Insuring the Risks of Brother-Sister Corporations: Think Captive

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1 Insuring the Risks of Brother-Sister Corporations: Think Captive Reprinted from the Journal of Taxation of Financial Institutions By Irving Salem and Jocelyn Noll Irving Salem is a partner and Jocelyn Noll is an associate at the law firm of Latham & Watkins, New York. This article first appeared in the May/June 2002 issue of the Journal of Taxation of Financial Institutions. Reprinted with permission.

2 Insuring the Risks of Brother-Sister Corporations: Think Captive Recent developments including the demise of the economic family test and the emphasis on the number of risks transferred should embolden taxpayers to explore brother-sister captive insurance arrangements. IRVING SALEM and JOCELYN NOLL Since 9/11, insurance coverage has been harder to obtain and is far more expensive. Fortuitously, both the courts and the IRS have opened a door previously considered problematic brother-sister companies that are members of the same affiliate group can deduct premiums paid to an insurer which is a sibling (even though the insurance company insures no unrelated parties). Accordingly, it behooves affiliated groups to think captive insurance while seeking adequate and affordable insurance coverage. This article will analyze the developments and the open questions. BACKGROUND One of the most contentious areas in the tax law has been the debate over the definition of insurance and the ability of a corporate taxpayer to deduct premiums paid to another member of its affiliated group. The IRS and some courts were very rigid at first, for exam- Irving Salem is a partner and Jocelyn Noll is an associate at Latham & Watkins, New York. ple denying a deduction in both parent-subsidiary and brother-sister arrangements and even where the captive had substantial amounts of outside business; however, the pendulum has swung. 1 Indeed, the Seventh and Ninth Circuits, in the Sears and Amerco cases, have expressed doubts as to the importance of the risk shifting and distribution requirements. 2 In devaluing the significance of the risk shifting/distribution analysis, both the Seventh and the Ninth Circuits suggest an alternative approach which seems to shift the burden to the IRS: However, we also agree with the Seventh Circuit that discussions of this area might seem less abstruse if we asked ourselves a somewhat different question: Suppose we ask not What is insurance? but Is there adequate reason to recharacterize this transaction?, given the norm that tax law respects both the form of the transaction and the form of the corporate structure. 3 The most recent judicial decision addressing the brother-sister issue is Kidde Industries. The Court of Federal Claims, in allowing a deduction, provides this pro-taxpayer analysis of the risk shifting occurring with respect to brothersister corporations: As explained in Humana, the wholly owned subsidiaries have no ownership interest in the parent s captive insurer and hence would not suffer any additional loss if payments by the captive insurer of future claims against the subsidiaries exceeded the amount of premiums the captive insurer received. For example, because a $1,000 claim against a Kidde subsidiary paid by [the captive insurer] KIC would not result in a corresponding decrease in that subsidiary s net worth, the risk as to that claim was shifted from the subsidiary, through National, to KIC. 4 The court then provided a pro-taxpayer risk distribution analysis: Similarly, when viewed from the perspective of that subsidiary, risk distribution also took place in that KIC distributed the risk faced by that subsidiary in a pool with the risks of other entities in which the May/June 2002 Vol 15 / No 5 INSURING BROTHER-SISTER CORPORATIONS

3 subsidiary did not have an ownership interest. 5 As described below, some recent developments confirm the trend and make a captive arrangement well worth considering. The IRS seems to have agreed with the brother-sister cases it has lost, and concluded that premiums paid to a bona fide insurance subsidiary insuring the risks of brother-sister members of the same affiliated group are likely to be deductible. RECENT IRS POSITION FURTHER OPENS BROTHER- SISTER CAPTIVE DOOR In a flurry of recent activity, the IRS seems to have agreed with the brother-sister cases it has lost, and concluded that premiums paid to a bona fide insurance subsidiary insuring the risks of brother-sister members of the same affiliated group regardless of the existence of outside business 6 are likely to be deductible. Chronologically, herein follow the recent developments: IRS Concedes Pending Brother-Sister Cases in FSAs. Somewhat surprisingly, in 2000, the IRS signaled a change in attitude by releasing an FSA which agreed to a 100% concession with respect to the brothersister captive structure in the transaction at issue, explaining: [B]oth the United States Court of Appeals for the Sixth Circuit [in Humana] and the United States Court of Federal Claims [in Kidde] have held that payments to a captive insurer by its sibling subsidiary were deductible as insurance premiums...