Captive insurance arrangements limited, not eliminated.

The Sixth Circuit has reversed the Tax Court's decision in Malone & Hyde, Inc., 62 F3d 835 (1995), and held that "brother-sister" insurance contracts were not insurance contracts for Federal tax purposes. The Sixth Circuit did not, however, reverse its own holding in Humana, 881 F2d 247 (1989). Accordingly, contracts between brother-sister companies can be considered to be insurance contracts for Federal tax purposes, provided that these insurance arrangements meet the requirements established by the Sixth Circuit in Humana and the following additional requirements now set out in Malone & Hyde

* There is a legitimate business reason for entering into the insurance arrangement. * The captive insurance company is adequately capitalized, not measured solely by reference to the minimum legal capitalization requirement of the jurisdiction in which the insurance company is located. * The parent or affiliates have not entered into indemnification or "hold-harmless" agreements relating to the captive insurance company.

In 1977, Malone & Hyde established a wholly owned Bermuda insurance subsidiary, Eastland, to provide reinsurance for itself and its subsidiaries. Eastland was capitalized at the minimum requirement under Bermuda law ($120,000). During the years in question, Eastland did not insure the risks of any unrelated third party. Northwestern provided primary coverage for Malone & Hyde and its wholly owned operating subsidiaries and divisions, providing workers' compensation, automobile liability and general liability insurance coverage.

Under a reinsurance agreement between Eastland and Northwestern, Northwestern reinsured the first $150,000 of coverage per claim with Eastland. Malone & Hyde also executed hold-harmless agreements with Northwestern under which Malone & Hyde agreed that in the event Eastland defaulted on its obligations as reinsurer of Northwestern, Malone & Hyde would hold Northwestern harmless for any liability.

In its original memorandum opinion, the Tax Court held that Malone & Hyde was not entitled to deduct as business expenses those portions of the amounts paid to Northwestern as insurance premiums that were in turn paid or "ceded" by Northwestern to Eastland as reinsurance premiums. Malone & Hyde filed a motion for reconsideration and requested permission to supplement the record on the brother-sister" issue in light of the Sixth Circuit's decision in Humana. On reconsideration, the Tax Court applied the Humana decision to the facts of Malone & Hyde and held in favor of Malone & Hyde on the brother-sister issue.

Under the Sixth Circuit decisions, the threshold question is whether the insurance arrangement serves a legitimate business purpose. The important tax considerations of risk distribution and risk shifting lose relevance if a legitimate business purpose cannot be established. Under the Sixth Circuit's analysis, a legitimate business purpose cannot be established solely by a tax deduction for premium payments if the deduction is accomplished through an undercapitalized foreign insurance captive that is propped up by guarantees of the parent corporation. Such a captive, according to the Sixth Circuit, is "essentially a sham corporation."

In further addressing whether the captive arrangement served a legitimate business purpose, the court emphasized a factual distinction between Humana and Malone & Hyde. In Humana, the captive insurance arrangement was established when Humana's insurance coverage was cancelled. Apparently, insurance coverage was available to alone & Hyde in the commercial market. There is concern that the Service will incorrectly interpret the Sixth Circuit decision as establishing as a matter of law that the only legitimate business reason for a captive insurance arrangement is that the insurance is not otherwise available from unrelated carriers.

In rendering its conclusion that the insurance arrangement lacked a business purpose, the court concluded that the insurance company was undercapitalized, in spite of "operating on the extremely thin minimum capitalization required by Bermuda law." The decision, however, does not provide any guidance as to what constitutes adequate capital. Since the captive insurance company was adequately capitalized under Bermuda's standard, the decision appears to reject the argument that adequate capitalization is determined by reference to the capitalization requirements of the state or foreign domicile of the captive insurance company.

The court also addressed the hold-harmless agreement running from Malone & Hyde to Northwestern, concluding that the "interdependent" separate agreements, when considered together, indicated an arrangement under which there was no risk shifting. Under the hold-harmless agreement, the ultimate risk for workers' compensation, auto liability and general liability claims remained with Malone & Hyde. Accordingly, the transactions did not result in Malone & Hyde or the subsidiaries receiving "insurance" from Eastland within the meaning of that term under the Internal Revenue Code.

From Kevin Owens, Esq., Washington, D.C.