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Humana case sets tax standard for captive's parent.

Humana Case Sets Tax Standard for Captive's Parent

In July 27, 1989, the United States Court of Appeals for the Sixth Circuit reversed, in part, the decision of the United States Tax Court in Humana Inc. v. Commissioner (No. 88-1403). In its findings, the Appellate Court affirmed the Tax Court's decision that premiums paid by a parent company to a captive insurance subsidiary are not true insurance premiums, but rather, they are contributions to a loss reserve, and, as such, are not currently tax deductible. However, it reversed the Tax Court's decision with regard to premium payments by affiliated "brother-sister" subsidiaries stating "the contracts between the affiliates of Humana Inc. and its Colorado captive insurance subsidiary, Health Care Indemnity, are in substance insurance contracts and the premiums are deductible." Both the Tax Court and the Court of Appeals specifically rejected the economic family arguments advanced by the government.

In reaching this decision, the court found that the test to determine deductibility was one based not on economics, but rather on the existence of an insurance contract. Insurance premiums are deductible as ordinary and necessary business expenses paid or incurred during the taxable year in carrying on a trade or business. A contract of insurance requires risk shifting and risk distribution.

According to the court, "Risk shifting involves the shifting of an identifiable risk of the insured to the insurer. The focus is on the individual contract between the insured and the insurer. Risk distribution involves shifting to a group of individuals the identified risk of the insured. The focus here is on whether the risk insured against can be distributed over a larger group than the relationship between the insurer and any single insured." The key to this analysis is that the presence of risk shifting must be determined prior to and independent of the test for risk distribution.

In testing for the presence of risk shifting, the court elected to evaluate the impact of an insured loss to the captive on the individual assets of the parent and affiliated subsidiaries. In the case of the parent, a loss incurred by the parent and insured 100 percent by a wholly-owned captive subsidiary, via consolidation, still reduced the assets of the parent in a like amount as if no insurance had been in place. The economic reality of the transaction is that no risk shifting takes place. However, in the case of "brother-sister" subsidiaries, a loss incurred by an operating subsidiary and insured with a captive subsidiary reduced only the assets of the captive subsidiary. According to the court, "If we look solely to the insured's assets, i.e., those of the various affiliates of Humana, Inc., and consider only the effect of a claim on those assets, it is clear that the risk of loss has shifted from the various affiliates to Health Care Indemnity."

With regard to the existence of risk distribution, "We see no reason why there would not be 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." In Gulf Oil Co. v. Commissioner, the Tax Court suggested that risk distribution is present where at least 50 percent of the business insured by the captive arises from unrelated parties. It should be noted, however, whatever the validity of this approach (and it has not yet been tested) the view of the court is that in no event can the presence of outside business be used to show that there is risk shifting.

Humana Inc. and its subsidiaries own and operate a number of hospitals. When their professional liability insurance was canceled, Humana Inc. incorporated a Colorado captive with $1 million in capitalization. Seventy-five percent of the capital was contributed by Humana Inc. in return for common stock; 25 percent was contributed by Humana Holdings N.V., a wholly-owned subsidiary of Humana in the Netherland Antilles, in return for preferred stock. This ownership structure prevented consolidation of Health Care Indemnity with Humana Inc. for tax purposes. Health Care Indemnity was licensed as an insurance company in good standing with the State of Colorado, had recently been audited and certified by the state, and, in the words of the court, "is currently a valid insurance company subject to the strict regulatory control of the Colorado Insurance Department.

Humana Inc. and its subsidiaries purchased guaranteed cost coverage from the captive through a consolidated insurance program, with premiums allocated back to the operating subsidiaries. There were no contractual guarantees or indemnities between Health Care Indemnity and Humana Inc. or other operating subsidiaries. The State of Colorado reviewed and approved premium rates.

Several factual circumstances were identified by the Court as relevant to their findings:

* Health Care Indemnity was fully capitalized

and no agreements existed whereby

Humana Inc. or its subsidiaries would

contribute additional capital to Health Care

Indemnity.

* It was undisputed that the insurance

policies involved were policies as

commonly accepted within the industry.

* The contracts between Health Care

Indemnity, Humana Inc., and the hospital

subsidiaries were arms length and legally

enforceable.

* Health Care Indemnity was formed for

legitimate insurance purposes.

* The operations of both Health Care

Indemnity and the hospital subsidiaries were

legitimate.

* Health Care Indemnity filed a separate tax

return, i.e., it was not consolidated with

Humana Inc. and the hospital subsidiaries.

* There was no accusation that premiums

were excessive or inadequate.

* Humana Inc.'s subsidiaries owned no stock

in Health Care Indemnity, nor vice versa.

The Humana ruling establishes case law in the Court (Tennessee, Kentucky, Ohio and Michigan) and provides a valuable precedent in other circuits. It should be noted that precedents supporting the economic family theory exist in the Tenth Circuit, (Stearns-Roger Corp. v. United States) and the Claims Court (Mobil Oil Corp. v. United States). The Sixth Circuit asserts that it is not in conflict with Stearns-Roger and Mobil Oil, citing that these cases addressed solely the issue of parent-subsidiary relationships and not brother-sister subsidiary relationships. The question to be evaluated is whether this is a valid distinction or a contradiction.

Although it is likely that Humana will be appealed to the U.S. Supreme Court, it is the first case addressing deductibility of premiums to a captive that clearly incorporates the well established doctrine of separate corporate existence. Should the U.S. Supreme Court either refuse to review the case or uphold the Humana decision, the U.S. Treasury Department would be forced to quickly seek legislative relief in Congress. While Congress, in its current deficit cutting efforts, would likely be receptive to legislative relief to the Treasury, a legislative remedy should be the Treasury's last alternative. The passage of legislation would set the date of enactment and prove a costly admission of defeat for prior outstanding tax periods.

The Humana decision will have a number of effects on risk managers. First, to those currently utilizing a captive program, a careful examination of the present program could lead to a substantially improved picture of deductibility for open tax years which should be discussed with corporate tax counsel. Second, for holding companies with two or more operating subsidiaries, each contributing no more than 50 percent of its insurance premiums, a captive may become a more cost effective risk financing alternative. For those corporations structured as a holding company with multiple subsidiaries, a substantial majority of premiums would fall within the context of the Humana ruling.

Although this may be a window of opportunity to be quickly closed, it rarely makes sense to build business strategy exclusively around tax positions. This is especially true when the maximum federal corporate tax rate is down to 34 percent.

But a number of key questions are raised. What is the significance of the onshore versus an offshore domicile? What is the significance of the cancellation of the expiring program as regards the establishment of "legitimate" insurance purpose? What is the significance of the fact that the captive's tax return was never consolidated with the parent's and operating subsidiaries'? While these factual variations are studied, the Humana decision offers a clear and well planned blueprint. Although the response of the Treasury Department should be known quickly, for those risk managers with a penchant for risk financing mechanisms, the Court has offered a number of viable alternatives for captive management in the near future.

Lucien P. Laborde Jr. is president of research and development for Corroon & Black Corporation in Nashville, TN.
COPYRIGHT 1989 Risk Management Society Publishing, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1989 Gale, Cengage Learning. All rights reserved.

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Author:Laborde, Lucien P., Jr.
Publication:Risk Management
Date:Oct 1, 1989
Words:1409
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