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 is a sham. 7 PLR Emphasizes Number of Risks, Demphasizes Number of Insureds. In a prior PLR ( , June 14, 1996), the IRS ruled favorably on a captive utilized by 33 unrelated regulated investment companies (RICs). Each RIC was a money market fund which held securities used by numerous issuers. Seeking coverage to insure the RICs would retain a note and value of $1.00 per share, bids were sought from unrelated third-party insurers. However, they were expensive and a mutual insurer was formed to insure the RIC against credit default risks. In a recent follow-up PLR ( ), the IRS again responded favorably even though the 33 RICs consolidated into no less than V Funds. The PLR notes the initial ruling was based in part on the analysis in Rev. Rul ( CB 107) which involved 30 unrelated corporations. In affirming the prior PLR, the diversity of the risks, not the number of insureds, was emphasized: [W]e note that the proposed transaction will not reduce the number of independent risks Mutual accepts.... As indicated below, the emphasis on the number of independent risks has become a consistent theme. Rev. Rul Eliminates Economic Family Test. Revenue Ruling provides that the IRS will no longer invoke the economic family theory enunciated in Rev. Rul , 10 citing the failure of 1 The IRS initially took the position that captive insurance arrangements were not insurance for tax purposes because the insuring corporation(s) and the captive subsidiary represented one economic family, and consequently there was no risk shifting or risk distribution. Rev. Rul , C.B. 53. Although no court fully accepted the economic theory, several courts denied deductions for premiums paid by affiliated corporations to captive insurance subsidiaries. See Clougherty Packing Co., 811 F.2d 1297 (9th Cir. 1987), aff g 84 TC 948 (1985); Beech Aircraft Corp., 797 F.2d 920 (10th Cir. 1986), aff g USTC 9803 (D. Kan. 1984); Stearns- Roger Corp., 774 F.2d 414 (10th Cir. 1985), aff g 577 F.Supp. 833 (D. Col. 1984); Carnation Co., 640 F.2d 1010 (9th Cir. 1981), aff g 71 TC 400 (1978); Mobil Oil Corp., 8 Cl. Ct. 555 (1985). However, beginning with Humana, Inc., 881 F.2d 247 (6th Cir. 1989), overruling in part 88 TC 197 (1987), the taxpayer began winning cases. In Humana, the Sixth Circuit reversed the Tax Court and held that, in respect to the sibling insureds, both risk shifting and risk distribution were present because payment of a claim by the captive insurer did not affect the balance sheet of sibling insureds and the losses were spread among the several separate corporations within the affiliated group. As there was no evidence that the captive was a sham or that the transactions lacked business purpose, the Sixth Circuit allowed the sibling insureds to deduct premiums paid to the captive insurer. Subsequent decisions followed the Sixth Circuit s analysis and allowed deductions for premiums paid pursuant to brother-sister arrangements. See Kidde Industries, Inc., 40 Fed. Cl. 42 (1997); Hospital Corp. of America, TCM ; Malone & Hyde, Inc., TCM , overruled by 62 F.3d 835 (6th Cir. 1995) (holding that the wholly owned insurance subsidiary was a sham and therefore reversing the Tax Court s finding of risk shifting). Some courts have allowed both the parent and subsidiary insureds to deduct premiums paid to a captive insurance subsidiary when the captive received what the court considered to be a significant amount of premiums from unrelated insureds, despite a contrary ruling by the IRS in Rev. Rul , C.B. 31. See Ocean Drilling and Exploration Co., 988 F.2d 1341 (Fed. Cir. 1993), aff g 24 Cl. Ct. 714 (1991) (44-46% from unrelated insureds); Sears, Roebuck and Co., 972 F.2d 858 (7th Cir. 1992), aff g 96 TC 63 (1991) (99.75% from unrelated insureds); Amerco, Inc., 979 F.2d 162 (9th Cir. 1992), aff g 96 TC 18 (1991) (52-74% from unrelated insureds); The Harper Group, 979 F.2d 1341 (9th Cir. 1992), aff g 96 TC 45(1991) (29-32% from unrelated insureds). For a more comprehensive discussion of JOURNAL OF TAXATION OF FINANCIAL INSTITUTIONS May/June 2002 Vol 15 / No 5

