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Tax ruling effects for insureds and captives.

Several recent U.S. tax Court decisions and Internal Revenue Service (IRS) rulings may have wide ranging implications for insureds and the owners of captive insurance companies. In December 1992, the IRS made available a list of "significant" issues that, during the course of an income tax audit, an IRS examining agent is instructed to consider and scrutinize more closely than what otherwise would have been the case. A number of those items are of particular interest to those managers involved in alternative funding arrangements and captive insurance companies. The issues discussed included: whether taxpayers who sell extended service contracts as the primary obligor may deduct insurance premiums to cover their obligations under the contracts in the year paid rather than amortize the premiums over the life of the contract, notwithstanding the income received or earned; whether premiums paid on retrospectively rated insurance policies are deductible as insurance premiums under Section 162 of the Internal Revenue Code (IRC), as amended in 1986; and whether certain reinsurance contracts involving financial reinsurance lack sufficient risk transfer traits to characterize them as contracts of insurance for federal income tax purposes.

In another matter, since the 1986 amendments to the IRC, concern has increased over the possibility that the IRS would assert that foreign insurers or reinsurers are engaging in the conduct of a trade or business in the United States and thus are taxable. This is being accomplished either under a "facts and circumstances" test (which generally applies to entities resident in jurisdictions that have not entered into income tax treaties with the United States) or based on the existence of a "permanent establishment" located in the United States (which generally applies if the foreign entity is resident in a country that has entered into an income tax treaty with the United States).

Recently, petitions were filed in the U.S. Tax Court involving Taisei Fire & Marine Insurance Co. Ltd., Nissan Fire & Marine Insurance Co. Ltd., Fuji Fire & Marine Insurance Co. Ltd. and Chiyoda Fire & Marine Insurance Co. Ltd. - Japanese reinsurers to which business was ceded by Fortress Re, a U.S. corporation. In each case, the IRS alleged that the relationship with Fortress Re created a permanent establishment in the United States thereby subjecting the Japanese companies to taxation on the business ceded through Fortress Re.

These cases will be followed carefully given the fact that little authority currently exists to deal with the question of whether an insurer or reinsurer is engaged in the conduct of a trade or business within the United States, based either on a facts or circumstances test or through a permanent establishment. The cases may have an effect on foreign captive insurers that operate from both treaty (e.g., Bermuda or Barbados) or nontreaty (e.g., Cayman or the Bahamas) jurisdictions, as well as foreign commercial insurers and reinsurers.

Excise Tax Application

Under an IRS Letter Ruling published last year, the IRS considered a situation in which a taxpayer sought to recover payments of federal excise tax imposed under IRC 4371. According to the facts of the ruling, a U.S. resident was insured by a foreign insurer to whom the U.S. insured paid casualty insurance premiums during the last quarter of 1986 and paid excise taxes for the fourth quarter of 1986. Under the method of accounting employed by the foreign insurer, the premiums paid by the U.S. insured were included in the foreign insurer's 1987 year.

In September 1987, the foreign insurer made a timely election under IRC 953(c)(3)(c) to treat its related person insurance income ("RPII") as effectively connected to a U.S. trade or business effective January 1, 1987. The foreign insurer paid the appropriate tax on the income included on its 1987 return (including the premiums paid by the U.S. insured during the last quarter of 1986). Subsequently, the insured sought a refund of the excise tax paid on the premiums it paid to the foreign insurer during the last quarter of 1986 that were included in the foreign insurer's 1987 income.

The IRS took the position that IRC 953(c)(3)(d)(ii) provides that the tax imposed by IRC 4371 is not applicable with regard to any RPII treated as effectively connected with the conduct of a trade of business in the United States under IRC 953(c)(3)(c). Accordingly, it was concluded that because the election was effective prior to the date on which the premium was included in income by the foreign insurer, the insured is eligible for a refund of the excise taxes.

Excise Tax Refund

During 1992, in a National Office Technical Advice Memorandum, the IRS considered a situation in which a U.S. domestic corporation paid premiums to an admitted carrier, which then paid the premium to a foreign captive wholly owned by the domestic corporation. For a number of years, the domestic corporation treated the premiums paid to its captive (through the admitted carrier) as deductible business expenses. Subsequent to an audit, the IRS disallowed the deductions concluding that the arrangement was one of self-insurance. After the domestic corporation had paid the deficiencies assessed by the IRS, the admitted carrier applied for a refund of the excise taxes paid under IRC 4371 on the theory that the excise tax should not be due because the amounts paid to the captive were not premiums.

