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In Reserve Mechanical Corp. v. Commissioner, the Tax Court has held that an Anguillan-domiciled captive insurance company (Reserve), owned by a Nevada limited liability company (Peak Casualty) and electing to be treated as a domestic insurance company under Section 953(d), was not eligible to make the Section 953(d) election and was not exempt from tax as an "insurance company" under Section 501(c)(15). The court concluded that Reserve's direct written policies did not cover sufficient risks or insureds to sufficiently distribute risk and that reinsurance arrangements by which Reserve purported to accept risk were not bona fide and did not supply Reserve with risk distribution. Further, the court held that payments Reserve received for the tax years at issue were subject to the 30% tax imposed under Section 881(a).

Peak Casualty was owned equally by two US individuals who were also the sole owners of Reserve's direct insureds, Peak Mechanical & Components, Inc. (Peak), RocQuest, LLC (RocQuest) and ZW Enterprises, LLC (ZW). The issues presented to the Tax Court were: (1) whether the policies issued by Reserve to Peak, RocQuest and ZW constitute insurance contracts for federal tax purposes; (2) whether Reserve qualifies as an "insurance company" eligible to elect under Section 953(d) to be treated as a US taxpayer and under Section 501(c)(15) to be treated as tax-exempt; and (3) if Reserve is not an insurance company and is not eligible to make an election under Section 953(d), whether payments that it received under the purported insurance contracts are subject to the 30% withholding tax imposed by Section 881(a).

The Tax Court's analysis of whether Reserve's contracts qualify as insurance and Reserve qualifies as an insurance company is very similar to its analysis in Avrahami v. Commissioner, 149 T.C. No. 7 (2017) (see "Avrahami — The wider implications"), a case addressing the qualification of a captive insurance company as a "small" insurance company eligible under Section 831(b) to be taxed only on its investment income. But Reserve is notable as it is the first case to address the validity of a captive insurance company's combined elections to be treated as a US taxpayer (the Section 953(d) election) and exempt from tax under Section 501(c)(15), the subject of dozens of adverse IRS rulings. The opinion is also notable for the Tax Court's discussion of the tax treatment of premium payments in a failed captive context, something that has not been present in any recent cases. Accordingly, it seems telling that the Tax Court issued this opinion as a memorandum opinion, which, unlike reported opinions (such as) are officially of no precedential value because, in theory, they do not address novel legal issues. Rather, memorandum opinions are issued when the Tax Court deems the applicable law to be settled and the result is factually driven. Thus, the court's decision to dispose of this case in a memorandum opinion could be seen as implying that the same analysis should be applied in a case arising under Section 501(c)(15) as is applied in a case arising under Section 831(b).

Background

Peak engaged in the business of distributing, servicing, repairing and manufacturing equipment used for underground mining and construction. During 2008–2009, Peak had 17 employees and was insured for general liability, worker's compensation, property, automobile, inland marine and international risks by unrelated commercial insurance carriers; in 2007, Peak's premium cost under these policies was approximately $96,000 and for the first six months of 2008, it was approximately $57,000.

In 2008, Peak hired Capstone Associated Services, Ltd. (Capstone), a captive insurance services provider, to complete a feasibility study and assist Peak and Peak Casualty in forming and running Reserve. On December 3, 2008, Reserve was incorporated in Anguilla (a territory of the UK) and received its Class B insurance license; its initial capitalization was $100,000, which satisfied Anguilla's minimum requirements for a Class B insurer. In August 2009, Capstone issued the feasibility study, which was based on an inspection of Peak's business operations, financial information and commercial insurance coverage. The feasibility study was based solely on the business operations and financial information of Peak and did not include information about RocQuest or ZW. (RocQuest owned real estate in two states and leased it to others for business operations and ZW was formed to help a former Peak employee finance a bar in which ZW held a 10% interest.)

