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Tax code imposes penalty for 'understatement.' (Neptune Mutual Association Limited of Bermuda vs. United States) (column)

Tax Code Imposes Penalty for `Understatement'

Section 6661 of the Internal Revenue Code of 1986 (IRC), as amended, imposes a penalty for "substantial understatement" of income tax. The rate is 25 percent for penalties assessed after October 21, 1986.

According to the code, a substantial understatement exists if the amount exceeds the greater of 10 percent of that required to be shown on the return or $5,000 ($10,000 for most corporations). Generally, the understatement is calculated by taking the difference between the tax required and the tax reported. The amount of understatement usually does not include an item the taxpayer discloses on the return or an attachment. Information must include the identity and amount of the item, as well as the specific facts or tax position taken.

Shareholders in most group-owned foreign insurers must now report Subpart F income as a result of their ownership interest in such an insurer under IRC [section] 951 and 953(c). Previously, just reporting Subpart F income derived from a foreign insurer on Form 5471 (Information Return with Respect to a Foreign Corporation) would have been deemed sufficient disclosure. Such disclosure would have allowed the income to be excluded from the amount of understatement. Accordingly, specific disclosure concerning a particular item affecting the calculation of Subpart F income was not previously required. However, Revenue Procedure 89-11, 1989-6, IRB 1, changes this rule.

New Reporting Procedures

A number of states during the past year have been drafting new procedures to deal with risk retention groups formed within their borders as well as those chartered by other states. In many instances, foreign risk retention groups are treated similarly to foreign insurers.

An example is Section 5904(c) of the New York Insurance Law, which requires licensed agents and brokers to report premiums of direct business for risks within New York which has been placed with risk retention groups chartered outside the state. Premiums paid to such risk retention groups must be reported on a written basis, not on a cash basis. And only the broker of record, not a sub-broker, may file.

Excise Tax is Preemptive

In Neptune Mutual Association, Ltd. of Bermuda v. United States, the Federal Circuit Court of Appeals reviewed the decision of the Claims Court which had held that the excise tax imposed under IRC [section] 4371 overrides the IRC's income tax provisions.

In the case, the owners of fishing vessels in New Bedford, MA, faced with rising insurance costs, formed Luxembourg Mutual Insurance Association to provide protection and indemnity insurance. The owners discussed the formation of the company with the Massachusetts Insurance Department, which indicated that it would take no action against the insurer. In 1976, Neptune was incorporated in Bermuda as a successor in interest to the Luxembourg company. Neptune filed federal income tax returns, taking the position that it was a foreign corporation conducting an insurance business in the United States. No excise taxes were paid on the insurance premiums paid to the Bermuda company.

For the period June 30, 1977, to June 30, 1980, the Internal Revenue Service assessed excise taxes, under IRC [section] 4371, on premiums paid to Neptune. Neptune argued that if a foreign insurer is subject to income tax in the United States, it should not be subject to the excise tax on premiums imposed by IRC [section] 4371. Neptune also argued that because it received permission of the Massachusetts Insurance Department, it qualified for an exemption under IRC [section] 4373(1) for insurers who are authorized to do business in the United States and have a representative in the U.S. with authority to sign or countersign policies. The IRS took the position, however, that the exemption from the excise tax is gained only through compliance with the statutory requirements, which Neptune did not meet (because it is not an "authorized" insurer). The Claims Court granted the government's motion for summary judgement and found that Neptune was not exempt from excise taxes under either theory.

The Federal Circuit has affirmed the Claims Court summary judgment regarding Neptune's liability for excise taxes. Although the result seems technical, the issue is one which could have far-ranging importance. In effect, the courts are stating that failure to come within the exemption in IRC [section] 4373(1) will require a foreign insurer to be subject to the excise tax on premiums paid to it. Consequently, because the excise and income tax cannot both apply, the insurer cannot be subject to income taxes on the premium income and related investment income under IRC [section] 842. The result is somewhat anomalous, as most tax lawyers are concerned that a company's activities may cause IRC [section] 842 to become applicable, potentially subjecting the company to income taxes which may be greater than the excise taxes imposed by IRC [section] 4371.

P. Bruce Wright is a member of the New York Bar. Mr. Wright is also a member of the law firm of LeBoeuf, Lamb, Leiby and MacRae.
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Article Details
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Author:Wright, P. Bruce
Publication:Risk Management
Article Type:column
Date:Apr 1, 1989
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