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The Tenth Circuit has affirmed the Tax Court in Reserve Mechanical Corp. v. Commissioner, agreeing that the taxpayer (1) did not issue or reinsure insurance policies, (2) was not taxable as an insurance company and therefore was ineligible to elect to be taxed as a US taxpayer, (3) did not qualify for a tax exemption as small insurance company, and (4) was liable for a 30% tax under IRC Section 881(a) on purported insurance premiums it had received. Reviewing the trial court's opinion to ascertain whether the Tax Court's findings were clearly erroneous, the appellate court concluded that the trial record supported the Tax Court's conclusions that the taxpayer did not achieve risk distribution by insuring or reinsuring a large number of independent risks and that the contracts it issued were not insurance in the commonly accepted sense.

Background

Reserve Mechanical Corp. (Reserve) was an Anguillan-domiciled captive insurance company owned by a Nevada limited liability company (Peak Casualty). Reserve elected to be treated as a domestic insurance company under IRC Section 953(d) and claimed to be a tax-exempt insurance company under IRC Section 501(c)(15). 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).

Peak distributed, serviced, repaired and manufactured 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; 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.

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 insuring against "loss of major customers" and cyber risk. With the input of 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.

Each of the policies that Reserve wrote 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% of the premiums on policies written by Reserve.

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. In addition, PoolRe coinsured with Reserve approximately 1% of its annualized liability for insurance risk it had assumed under vehicle service contracts issued by another insurer; during the tax years in issue, PoolRe executed similar coinsurance agreements with other captives administered by Capstone.

The only claim made under Reserve's direct written policies occurred in 2009 and related to Peak's loss of a major customer. The claim was made on April 6, 2009; Reserve paid the bulk of the claim on April 21, 2009, and paid the small remaining amount on May 27, 2009.

The IRS issued a deficiency notice for 2008, 2009 and 2010, asserting that Reserve was not a tax-exempt insurance company under IRC 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 IRC Section 953(d) to be treated as a domestic corporation and had to file Form 1120-F, US Income Tax Return of a Foreign Corporation, for the tax years in issue.

On substitute returns that the IRS prepared for Reserve for the tax years at issue, the amounts Reserve reported as program service revenue were reported as taxable income subject to 30% withholding under IRC Section 881(a). Because Reserve had failed to file Forms 1120-F within 18 months of the due dates for the tax years at issued, it was barred from claiming all deductions and credits in computing its taxable income.

Tax Court decision

The Tax Court sustained the Service's determinations, 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. (See Tax Alert 2018-1321.) The court concluded that Reserve would not be taxed as an insurance company were it a US company and therefore may not be treated as a domestic entity under IRC Section 953(d) or a tax-exempt entity under IRC Section 501(c)(15). Consequently, amounts that Reserve had received as purported premiums constituted payments of US-source fixed or determinable, annual or periodical (FDAP) income, subject to a 30% withholding tax under IRC Section 881(a).

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. In this case, points (3) and (4) were at issue.

The Tax Court acknowledged that, in previously decided cases, it had found risk distribution to exist despite the captive's insuring only a small number of related entities because the captive also insured significant numbers of independent risk exposures. But here, the Tax Court concluded that Reserve did not distribute the related-party risks because Peak was the primary insured under all the policies directly issued by Reserve as the risks and operations of two other related parties were insignificant. The Tax Court concluded that "the number of insureds and the total number of independent exposures were too few to distribute the risk that Reserve assumed under the direct written policies."¹

For each tax year under a quota-share arrangement, the trial court found that Reserve would receive payments from PoolRe in the same amount as the payments that Peak paid to PoolRe for stop-loss coverage, which indicated to the Tax Court that there was a circular flow of funds. In addition, according to the Tax Court, the lack of evidence explaining the premium pricing or the "perfect matching of payments under the corresponding stop loss endorsements and quota share policies (from insureds to PoolRe, and from PoolRe to captives)" indicated the contracts between Reserve and PoolRe were not actuarially priced or negotiated at arm's-length. These findings led the Tax Court to conclude that the quota share stop-loss transactions between Reserve and PoolRe were not bona fide insurance (reinsurance) transactions. While accepting that the coinsurance contracts arguably shifted risk from PoolRe to Reserve, the Tax Court found this risk de minimis and therefore insufficient to permit Reserve to distribute any risk shifted to it under its contacts with related parties.