During the tax years at issue, Reserve issued direct written insurance policies for losses of Peak, RocQuest and ZW that covered certain somewhat nontraditional lines of business for a company like Peak, including Loss of Major Customer insurance and Cyber Risk.¹ Each of Reserve's policies showed one premium price and did not specify amounts to be paid by each insured. With the input of Mid-Continent General Agency, Ltd. (Mid-Continent), an unrelated firm, Capstone determined the premiums that Reserve would charge based on Peak's annual sales and on the amount of premiums charged by other Capstone-managed entities that offered similar coverages. Capstone then selected and drafted the policies that Reserve issued to Peak and the other insureds.

The policies written by Reserve were effective from December 4, 2008, through January 1, 2009, and provided an aggregate amount of insurance coverage of $13 million at a premium cost of $412,089; for six lines of coverage, the policies covered losses arising since January, 1, 2005.² For policies issued covering Reserve's second year, effective from January 1, 2009, through January 1, 2010, the total premiums were $448,127, although this covered two fewer lines of business.³ The premium amount for the 2010 calendar year was $445,314.

Each of the policies written by Reserve listed PoolRe Insurance Corp. (PoolRe), a reinsurer administered by Capstone that was formed in 2008 in the British Virgin Islands and redomiciled in Anguilla in 2009, as the stop loss insurer for the risk insured by Reserve. PoolRe's obligations under the stop loss coverage were not triggered until Reserve's insureds suffered a specified number of losses that exceeded both a set loss amount and 100% (for 2008 and 2009, 35% for 2010) of the premiums written by Reserve. PoolRe's liability under the stop loss coverage was limited to 50% of covered excess losses. Approximately 19% of the total annual premiums written by Reserve were shared with PoolRe for its stop loss coverage.

PoolRe pooled the risk of Reserve's excess losses with excess loss risk ceded to it under stop-loss coverage it issued to other captive insurance companies administered by Capstone and then entered into quota share reinsurance agreements to redistribute these pooled excess risks to all of the companies that purchased stop loss coverage from PoolRe. The quota share that Reserve assumed from PoolRe was calculated so that Reserve would receive payments from PoolRe equal to the premiums that PoolRe was entitled to receive from Reserve's insureds. For example, PoolRe received premiums of $76,236 in 2008, representing 18.5% of the total combined premiums paid by Peak (and the other related insureds) on the direct insurance policies. At the same time, under the quota share policy, PoolRe agreed to pay Reserve reinsurance premiums of $76,236 for assuming approximately 1.35% of PoolRe's stop-loss pool.

Reserve also entered into a coinsurance agreement with PoolRe for risks arising under vehicle service (extended warranty) contracts ceded to PoolRe by CreditRe Reassurance Corp., Ltd. (CreditRe). CreditRe had acquired this risk from ARIA (SAC), Ltd., a Bermuda-domiciled insurance company that had reinsured these risks from Lyndon Property Insurance Co., a US-based direct writer. PoolRe ceded approximately 1% of its annualized liability for the vehicle service risk to Reserve; during the tax years in issue, PoolRe executed similar coinsurance agreements with other captives administered by Capstone.

The only claim under one of Reserve's direct written policies was made in 2009 and related to Peak's loss of a major customer. The date of occurrence for the claim was January 5, 2009, and the date of the claim was April 6, 2009. Reserve paid the bulk of this claim on April 21, 2009, and paid the small remaining amount on May 27, 2009. The claim was reopened later in 2009, with an additional $175,000 being paid to Peak. No claims were made under the stop-loss coverage with PoolRe. Similarly, Reserve did not incur any losses under its quota share arrangement with PoolRe. (Although the opinion is silent on whether any claims were filed with PoolRe under the stop-loss coverage, the claim experience of Reserve makes it unlikely that the stop-loss coverage was triggered.)⁴

In its notice of deficiency (notice) for 2008, 2009 and 2010, the IRS determined that Reserve was not a tax-exempt insurance company within the meaning of Section 501(c)(15) because its insurance and reinsurance transactions lacked economic substance. The IRS also determined, in the alternative, that Reserve was not an insurance company within the meaning of subchapter L of the Code because its predominant activity was not insurance. Further, because Reserve was not an insurance company, it could not elect under Section 953(d) to be treated as a domestic corporation, but was instead required to file Form 1120-F, US Income Tax Return of a Foreign Corporation, for the tax years in issue. According to the notice, the IRS had prepared substitute returns for Reserve for the tax years at issue and the amounts Reserve reported as program service revenue for the tax years at issue were reported as taxable income subject to 30% withholding under Section 881. Finally, because Reserve had failed to file Forms 1120-F for the tax years at issue within 18 months of their respective due dates, it was barred from claiming all deductions and credits in computing its taxable income.