4 the courts (specifically in Humana, Clougherty, and Kidde) fully to accept the theory. The ruling, however, cautioned that the IRS may continue to challenge certain captive insurance transactions based on the facts and circumstances, citing the Sixth Circuit s decision in Malone. At a tax conference shortly after the publication of Rev. Rul , the tax press reported the following comments of Robert A. Martin, an IRS official in the Office of the Associate Chief Counsel (Financial Institution & Products) with a high degree of involvement in the new ruling: Martin, who drafted the latest ruling, explained that the IRS had successfully invoked the economic family theory in cases involving wholly owned insurance subsidiaries without unrelated insurance contracts. However, the Service was not successful in applying the theory to cases in which the sub insured unrelated parties or in brothersister captive situations. According to Martin, the IRS will focus on this fact-based approach for transactions resembling the last two situations. The Service will continue to view such factors as guaranty and indemnity agreements, capitalization of subs, actuarially determined reserves, and whether premiums are priced at arm s length to gauge whether premiums paid to a sub are deductible. It s a sliding scale, Martin said of the analysis. The closer it resembles a commercial, arm slength insurance transaction, the better you ll be, he added. 11 While unstated, presumably another of the factors the IRS will continue to focus on will be whether the balance sheet of the insured entity is affected by the captive insurer s payment of a claim. 12 Thus, the IRS is likely to apply a balance sheet test to disallow a deduction for premiums paid by a parent to a captive insurance subsidiary, particularly where there is little or no outside business. TAM Blesses Brother-Sister Arrangement. In TAM , 13 a domestic insurance company (the Insurer ) provided workers compensation coverage only to its sibling operating subsidiaries. A portion of the insurance was reinsured In 2000, the IRS signaled a change in attitude by releasing an FSA which agreed to a 100% concession with respect to the brother-sister captive structure in the transaction at issue. with unrelated insurers. The TAM said there was sufficient risk shifting and risk distribution, concluding that the insurer qualified as an insurance company under subchapter L. Factors which the TAM found important in analyzing the issue were: 1. There were no parental or related party guarantees propping up Insurer; 2. Insurer was adequately capitalized; 3. Insurer s premium to surplus ratio was strong; 4. Insurer was formed in part because of significant disruptions in the market price of workers compensation insurance; this history, see Emanuel Burstein, What is Insurance? The Insurance Tax Review 25 (January 1997); Joe Taylor, Mysteries of the Term Insurance Continue Following Sixth Circuit Reversal of Tax Court in Malone & Hyde, The Insurance Tax Review 1723 (November 1995). 2 Amerco, 979 F.2d at 168. The Seventh Circuit in Sears was emphatic in its devaluation of the significance of risk shifting and risk distribution: Much insurance sold to corporations is experience-rated. An insurer sets a price based on that firm s recent and predicted losses, plus a loading and administrative charge. Sometimes the policy is retrospectively rated, meaning that the final price is set after the casualties have occurred. Retrospective policies have minimum and maximum premiums, so the buyer does not bear all of the risk, but the upper and lower bounds are set so that almost all of the time the insured firm pays the full costs of the losses it generates. Both experience rating and retrospective rating attempt to charge the firm the full cost of its own risks over the long run, a run as short as one year with retrospective rating. Sears, 972 F.2d at Internal citations in all quotations generally omitted Fed. Cl. 42, Id. 6 However, courts may be more inclined to rule that premiums paid to a captive insurance subsidiary are deductible if the captive writes a significant amount of unrelated business (see note 1, supra). Accordingly, if practicable, the captive insurer should accept risks from unrelated corporations, either directly or through reinsurance arrangements. 7 FSA (July 21, 2000). Similar FSAs are FSA (June 22, 2001); FSA (June 22, 2001); FSA (October 27, 2000); FSA (October 26, 2000). 8 May 25, I.R.B C.B The Insurance Tax Review 9 (July 2001). 12 The balance sheet approach was originally put forth by the Ninth Circuit in Clougherty, in connection with the court s analysis of the IRS s economic family theory. See note 1, supra. 13 December 7, May/June 2002 Vol 15 / No 5 INSURING BROTHER-SISTER CORPORATIONS