The IRS denied the claim for a refund on the theory that the period within which the claim could be made had expired. The admitted carrier took the position that the doctrine of "equitable recoupment" applied, and therefore the statute of limitations defense should not be applicable. In general, under the doctrine of equitable recoupment, a claim for a refund is not barred if a single transaction is subjected to two taxes based on inconsistent legal theories.

The IRS has taken the position, however, that the doctrine of equitable recoupment applies only when the two taxes are paid by the same taxpayer; because the domestic corporation in question had paid the income taxes under the assessment and the admitted carrier had paid the excise tax (notwithstanding that the excise tax related to premium paid by the domestic corporation), the theory of equitable recoupment would therefore not apply. It should be noted that in similar situations in which the domestic insured pays the excise taxes on premiums paid directly to a foreign insurer, the doctrine of equitable recoupment should be applicable if a refund application for excise taxes is made by the domestic insured.

No Avoiding It

IRC 845, ENACTED as a part of the 1986 amendments to the IRC, permits the IRS, among other things, to recharacterize certain aspects of reinsurance transactions if the transaction had a tax avoidance effect. Furthermore, recharacterization may take place even if the transaction had not been motivated by a tax avoidance intention, as long as the effect of the transaction resulted in tax avoidance. The broad power resulted in a good deal of concern that any number of transactions could be recharacterized.

In another National Office Technical Advice Memorandum, the IRS addressed the ability of a property/casualty insurer to elect to use its own payment pattern to discount losses for tax purposes, when its reporting of certain transactions for financial statement purposes differed from its reporting for tax purposes. The taxpayer in question had entered into a loss portfolio agreement with an unrelated insurer, pursuant to which the taxpayer had assumed $158 million of workers' compensation liabilities, and received $129 million of cash and marketable securities. On its 1985 federal income tax return, the taxpayer treated the transaction as reinsurance; however, on its 1985 National Association of Insurance Commissioners (NAIC) annual statement, the taxpayer treated the transaction as a hybrid involving both a financing transaction and reinsurance, in order to minimize the transaction's effect on the financial ratios used to develop its insurance rating. The taxpayer's 1985 return was audited, and no adjustment was made to the reporting of the transaction.

On its 1987 federal income tax return, the taxpayer elected to use its historical loss payment pattern for purposes of computing discounted unpaid losses. In examining the taxpayer's 1987 tax return, the IRS agent sought to disallow the election, on the basis that the NAIC annual statement reporting of the loss portfolio transaction resulted in a material distortion of the taxpayer's historical loss payment pattern. The taxpayer admitted that the NAIC reporting resulted in a material distortion, but argued that the IRS could not disallow the election, nor could it adjust the taxpayer's computation of discounted unpaid losses, because the taxpayer had followed the methodology set forth in the legislative history of IRC 846 for computing its historical loss payment pattern.

After examining the plain language of IRC 846(e), and the administrative guidance provided thereunder, the IRS National Office concluded that there was no authority that would allow the examining agent to disregard the taxpayer's election to apply its historical loss payment pattern to discount unpaid losses. However, under the broad authority of IRC 845(b), the IRS is permitted to make proper adjustment to one or both parties of a reinsurance transaction, whether related or unrelated, to eliminate a tax avoidance effect of the transaction. As a result, the IRS National Office also concluded that the examining agent could recompute the taxpayer's historical loss payment pattern to eliminate the distortion caused by the NAIC reporting of the loss portfolio transaction. While the reporting of loss portfolio transactions changed beginning with the 1990 NAIC annual statements, this ruling by the IRS National Office is indicative of the broad scope of IRC 845(b) and the IRS's willingness to apply it in order to eliminate that the IRS perceives to be an incorrect result.

P. Bruce Wright is a partner with the law firm of LeBoeuf, Lamb, Leiby & MacRae in New York and a member of Risk Management's Editorial Advisory Board.
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Author:Wright, P. Bruce
Publication:Risk Management
Date:May 1, 1993
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