with products like hurricane insurance or flood insurance, an insurer may go many years without paying any claims. However, that does not mean it is not insurance.
Additionally, in deciding the issue of risk-shifting, the court stated that they “have no difficulty concluding that the lessor and finance companies that purchased the RVI policies transferred to petitioner a meaningful risk of loss.” Without the policy, the insured would bear the entire risk associated with a loss-causing event. The court also considered whether the taxpayer was actually financially capable of paying the claims. Regarding this matter, they determined that the taxpayer was “well-capitalized” and “fully capable of paying claims and absorbing the risk transferred to it.”
The IRS also argued that the risk-distribution was “less than is usual for an insurer” as “some systemic risks, like major recessions, could cause insured assets to decline in value simultaneously.” In one year, the taxpayer distributed risk through 951 policies covering 714 different insured, doing so across three business segments with different asset types spread through several geographic regions and different lease durations. The insured assets could be affected differently by things like regional economic downturns, rising fuel prices, technological improvements or over-supply of particular assets.
The court acknowledged that the taxpayer did face certain systemic risks, but they also faced a number of uncorrelated risks. The court stated that “even systemic risks like major recessions were mitigated by temporal distribution” over lease terms of up to 28 years. In shooting down the IRS’ argument, the court stated that “we have no difficulty concluding … that the RVI policies accomplish sufficient risk distribution to be classified as insurance for federal tax purposes.”
Acting Like Insurance
In determining that the policies are consistent with the commonly accepted notion of insurance, the court considered whether the taxpayer was organized and operated in accordance with insurance regulations; whether the taxpayer was adequately capitalized; whether the polices were valid and the premiums were reasonable; and whether premiums and claims were paid. The taxpayer was organized in every state they did business in and had more than sufficient capital to satisfy its claims. The court found that the policies contained standard provisions typical of insurance policies. The court also ruled that the policies were valid and when covered losses occurred, claims were filed and paid.
Finally, the court compared the RVI policies with other policies commonly accepted as insurance. As stated above, the court compared the policies to mortgage guaranty insurance and municipal bond insurance, using this comparison to demonstrate that the underlying asset involved with the policy could gain value—as well as lose value or remain the same in the process. Another reference by the court involved a 1933 Pennsylvania Supreme Court case that held that an insurer’s indemnification against loss forms a decline in a value of real estate involved insurance risk. Additionally, several state statutes define residual value policies as a form of insurance.
In the end, the court concluded that upon analyzing insurance risk, risk transfer, risk distribution and the commonly accepted notion of insurance, the residual value policies were insurance for federal tax purposes. In this process, the IRS took another big hit when it comes to insurance. We have seen in examinations where we were representing captive managers, captive insurance companies or their related operating companies, that the IRS has made similar aggressive arguments attempting to limit the definition of insurance. This decision follows other recent court decisions that do not support such a limited view. The IRS remains active in the area however and we will continue to monitor the impact of this ruling on future captive insurance court cases.
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