The first fact pattern outlined in Revenue Ruling 77-316 is entirely insular:
During the
taxable year domestic corporation X and its domestic subsidiaries entered into
a contract for fire and other casualty insurance with S1, a newly organized
wholly owned foreign “insurance” subsidiary of X. S1 was organized to insure properties and
other casualty risks of X and its domestic subsidiaries. X and its domestic subsidiaries paid amounts
as casualty insurance premiums directly to S1. Such amounts reflect commercial rates for the
insurance involved. S1 has not accepted
risks from parties other than X and its domestic subsidiaries.[1]
In other
words, the captive only deals with other subs – it writes no policies outside
the corporate family, nor does it obtain any reinsurance. The captive is expected to stand on its own. Several cases successfully prosecuted by the
IRS illustrate how the service attacked this fact pattern.
The plaintiff
in Stearns Rogers designed and
manufactured “large mining, petroleum and power generation plants.”[2] In order to bid on projects, the company had
to obtain insurance for its own contractors as well as its clients.[3] Starting in the early 1970s, the company
“found it difficult or impossible to obtain from traditional companies the
types and huge amounts of coverage needed.”[4] Therefore the company formed a captive
insurance company under the Colorado Captive Insurance Company Act.[5] In order to gain approval from the Colorado Insurance
Commissioner, Stearns Rogers had to demonstrate the company could not find
other insurance.[6] The plaintiff named the company Glendale
Insurance Company, which only issued insurance policies for the plaintiff, the
plaintiff’s subsidiaries and the plaintiff’s clients.[7] Glendale
did not use reinsurance. The plaintiff
agreed to indemnify the captive for up to three million dollars. The plaintiff deducted payments it made to Glendale under the theory
that the payments were insurance premiums.[8] The service disallowed the deductions,[9]
claiming the payments were in fact self-insurance or payments to a reserve
which are not deductible.[10]
At
trial, the service advanced its “economic family” argument,[11]
while the plaintiff argued the payments were insurance premiums paid between
two distinct corporate entities, thereby invoking Moline Properties.[12] After an analysis that determined the captive
was formed for a legitimate business purpose (and therefore not a sham for tax
purposes), the court ruled Stearns-Rogers and Glendale Insurance were two
distinct corporate entities which should be recognized.[13] Next the court explained the “economic
family” doctrine of Revenue Ruling 77-316, citing from Carnation v. Commissioner,[14]
“The essence of that ruling [Carnation] is that there can be no deduction
where, in actuality, there has been no shifting of risk outside the economic
family.”[15] To bolster its argument, the court
distinguishes Stearns Rogers from Weber
Paper Company, stating,
“Its
[Stearns Rogers] problem is that in contrast with the Weber Paper Company, it
did not ally itself with others similarly situated so that the risk of any one
member’s flood loss would be shifted to the “economic families” of the other
insured members.[16]
In
effect, because Glendale
did not insure any other company’s risks, there was no risk shifting. There was no insurance, because “profits and
losses stay within the Stearns Rogers “economic family.” In substance the arrangement shifts no more
risk from Stearns Rogers than if Stearns Rogers self-insured.”[17]
The
appeals court affirmed the district court.[18] They first noted that self-insurance plans do
not constitute insurance.[19] They next noted that risk did not leave the
“parent company.” The payments for
coverage went from parent to subsidiary but the ultimate burden for losses was
always on the parent.”[DL1] [20] In effect, the court is arguing Stearns
Rogers established a reserve fund without actually stating same. In addition, the appeals court sidesteps the
problems of not properly applying Moline
Properties to the fact pattern by noting,
The
separation [between the companies] is not ignored. Instead the focus must be on the nature and
consequences of the payments by the parent and the Supreme Court’s requirement
that there must be a shift of risk to have insurance … The comparison of the arrangement here made
to self-insurance cannot be ignored.[21]
This
is the exact same reasoning offered by the service regarding the possible
problems of Moline Properties:
However,
we are of the view that the concept of independent corporate identity is not
being challenged by the rationale espoused.
We do not propose to ignore the taxpayer’s separate identity. Rather, the proposed ruling examines the
transaction for its economic reality.[22]
The service is
making an anti-abuse argument by asking the court to look beyond legally and
legitimately established corporate forms to see an “economic family.” In effect, the service is advancing a new
anti-avoidance theory.
In Beech Aircraft v. U.S., the plaintiff
lost a jury verdict of $21,700,000 in 1971.[23] The old insurance policy did not allow Beech
to investigate claims against the company or participate meaningfully in their
legal defense.[24] As a result, Beech formed a captive insurance
company in Bermuda on March 2, 1972 named Travel Air Insurance
Company, Ltd.[25] Travel Air was originally capitalized with
$120,000.[26] Beech paid a $1.5 million dollar premium to
Travel Air for a $2 million dollar policy for the fiscal year September 1, 1971 to August 31, 1972.[27] Beech made no assurances to Travel Air that
Beech would “pay any losses which occurred greater than the excess insurance
carried by Travel Air, nor did it agree to further enlarge the capital
structure of Travel Air in any event.”[28] Beech obtained an additional policy from
Fairfax Underwriters for $10 million.[29] While Travel Air sought outside business
after 1973, that occurred after the period in question for this case.
The court’s
reasoning was short. First they noted
that a transaction’s substance governs the tax consequences[30] –
which is essentially an anti-avoidance argument. The court’s primary ruling dealt with the
corporate inter-relationship of Beech and Travel Air; because Beech owned a
majority of Travel Air’s stock, a payment from Travel Air would lower Beech’s
net worth: “Here the gain or loss enjoyed or suffered by Travel Air is reflected
directly on the net worth of the parent Beech.[31]
In addition, because Travel Air had a capitalization of $150,000, they would
have to ask Beech for additional capital in the event of a payout larger than
$150,000.[32]
Not stated,
but certainly implied by the ruling, is the circular nature of the cash
flows. Beech paid a premium to Travel
Air who would in turn pay Beech in the event of a claim against Beech. In effect, Travel Air was a reserve fund for
Beech that simply stored funds until requested by Beech. Hence, the court’s quoting of the primary
anti-avoidance concept of substance over form in conjunction with this concern:
“It is conceivable, though unlikely, that if no losses were encountered, the
deduction of purported insurance premiums could become a tax loophole for the
parent company.”[33]
[1] Rev. Rul
77-316.
[2] Stearns-Rogers Corp., Inc. v. U.S., 577
F. Supp. 833, 834, (Colorado
1984).
[3] Id.
[4] Id.
[5] Id.
[6] Id.
[7] Id.
[8] Id at 834-835.
[9] Id at 835.
[10] Id .
[11] Id .
[12] Id at 835-836.
[13] Id at 836.
[14] Carnation Co. v. Commissioner, 640 F.2d
1010 (9th Circuit 1981).
[15] Stearns-Rogers at 837.
[16] Id at 838.
[17] Id.
[18] Stearns Rogers Corp. v. U.S., 774
F.2d 414, (10th Circuit 1985).
[19] Id at 415.
[20] Id.
[21] Id at 416.
[22] Gen. Coun. Memo. 35349 (May 15, 1973).
[23] Beech Aircraft v. U.S., 1984 WL 988 at 1.
[24] Id .
[25] Id.
[26] Id.
[27] Id.
[28] Id at 2.
[29] Id.
[30] Gregory v. Helvering.
[31] Id at CONCLUSIONS OF LAW paragraph 4.
[32] Id at paragraph 5.
[33] Id at ADDITIONAL SPECIFIC FINDINGS OF
FACT paragraph 14.