The Tax Court's opinion

The Tax Court held in favor of the IRS, finding that Reserve's business arrangements with Peak and PoolRe lacked both risk distribution and common notions of insurance and therefore did not qualify as insurance; thus, Reserve would not be taxed as an insurance company were it a US company. Reserve was therefore ineligible to be treated as a domestic entity under Section 953(d) and ineligible to elect tax-exempt status under Section 510(c)(15). Consequently, amounts that had been treated as premiums when paid from the insureds to Reserve were no longer treated as such, but were instead treated as payments of US-source fixed or determinable, annual or periodical (FDAP) income to which the 30% withholding tax under Section 881(a) applied.

For Reserve's arrangements to qualify as insurance, the Tax Court noted, the four pillars of insurance developed under case law must be met: 1) the arrangement must involve insurance risks; 2) the arrangement must shift the risk of loss to the insurer; 3) the insurer must distribute the risk; and 4) the arrangement must be insurance in the commonly accepted sense. As in the recent Avrahami case, the Tax Court's initial focus was on the risk-distribution pillar. The court noted that, in this case, as in Avrahami, the captive insured only a handful of risks — in contrast to the thousands of risks insured in the Rent-a-Center (see Tax Alert 2014-0142) and Securitas (see Tax Alert 2014-1968) cases, in which the Tax Court found risk distribution existed. Tax Court also considered the number of insured entities and found that only "one company, Peak, was the primary insured under all of the policies," because the risks and operations of RocQuest and ZW were insignificant.

Reserve argued that, although there were very few direct insureds, the stop-loss coverage with PoolRe, followed by the quota-share cession of PoolRe's pooled stop-loss coverage to Reserve, plus the coinsurance of CreditRe, resulted in Reserve insuring thousands of risks. Rejecting this argument, the Tax Court noted that, under the stop-loss and quota-share arrangements, Reserve paid premiums to PoolRe equaling the premiums that it received under the quota-share agreement and Reserve never had any losses or expenses in connection with the quota-share liabilities. Accordingly, the end result for each tax year under the quota-share arrangement was that Reserve would receive payments from PoolRe in the same amount as the payments that Peak paid to PoolRe for the stop-loss coverage. The Tax Court found this arrangement similar to a circular flow of funds and viewed it unfavorably for purposes of the risk distribution analysis. Other items considered in the Tax Court's finding that the PoolRe arrangement did not support Reserve's risk distribution included: the lack of arm's-length premiums at PoolRe; the lack of actuarial input in determining premiums; the fact that all the insureds of the participants in the quota-share arrangement were obligated to pay the same percentage of premiums to PoolRe; and the lack of evidence that the vehicle service risks even existed within PoolRe. Based on these facts, the Tax Court declined to treat PoolRe as a bona fide insurance company. Consequently, the risks that Reserve had assumed under the quota-share reinsurance contract did not exist for purposes of risk distribution.

The Tax Court also found that Reserve did not satisfy the fourth pillar of insurance, insurance in the commonly accepted sense. The court noted a lack of due diligence in determining both the premiums charged by Reserve and the premiums paid to PoolRe, as well as a lack of due diligence relating to the payment of the one claim filed on a Reserve policy. The Tax Court also noted that Reserve offered no explanations for policy limit decreases or inconsistent premium charges for the same lines of business over different periods. As a result, Reserve's arrangements with Peak did not qualify as insurance in the commonly accepted sense.

Key takeaways

— The standout issues presented by this case include the Tax Court's reliance on the number of statistically independent risks and the number of insureds when deciding whether risk was adequately distributed. This is the same analysis used in Avrahami but differs somewhat with the Tax Court's opinions in Rent-A-Center ⁵ and Securitas,⁶ in which the court found risk distribution based on the number of statistically independent risks and was silent on the number of insureds. The Reserve case further strengthens the notion that the number of risks is an integral part of risk distribution and needs to be considered, as opposed to focusing solely on the number of insured entities.

