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IRS issues ruling on premiums for transpired events.

IRS Issues Ruling on Premiums for Transpired Events

In Revenue Ruling 89-96, the Internal Revenue Service questioned the status of a payment as a premium when it covers an event which has already transpired. The facts are described as follows:

"As a result of a catastrophe during June 1987, Y incurred a liability to injured persons the exact amount of which could not be ascertained, but was expected to be substantially in excess of $130x. At the time the catastrophe ocurred (sic), Y's liability insurance coverage totaled $30?. In July 1987, for a premium of $50x, Y obtained from taxpayer Z additional 'liability insurance' coverage in the amount of $100x. Z is a commercial insurance company unrelated either to Y or to Y's primary liability carrier. Under this contract, Z promised to pay on behalf of Y (subject to the contract's limit of $100x) those sums in excess of $30x for which Y would thereafter become legally liable to pay as damages as a result of the June catastrophe. Y fully disclosed all the facts concerning the catastrophe to Z on the application for additional coverage. On its annual statement for state regulatory purposes, Z included the $50x 'premium ' from Y in earned premiums and included $100x in unpaid losses.

"Z is a calendar year taxpayer. On its 1987 federal income tax return, in computing its gross income under section 832 of the Code, Z treated the gross 'premium ' of $50x as fully earned. Z's expenses ('loading') allocable to the contract were deminimis relative to the $50x. As part of its losses inccured on insurance contracts, Z included the unpaid loss of $100x and deducted an appropriately discounted amount. The net effect of entering into the contract with Y was to reduce Z's underwriting income for 1987 by the excess of the discounted $100x loss over the $50x 'premium.' From the economic terms of the contract it was reasonable to expect that the amount of net 'premium' received from Y (gross premium less loading), the amount of its tax savings resulting from the increased deduction for 'losses incurred,' and the investment income earned on those amounts would probably exceed its premium anticipated liability, $100x, under its contract with Y."

The IRS thus takes the position that the arrangement does not contain sufficient risk shifting to constitute insurance for federal income tax purposes. It asserts that the only risk in an investment risk not sufficient to amount to risk shifting for federal income tax purposes. The IRS contends that the "premium" of $50x was charged because it was reasonable to expect that the sum of the net premium; the amount of tax savings resulting from the increased deduction for losses incurred; and the anticipated investment income would exceed the maximum liability of $100x. The only risks borne by the insurer are that it may have to pay its liabilities sooner than anticipated and the available investment yield will be less than anticipated.

Accordingly, it is held that the insurer, Z, cannot include the $100x loss in "losses incurred on insurance contracts" under Section 832(b)(5) of the Internal Revenue Code of 1980. Clearly, the corollary is that no deduction will be available to the premium payor until the losses are paid.

The ruling leaves a number of questions unanswered from the insurer's perspective. For example, must it include the $50x in income as a premium received and is the insured or insurer taxed on the investment income? also, the implications of the ruling on other areas is important because its impact may be broad. These implications include what the effect will be on portfolio cessions and on the insurance of a book of business that had been self-insured, especially for a line of business which is not particularly volatile, such as workers' compensation.

On July 31, the Treasury Department published a proposed regulation for comment in the Federal Register concerning how a foreign corporation engaged in trade or business within the United States will be dealt with if it does not file a tax return on a timely basis.

Under IRC $S 882(s)(1), a foreign corporation engaged in trade or business within the United States is taxed on its taxable income effectively connected with the conduct of that business. In determining the amount of taxable income which is taken into account (i.e., effectively connected), the foreign corporation is allowed to deduct from the effectively connected gross income expenses that are properly allocable and apportioned to that income. Such deductions are only available if a true and accurate return is filed pursuant to all of the rules of the IRC. Because the filing of a timely return is one of the requirements set forth in the code, the new regulations provide that otherwise allowable deductions and credits will be allowed only if the return is filed by the time limit set forth in the regulations. In the past, the taxpayer would then immediately file a tax return if assessment appears imminent.

Under the regulation, where the return has been filed on a timely basis for purposes of IRC $S 874(a) or 882(a)(2) depends upon whether the non-resident alien or foreign corporation filed a return for the taxable year immediately preceding the taxable year for which the deductions or credits are claimed. If the return was filed for the preceding year, a return for the current year must be filed within one year of the extended due date (as defined below) set forth in IRC $S 6072 or 6081 for filing that return. If the return has not been filed for the preceding year, but the current year is the first year for which the return is required under IRC $S 874(a) or 882(c)(2), the current year's return must have been filed no later than the earlier date. That date is one year after the extended due date set forth in IRC $S 6072 and 6081 for filing that return or the date the IRS mails a notice informing the taxpayer that the tax return has been filed and that no deductions or credits may be claimed.

Although this regulation is a proposition, it may have a direct impact on foreign insurance companies doing business in the United States. It should be noted that if deductions are disallowed, all deductions of the foreign corporation will be disallowed. This would include deductions for losses and presumably for the unearned premium reserve. Accordingly, it is important that foreign corporations make a concerted effort to determine whether they are engaged in trade or business and take appropriate action.

P. Bruce Wright is a member of the New York Bar. Mr. Wright is also a member of the law firm LeBoeuf, Lamb, Leiby and MacRae.
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Title Annotation:Internal Revenue Service
Author:Wright, P. Bruce
Publication:Risk Management
Article Type:column
Date:Nov 1, 1989
Words:1128
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