The New York Division of Tax Appeals (NY Div. of Tax Appeals) recently ruled that a parent company cannot deduct premiums paid to a subsidiary captive insurance company from its New York entire net income (NY ENI) because the premiums paid did not constitute insurance for federal income tax purposes. Matter of Stewart's Shops Corporation,DTA No. 825745 (NY State Div. of Tax App. March 10, 2016).

The parent company (Parent) is an employee-owned and family-owned corporation that operates hundreds of convenience stores and gas stations in upstate New York and Vermont. The stores are all directly owned and operated by the single parent and are not held within separate subsidiaries. In 2003, Parent formed a New York captive insurance company (Captive) to increase its control of risk, its control of claims and its incentive for risk management. Captive was formed under New York's captive insurance company law on January 1, 2004, after extensive discussions with insurance professionals and members of the captive insurance division of the New York Department of Insurance. Captive was 100% owned by Parent. Captive operated independently of the Parent and hired a third-party captive services company provider to ensure the premiums charged were comparable to those of non-captive insurance companies for similar insurance lines. Captive used Parent's offices and employees to perform its services. Captive had no property, employees or business independent of the Parent.

For the 2006 through 2009 tax years (Audit Period), Parent filed a consolidated federal income tax return, Form 1120, that included Captive and other affiliates. In computing consolidated federal taxable income (FTI), the deductions for premiums paid by the Parent to the Captive were eliminated as intercompany transactions. For New York tax purposes, Parent filed a combined Article 9-A corporation franchise tax return that did not include Captive. Moreover, in each year, Parent modified its FTI to determine NY ENI by deducting premiums paid to Captive in arriving at its combined NY ENI. Since its formation, Captive paid captive insurance company premiums tax under Article 33 and the Department determined that Captive could not be included in Parent's New York combined reporting group because it was an insurance corporation (Item 183). In 2010, Parent dissolved the Captive.

The New York State Department of Taxation and Finance (Department) initiated an audit of Parent for the 2006 through 2009 calendar years. As part of the audit, the Department inquired of Parent's modification of its NY ENI from its FTI for the premiums it paid to the Captive. The Department found that Captive provided many different additional lines of insurance that it had previously not purchased from third parties. The Department issued a notice of deficiency (Notice) on December 23, 2011, asserting that the premiums paid from Parent to Captive were incorrectly excluded from Parent's NY ENI since the tax law provided for no modification of FTI for insurance premiums paid.

The NY Div. of Tax Appeals upheld the Division's Notice, finding that insurance premiums paid to the Captive were not properly deductible in determining its NY ENI. The NY Div. of Tax Appeals reasoned that the taxpayer could not deduct such premiums in determining NY ENI because New York uses FTI as the starting point for determining NY ENI and the statute did not contain any modifications for insurance premiums paid.

The NY Div. of Tax Appeals went on to examine the underlying treatment of the insurance provided by the Captive and whether that insurance would be deductible for federal income tax purposes. It concluded that, in order for a corporation to deduct insurance premiums in computing FTI, federal courts have historically looked at the following four factors to determine whether an arrangement is considered insurance (see Rent-A-Center, Inc. v. C.I.R., 142 TC 1 [2014]):

1. The arrangement involves insurable risk
2. The arrangement meets commonly accepted notions of insurance
3. The arrangement shifts the risk of loss to the insurer
4. The insurer distributes the risk among its policyholders

While the NY Div. of Tax Appeals noted that the arrangement satisfied the first two prongs (there were legitimate nontax reasons for forming Captive and Parent had previously obtained similar lines of insurance from third-party carriers), the insurance provided by the Captive did not satisfy the third and fourth prongs of the federal test. Specifically, Parent failed the last two prongs of the test because it neither shifted the risk of loss to Captive nor distributed the risk amongst policyholders. The NY Div. of Tax Appeals used the balance sheet and net worth approach to determine whether or not risk had shifted from Parent to Captive. The balance sheet and net worth approach considered whether a payment from Captive to Parent with respect to an insurance claim would directly affect the Parent's balance sheet and net worth. The NY Div. of Tax Appeals concluded that, as a 100% owned subsidiary, any payments made from Captive to Parent would affect Parent's balance sheet and net worth. Additionally, because Parent was organized as a single operating entity, rather than operating in various subsidiaries and affiliates, there was a lack of statistically independent risk exposures and, as a result, a lack of risk distribution.

Further, while the NY Div. of Tax Appeals did not specifically address the deductibility of premiums paid by subsidiaries or affiliates of a parent company to a captive insurance company, it appears to be following federal income tax law, which allows for premiums paid in a "brother-sister arrangement" from a subsidiary to a captive insurance company to be deductible (Clougherty Packing Co. v. Commissioner (811 F2d 1297 [9th Cir 1987]; Humana Inc., v. Commissioner (881 F2d 247 [6th Cir. 1989]) ). The court in Humana reasoned that insurance risk shifts when the captive insurance company pays a claim that would not affect the assets of the subsidiary, as opposed to that of the parent company. Risk distribution is achieved when a captive insurance company is exposed to "a large pool of statistically independent risk exposures" (Securitas Holdings, Inc. v. C.I.R., TC Memo, 2014-225 (2014)). A captive insurance company may achieve statistically independent risk exposure if it insures only subsidiaries within its affiliated group that employs a large number of employees, vehicles and services provided by the subsidiaries (Rent-A-Center, Inc. v. C.I.R. at 24).

It appears that the NY Div. of Tax of Appeals following prior federal tax rulings concluded that the payments made by the parent to the captive did not constitute insurance and therefore would not have been deductible for federal income tax purposes and thus, are not deductible in computing Parent's ENI. Notably, because of the novelty of the issue and the lack of specific New York administrative precedent on payments to a captive insurance company, the ALJ could not conclude that the taxpayer acted in bad faith or failed to adequately disclose its treatment of the payments to the captive insurance company and therefore, concluded that penalties should not be imposed on the taxpayer.

Implications

Although this case is not precedent and cannot be relied upon by taxpayers or the Department, New York taxpayers that currently have a captive insurance company or may be organizing a captive insurance company should consider this recent decision. We will monitor this case to see if it appealed by the taxpayer. Moreover, taxpayers should consider New York's new law on captive insurance companies.¹

For general (non-financial) corporations, please contact David Schmutter, Bill Korman, or Sam Cohen. For financial corporations, please contact Timothy Mahon or Karen Ryan.

———————————————

———————————————
ENDNOTES

¹ See New York State Tax Law Sections 2 (11) and 210-C.2(b).