— Does the Tax Court's opinion in Reserve give the IRS support for continuing to argue that risk distribution requires a minimal number of insureds? If so, how persuasive is it given the court's other recent opinions focused on the number of risks? The weight of authority of recent Tax Court opinions provides significant support for the notion that the number of risks is an integral — perhaps even the primary — point for finding risk distribution. Once again, Tax Court's most recent opinion in the captive insurance space is leaving the market in the middle of a grey area that calls for a close analysis of each situation's facts and circumstances.

— Although the Reserve opinion cites Avrahami on a number of occasions, one could argue that the more recent case had more favorable facts and can be distinguished from Avrahami. Nonetheless, Reserve reinforces that all four pillars of qualification for insurance should be met and that failure to satisfy any of the four will likely cause a captive to fail to qualify under subchapter L.

— Because the arrangement was not viewed as insurance for US federal tax purposes, the Section 953(d) and 501(c)(15) elections were revoked, so the payments that were treated as deductible premiums to a US affiliate are now treated as payments to a foreign related party. The Tax Court discussed the classification of these premiums in the failed captive context, something that has not been discussed in any recent cases. In Revenue Ruling 2005-40,⁷ the IRS states that "an arrangement that purports to be an insurance contract but lacks the requisite risk distribution may instead be characterized as a deposit arrangement, a loan, a contribution to capital (to the extent of net value, if any), an indemnity arrangement that is not an insurance contract, or otherwise, based on the substance of the arrangement between the parties." Many nonprofit-owned offshore captives have historically been treated as failing insurance company treatment for US federal tax purposes and have treated their premiums as either contributions to capital or deposits. In Reserve, the lack of evidence that the parties intended to treat the arrangement as a contribution to capital resulted in the premiums' being classified as FDAP, which caused the 30% withholding tax to apply. A point to ponder is what evidence would support nontaxable treatment (contribution to capital or deposit) of failed insurance premiums.

— The Tax Court notes that it is concerned with a "one-size-fits-all" rate for all the participants in quota-share pooling arrangement, whereby all participants pay the same percentage of their direct premiums into the pool. Reserve is a good reminder that, when participating in a pooling arrangement, it is important that a captive looks to its individual needs to determine the degree of its participation.

Contact Information For additional information concerning this Alert, please contact:   Insurance Group • Paul H. Phillips III (214) 754-3232 • Maureen Nelson (202) 327-6021 • Ted Clabault (202) 327-6839 • Karey Dearden (212) 773-7056 • Mikhail Raybshteyn (516) 336-0255

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ENDNOTES

¹ A complete list of the coverages offered by Reserve in 2008 includes: Excess Directors & Officers Liability, Special Risk — Loss of Major Customer, Special Risk — Expense Reimbursement, Special Risk — Loss of Services, Special Risk — Weather Related, Business Interruption, Excess Pollution Liability, Special Risk — Tax Liability, Excess Intellectual Property Package, Special Risk — Regulatory Changes, Special Risk — Punitive Wrap Liability, Excess Employment Practices Liability, Excess Cyber Risk, Special Risk — Product Recall

² These lines of coverage were Excess Directors & Officers Liability, Excess Pollution Liability, Excess Intellectual Property Package, Special Risk — Punitive Wrap Liability, Excess Employment Practices Liability and Excess Cyber Risk.

³ Excess Cyber Risk and Weather-Related Business Interruption were not included in 2009.

⁴ Reserve claimed that it suffered losses under the vehicle service coinsurance agreement; the Tax Court, without making a finding on this point, concluded that any such loss was de minimis and of no effect upon its conclusions.

⁵ Rent-a-Center, Inc. v. Commissioner, 142 T.C. 1 (2014).

⁶ Securitas Holdings, Inc. v. Commissioner, T.C. Memo. 2014-1630 (2014).

⁷ Revenue Ruling 2005-40, 2005-2 C.B. 4.