5 5. Insurer was a fully regulated domestic insurance company under the laws of State of C; 6. Insurer issued a separate policy to each sibling, and maintained separate records; and 7. Insurer hired a number of employees in the year in issue, and hired more after that. Perhaps most critically, while the numbers of siblings and insured workers were undisclosed, the TAM noted the Insurer distributed a large number of homogeneous, independent risks among its insureds. In PLR ( the IRS again responded favorably even though the 33 RICs consolidated into an unspecified number of funds. FSA Expresses Doubt in Dubious Brother-Sister Arrangement; Quantum of Risks Again Emphasized. Lastly, FSA , 14 again emphasizing a facts and circumstances approach, expressed serious reservations over a brother-sister captive arrangement. Only two subsidiaries were involved and only a few properties (two plants, one of which was operated jointly). The FSA, after reviewing the case law on brother-sister insurance, expressed concern over: 1 The few entities and few properties insured (one insured accounted for 86-88% of the captive insurer s premium income, and that same insured s single processing facility accounted for the vast majority of the risks transferred), 14 January 11, Humana, 881 F.2d at The dilution of the insurance coverage allowed by the contract if subsequent insurance were issued to another insured, 3 The retroactive change made to the policies; and 4 The investment of 97.5% of the premium by the insurer in affiliates of the insured. The FSA, however, could be viewed as supportive of many brother-sister arrangements. While reviewing the brother-sister judicial decisions, the FSA emphasizes the number of properties insured, rather than the number of insureds: Similarly in the present case, we expect that with only the working operations of Operating Subsidiary 1 and 2, Insurance Subsidiary was unable to achieve adequate risk distribution which, as discussed previously, incorporates the concept of the law of large numbers. The inherent risk distribution in the present case is much more limited than the three brother-sister captive insurance cases that the Government has lost. In Humana, supra, during the years under consideration the taxpayer operated an average of 77 hospitals with 12,558 patient beds for which it needed liability coverage. In HCA v. Commissioner, the taxpayer operated an average of 160 hospitals with an average of 26,574 patient beds for which it needed similar coverage. In Kidde Industries, Inc., supra, the taxpayer was a broad based decentralized conglomerate with 15 separate operating divisions and 100 wholly owned operating subsidiaries for which it needed workers compensation, automobile and general (including products) liability coverage. In contrast, the present case involves risks of two insureds and two working operations (one of which consists of the a and b works with a joint processing faculty (sic) on the same property). Thus, the large number of independent risks is highlighted in discussing all three judicial decisions analyzed in the FSA, and the number of corporate siblings is only mentioned with respect to one of the decisions. SOME OPEN ISSUES Is One Subsidiary Enough? Probably. There is no conclusive authority dealing with the minimum number of subsidiaries that would meet the risk distribution test under the brother-sister analysis. Based on Humana, and the IRS s acceptance of the Sixth Circuit s analysis, it seems clear that even a relatively small number of insureds, each of whom insure a significant number of risks, can achieve risk distribution. Although there were from 22 to 48 brother-sister corporations involved in Humana, the Sixth Circuit s language could be read broadly as blessing a much smaller group: [W]e see no reason why there would not be risk distribution in the instant case where the captive insures several separate corporations within an affiliated group and losses can be spread among the several distinct corporate entities. 15. In Malone, the Tax Court accepted risk distribution with respect to eight brother-sister corporations, suggesting that the above-quoted language from the Sixth Circuit did not foreclose the ability of a few insureds with many different insurable risks to demonstrate that they also had achieved risk distribution (emphasis supplied): We conclude that petitioner has demonstrated the presence of JOURNAL OF TAXATION OF FINANCIAL INSTITUTIONS May/June 2002 Vol 15 / No 5