When evaluating whether the transactions reflected "insurance in the commonly accepted sense," the Tax Court found that Reserve had not exercised due diligence in determining the premiums it charged or in paying the one claim ($400k) 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.

Because Reserve's contracts did not qualify as insurance contracts, it did not qualify as an insurance company under the Code and was therefore ineligible to elect to be taxed as a US taxpayer or to be treated as exempt from tax under IRC Section 501(c)(15). Rejecting the taxpayer's arguments that the amounts Reserve received from related parties, if not insurance premiums, qualified as capital contributions, the Tax Court found that Reserve produced insufficient evidence to rebut the Service's characterization of the amounts Reserve received under the direct policies as "fixed or determinable annual or periodical" income subject to 30% withholding under IRC Section 881.

Appellate decision

Sustaining the Tax Court's decision, the Tenth Circuit concluded the lower court "could properly find that Reserve had not satisfied its burden — in particular, Reserve had not proved that its purported insurance transactions were truly arrangements for insurance." Further, the appeals court sustained the Tax Court's refusal to accept Reserve's alternative argument that the amounts it received from Peak were nontaxable capital contributions if they were not insurance.

After noting that Reserve did not challenge the Tax Court's finding that the related-party transactions did not provide Reserve with risk distribution, the appeals court focused on Reserve's argument that its contracts with PoolRe allowed it to distribute related-party risk. Recounting the facts at issue in detail, the appeals court concluded that the trial record supported the Tax Court's findings that Reserve's transactions with PoolRe were not bona fide insurance transactions or were insufficient to permit Reserve to distribute risk as required for insurance to exist. As to whether the transactions between Peak and Reserve were insurance in its commonly accepted sense, the appeals court agreed with the Tax Court that Reserve had not conducted its affairs in a businesslike manner, noting in part that:

• Several "policies were executed with singular carelessness"
• The pricing of two policies contained "remarkable errors"
• Reserve's experts presented no evidence that certain premiums were reasonable
• There was "no evidence in the record that the choice of policies, or their specific contents, was based on an assessment of Peak's particular needs"
• Reserve only handled one claim during the years at issue
• Reserve's reinsurance policies appeared to be "of very little financial utility" and had been entered into merely to create the illusion that Reserve was spreading risk among many insureds

The Tenth Circuit therefore affirmed the Tax Court's holdings that Reserve's contracts with its related parties did not qualify as insurance contracts and Reserve did not qualify as an insurance company and was therefore unable to make a valid election under IRC Section 953(d) to be taxed as a US taxpayer or to be treated as tax-exempt under IRC Section 501(c)(15). Agreeing with the Tax Court that "whether a payment constitutes a capital contribution turns on the motive of the payor," the appeals court also noted the lack of evidence produced by Reserve at trial in support of its argument that these payments were intended to be contributions to capital.

Implications

This opinion, while perhaps remarkable in detail, is not novel in its affirmation of the Tax Court's conclusion that Reserve's transactions did not qualify as insurance. Indeed, though it may be the first appellate captive insurance opinion to address the characterization of purported premium payments as FDAP, the appeals court merely cited accepted authority holding that whether payments qualify as capital contributions depends upon the motive of the party making such payments and then agreed with the Tax Court that there was no evidence supporting such a conclusion presented at trial.

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ENDNOTE

¹ Reserve did not challenge this finding on appeal, but instead argued that risk distribution existed as a result of the transactions with PoolRe.