InIn the Matter of Stewart's Shops Corporation, ¹ the New York Tax Appeals Tribunal² upheld a decision³ by an administrative law judge (ALJ) 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 arrangement for which the premiums were paid did not constitute insurance for federal income tax purposes. In upholding the ALJ, the Tax Appeals Tribunal did not modify the ALJ's conclusions of law (see Tax Alert 2016-0608).

Background

Stewart's Shops operates convenience stores in upstate New York and Vermont. These stores are all owned and operated by a single corporation (Parent). In 2003, Parent formed a captive insurance company under New York's captive insurance law (Captive) after extensive discussions with the captive insurance division of the New York Department of Insurance (NY DOI).

Captive paid New York premium tax on the premiums paid by Parent to Captive (albeit at the significantly reduced rates New York provides for captive insurance companies). For federal income tax purposes, Stewart's Shops filed a consolidated return that included Captive in the federal consolidated group, so the premiums paid to Captive were eliminated as intercompany transactions for US federal income tax purposes and had no material federal income tax effect. For New York Article 9-A corporate franchise tax purposes, however, Parent deducted the premiums paid to Captive from its NY ENI, as Captive, as an insurance company subject to New York premium tax, was not includable nor included in its Article 9-A New York combined group.

The audit division of the New York Department of Taxation and Finance (Department) audited Stewart's Shops Article 9-A New York combined group return and denied the deduction from its NY ENI for the premiums paid to Captive, as New York's Article 9-A tax law does not explicitly provide for any such deduction. At the same time, the Department refused to refund the New York premium taxes paid by Captive. Stewart's Shops appealed the franchise tax assessment to the ALJ. The ALJ denied the appeal except as to relief from penalties.

On appeal before the Tax Appeals Tribunal, Stewart's Shops argued, among other things, that:

— The Department should be estopped from assessing the tax because representatives of the captive insurance division of the NY DOI encouraged Stewart's Shops to form Captive for the favorable tax treatment it sought in the way it filed its New York state combined return, among other things (The ALJ in her recitation of findings stated that the representatives of the NY DOI's captive insurance division did not recall making any such representations regarding income tax benefits)

— It was being unfairly subject to double taxation by first having Captive's premiums subject to New York premium tax and then, by being denied a deduction for the same premiums paid to Captive by the insured Parent, thereby increasing its NY ENI and thus, its corporate franchise tax liability

— This double taxation led to an "absurd result"

— New York's Article 9-A tax code should be read in concert with New York's Captive Insurance Act to find a deduction from NY ENI for the captive insurance premiums it paid⁴

The Tax Appeals Tribunal rejected Stewart's Shops' arguments on similar grounds found by the ALJ. The Tax Appeals Tribunal agreed with the Department's position that the insurance provided by Captive and the premiums paid did not constitute true "insurance" under federal tax case law and, therefore, would not have been deductible for federal income tax purposes (noting that Captive and Parent were members of the same consolidated group and thus, the premium income to Captive was eliminated by the deduction taken by Parent and therefore was of no consequence for federal income tax purposes).⁵ Moreover, New York's Article 9-A franchise tax plainly does not provide for a separate deduction for such "premiums" from NY ENI. Accordingly, "premiums" paid to a captive insurer that would not have been deductible for federal income tax purposes cannot be deducted from New York ENI.

The Tax Appeals Tribunal noted that the Department had reversed its position on audit and had subsequently offered to refund Captive's premium tax payments, therefore rectifying the double taxation result of which Stewart's Shop complained.

Implications

As noted, the Tax Appeals Tribunal upheld the ALJ's conclusions of law, and the decision is now precedent. New York taxpayers that currently have a captive insurance company or may be organizing a captive insurance company should consider this recent decision. Both the ALJ's decision and the Tax Appeals Tribunal contain a detailed recitation of the facts in this case suggesting that the insurance provided would not have qualified as "insurance" for federal income tax purposes. In any such captive insurance situation, respecting the treatment of the insurance as "true" insurance would appear to be critical to a favorable finding allowing the deduction for such premiums.

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ENDNOTES

¹ In the Matter of Stewart's Shops Corporation, DTA No. 825745 (NY Tax App. Trib. July 27, 2017).

² The Tax Appeals Tribunal is an appellate quasi-judicial body for New York tax disputes and its decisions are precedential for New York tax purposes.

³ Matter of Stewart's Shops Corporation, DTA No. 825745 (NY State Div. of Tax App. March 10, 2016).

⁴ See Tax Appeals Tribunal DTA no. 825745, at 36 to 39.

⁵ On the other hand, brother-sister captive insurance arrangements may constitute "insurance" for federal income tax purposes (because of the perceived risk shifting), assuming other requirements are met.