6 risk distribution in this case. Although at most only eight subsidiaries, as compared with between 22 and 48 subsidiaries in Humana, participated in the reinsurance agreement, worker s compensation, automobile liability, and general liability claims involve diverse risks and potentially represent thousands of individual loss events. 16 Conversely, based on FSA , risk distribution will be a problematic issue when there are only two subsidiary insureds, and each of whom are insuring a small number of risks located in the same area. 17 An intriguing question is whether a captive subsidiary insurer which insures only a single subsidiary that has a large number of independent risks can achieve risk distribution. The Tax Court has addressed this issue, in dicta, in Gulf Oil, 18 in which the court said risk transfer and risk distribution occur only when there are sufficient unrelated risks in the pool for the law of large numbers to operate, and that a single insured can have sufficient unrelated risks to achieve adequate risk distribution. 19 This language was quoted by the Tax Court in Malone, in support of its conclusion that risk distribution was present. 20 The IRS had a chance to reject the single insured case, but blinked. There was apparently only one subsidiary insured in FSA , in which the IRS conceded the deduction of premiums paid by a subsidiary ( a domestic corporation ) to its sibling subsidiary insurance company. The analysis by the IRS did not, however, address the issue of risk distribution beyond stating that risk distribution is a requisite element of insurance; moreover, FSAs have no precedential value. A classic single sibling case would involve an insured like Hertz. Assuming that thousands of automobiles rented throughout the country by Hertz were owned by a single entity, such entity should be able to deduct premiums paid to a bona fide sibling captive. However, whereas reliance on the number of risks, not entities or insureds, seems eminently sound, it may take some time to fully clarify the issue since language (one might suggest is merely loose ) referring to the number of either entities or insureds can be found in the case law, 21 IRS publications, 22 a Joint Staff document, 23 and certain non-tax descriptions of insurance. 24 Assuming one entity is acceptable, that still leaves open the question of how many risks must the entity insure in order to meet the law of large numbers. It has been In Malone, the factors the Sixth Circuit pointed to in determining that the transaction was a sham were that the insurer subsidiary was thinly capitalized, it was propped up with parent guaranties and a hold harmless agreement with the unrelated primary insurer, and it was loosely regulated by the jurisdiction in which it was incorporated. stated that, [g]enerally, the more policies that the primary insurer writes, the more predicable its underwriting results will be. 25 In order to get a better understanding of the parameters of large numbers, one is required to understand some statistical nightmares (for example, The Central Limit Theorem ), an adventure beyond the scope of this article. Be Careful to Do What You Said You Were Going to Do. Both the courts and the IRS have identified factors that may indicate that the transaction is a sham and thus not true insurance. In Malone, the factors the Sixth Circuit pointed to in determining that the transaction was a sham were that the insurer subsidiary was thinly capitalized, it was propped up with parent guaranties and a hold harmless agreement with 16 TCM at Query, if the two plants in FSA were split among 30 corporations, would the result be different. A very close question TC 1010 (1987), reversed in part on other grounds, 914 F.2d 396 (3rd Cir. 1990). 19 Id. at TCM , at Kidde, 40 Fed. Cl. at 46 (risk distribution took place because the subsidiary s risk was placed in a pool with the risks of other entities ) ; Humana, 881 F.2d at 257 (risk distribution was present where the captive insures several separate corporations and losses can be spread among the several distinct corporate entities ). 22 FSA (April 16, 1999) (risk distribution is accomplished where the risk is distributed among insureds other than the entity that incurred the loss. ) 23 Staff of the Joint Committee on Taxation, Tax Reform Proposals: Taxation of Insurance Products and Companies (JCS ), 60 (September 20, 1985) (risk distribution occurs when there is a group of a large number of individual insureds who share a similar type of risk of loss ). 24 See R. Riegel & J. Miller, Insurance Principles and Practices (6th ed. 1976) (referring to insurance as an arrangement in which risks of individuals are combined in a group). 25 R. Michael Cass et al., Reinsurance Practices 35 (2nd ed. vol. 1, 1997) F.3d at 840. May/June 2002 Vol 15 / No 5 INSURING BROTHER-SISTER CORPORATIONS

