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A redefinition of subpart F income.

IN THE CASE of Ocean Drilling & Exploration Co. (ODECO), the claims court has generally expressed its agreement with the tax court decisions in the Harper Group v. Commissioner and Sears, Roebuck & Co. v. Commissioner cases.

The Ocean case involved tax years 1974 and 1975 and dealt with the issue of whether payments by a parent corporation to its wholly owned Bermuda insurer were deductible as insurance premiums. In addition, the case addressed the issue of if the payments were premiums, whether the premiums were for insuring property located in the United States and, therefore, in those tax years considered subpart F income taxable to the parent of the Bermuda insurer, which was a controlled foreign corporation.

Because of difficulty during the 1960s in securing coverage for offshore drilling rigs, Mentor Insurance Ltd. was formed in Bermuda in 1968 by ODECO. In June 1969, Mentor's capital was increased due to its desire to write additional risks of ODECO, and because it wanted to attract unrelated entities to insure with Mentor. Rates charged by Mentor to ODECO were based on prevailing commercial rates in London at the time. Typically, policies issued to ODECO were coinsured with an unrelated entity that would write 5 percent to 20 percent of the plaintiffs risk. In addition to this coinsurance, Mentor reinsured a portion of ODECO's risk. Mentor'sinsurance of risks for ODECO's subsidiaries covered the full value of property and the deductible of a policy ODECO purchased from Oil Insurance Ltd. In addition, Mentor received unrelated net premium from Highlands Insurance Co. and other sources. The incurred loss ratio on all unrelated business for 1974 and 1975 was 123.4 percent and 101 percent. The incurred loss ratio on ODECO's business for those years was 15 percent and 14 percent. ODECO contended that the unrelated business accounted for 44 percent and 66 percent of Mentor's total business for 1974 and 1975.

The Internal Revenue Service, in its audit of ODECO for 1974 and 1975, determined that premiums paid by ODECO and its affiliates to Mentor in those years should be disallowed as a business expense because they constituted additions to a reserve for selfinsurance. Alternatively, if the premiums were held to be deductible, the IRS determined that the portion of the premiums paid for the insurance of drilling rigs on the Outer Continental Shelf of the Gulf of Mexico were premiums for the insurance of U.S. risks. As such, the premiums constituted subpart F income.

Prior to the Tax Reform Act of 1986, subpart F income included income from insurance of U.S. risks. The act, however, changed the provisions so that all insurance income regarding risk outside the country of incorporation of the insurer constitutes subpart F income. This second issue would not have been raised if the case had involved post-1986 fiscal years of ODECO. Accordingly, attributable underwriting income should be included in income by ODECO,

Considering the deductibility of premium issue, the claims court reviewed a number of prior decisions, including its own 1985 decision in Mobil Oil Corp. v. United States, in which it held premiums paid by Mobil and its affiliates are not deductible. The claims court based its decision on the theory that "insurance through a wholly owned insurance affiliate is the same as setting up reserve accounts." The court noted, however, that the Mobil case did not address the impact of unrelated business written by the affiliate insurer.

The claims court then turned to a review of the tax court's decisions in Sears, the Harper Group, and AMERCO, which imposed a three-pronged test to determine whether insurance exists if the affiliate insurer wrote unrelated business,

The test would specifically determine the presence of insurance risk, risk shifting and risk distributing, and commonly accepted notions of insurance. The claims court concluded that, before applying these tests, it must address whether Mentor's business operations were fraudulent. If so, the company's corporate form could be disregarded. The claims court indicated that this argument was unsuccessfully raised by the United States at trial and was abandoned in its post-trial argument. Nevertheless, the court analyzed such facts as receipt of premium, payment of claims and maintenance of adequate capitalization that demonstrate Mentor was a valid insurer.

The court then found that risk was present and that risk transfer had occurred, stating that unrelated business operates to reduce the amount of risk to which ODECO was exposed. ODECO, as the parent company of Mentor, bore a level of risk significantly lower than the level it initially transferred to Mentor, because of the considerable amount of unrelated business it wrote. Accordingly, ODECO's premiums constituted a transfer of risk, because the risk transferred to Mentor and the risk ultimately borne by ODECO were not the same.

The court, however, refused to quantify the amount of unrelated premiums necessary to result in transfer of risk. The court apparently conceded that its analysis focused on the unrelated business present and concluded that approximately 44 percent and 66 percent unrelated business sufficiently spreads risk, noting that in the tax court's Harper decision it was determined that 30 percent unrelated business was sufficient.

Based on these findings, the claims court held that under Helvering v. LeGierse insurance was present and the premiums paid were deductible. Although the second issue in the case would not be an issue under its current law, it is important because some companies may still have "open" pre-1986 act tax years for which the statute of limitations has not lapsed. Prior to the 1986 act, section 952 of the Internal Revenue Code of 1954 (the Code) provided that subpart F income included income derived from the insurance of U.S. risks.

Section 953 of the Code did not specifically deal with whether the Continental Shelf area was part of the United States in determining whether a risk was a U.S. risk. The regulations under IRC sec. 953 and IRC sec. 7701(a) (9) provided that the United States includes only the states and the District of Columbia. The government contended that IRC sec. 638, which states that the Continental Shelf area will be treated as part of the United States for certain specified purposes, applied to IRC sec. 953 as well.

ODECO argued, however, that IRC sec. 638 applied only to determining the source of income derived from activities involving the actual exploration and exploitation of natural resources or personal services performed on mines, oil and gas wells, and other natural deposits.

The claims court agreed with ODECO in stating that IRC sec. 638 does not affect IRC sec. 953 and also noted that the legislative history of IRC sec. 638 referred specifically to mining activities and personal services performed at mining sites, not to insurance activities.

Accordingly, taxpayers with open pre-1986 act years that owned captives that insured risks on the Continental Shelf may, in some cases, seek refunds if income from such activity by the captive was previously reported as subpart F income of the taxpayer. Such refunds might be applicable regarding pre-1986 act open years if premiums were paid by unrelated persons or related persons prior to the effective date of the Deficit Reduction Act of 1984 and premiums were paid prior to the effective date of the Tax Reform Act of 1986. The act would have treated related premiums as subpart F income under IRC sec. 954 (e) and as deductible to the owner of the captive or the owner's affiliates. P. Bruce Wright is a partner with the law firm LeBoeuf, Lamb, Leiby & MacRae and a member of Risk Management's Editorial Board.
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Author:Wright, P. Bruce
Publication:Risk Management
Date:May 1, 1992
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