7 the unrelated primary insurer, and it was loosely regulated by the jurisdiction in which it was incorporated. 26 The IRS has cited these factors and identified several more, in FSA : In addition to the factors set forth in Malone, other factors considered 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 Generally, meeting the business purpose requirement should be a non-issue today. 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. Additionally, favorable IRS opinions normally mention that business reasons prompted the use of a captive. 27 Generally, meeting the business purpose requirement should be a non-issue today. For example, an article in the Wall Street Journal of January 9, 2002, Workers Compensation Insurance Now Harder to Get, quotes 27 For two recent articles that plumb the depths of business purpose, see Stephen Bowen, Whither Business Purpose? Taxes 275 (March 2002); David Garlock, Is There Any Substance to the Sham Transaction Doctrine? Tax Management Memorandum 83 (2002). 28 Gregory, 293 U.S. 465 (1935) TC at F.2d at a managing director of Marsh Inc. as saying: The entire market that provided workers compensation catastrophe insurance has dried up. Another article, also in the Wall Street Journal, on February 26, 2002, Property-Casualty Insurers 4th-Period Charges To Boost Claims Reserves Don t Faze Investors, further confirms the need to consider alternative ways of obtaining necessary insurance coverage: You pick up the paper every day and everyone is talking about 30% rate increases, 100% rate increases. The facts and circumstances test is a sort of Gregory 28 -type analysis did the taxpayer in fact do what he said he did, namely, was the risk of loss in fact transferred to a separate and distinct entity which functioned like a normal insurance company, and was there a business purpose for the arrangement? If this test is met, presumably the transaction will also meet the test suggested by the Seventh and Ninth Circuits (that is, no adequate reason to recharacterize this transaction ). Will Courts Respect the Form of the Brother-Sister Transaction? A concern that prompted the Tax Court in Humana to extend the analysis and the holdings of the parent-subsidiary cases to the brother-sister arrangement at issue was that a failure to do so would exalt form over substance and permit a taxpayer to circumvent our holdings by simple corporate structural changes. 29 In overturning the Tax Court, the Sixth Circuit rejected this rationale: Such an argument provides no legal justification for denying the deduction in the brother-sister context. The legal test is whether there has been risk distribution and risk shifting...[if the parent corporation] changes its corporate structure and that change involves risk shifting and risk distribution, and that change is for a legitimate business purpose and is not a sham to avoid the payment of taxes, then it is irrelevant whether the changed corporate structure has the side effect of also permitting [the parent s] affiliates to...deduct payments to a captive insurance company under the control of the...parent as insurance premiums. 30 Thus, provided that the requirements discussed in the preceding subsection are met, courts should respect the form of a brother-sister captive insurance arrangement. CONCLUSION Current developments including the demise of the economic family test and the emphasis on the number of risks transferred should embolden taxpayers to explore brother-sister captive insurance arrangements. While the IRS will scrutinize the facts and circumstances, large affiliated groups with numerous subsidiaries and risks should be able to deduct premiums paid to a bona fide insurance subsidiary even though it is a sibling and insures no outside risks. Further, the number of subsidiaries, while still an open question, need not be very significant indeed, could be a single corporation if one or more siblings has a large number of independent risks (e.g., workers compensation) which are effectively being pooled. JOURNAL OF TAXATION OF FINANCIAL INSTITUTIONS May/June 2002 Vol 15 / No 5