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International Tax Updates


12/1/15

This article was distributed as part of CohnReznick's National Tax Update - December 2015 newsletter.

Synopsis

On September 21, 2015, the Tax Court in RVI Guaranty Co. Ltd v. Commissioner, 145 TC No. 9 (2015), held that residual value insurance policies are insurance for federal income tax purposes and that the risks insured by such policies are insurable risks.

Facts

RVI Guaranty Co. Ltd (“RVI”) is an insurance company domiciled and regulated in the State of Connecticut.  RVI offered residual value insurance policies to unrelated insureds, such as leasing companies, financial institutions and manufacturers that either leased or financed passenger vehicles, commercial real estate, and commercial equipment.

The insurance policies insured against the risk that the actual value of the asset upon termination of the lease or financing arrangement would be significantly lower than the expected value. The primary question for the Tax Court was whether the policies offered by the taxpayer were merely investment risks, and consequently that the RVI contracts were not insurance contracts.

Analysis 

While the term “insurance” is not defined in the Internal Revenue Code of 1986, as amended (the “Code”), the Tax Court reviewed the precedential case law including Helvering v. Le Gierse, 312 U.S. 531, 539 (1941), which held that insurance involves “risk-shifting and risk-distribution.” Further, cases have held that in addition to risk shifting and risk distribution a transaction must constitute insurance in its commonly accepted senses and that the transferred risk was an insurance risk.1 The Tax Court articulated these concepts as they applied to RVI’s insurance policies:

  • Risk Shifting: the payment of premium by insured provided the insured with protection from financial loss if the residual value declined precipitously.
  • Risk Distribution: the insurer pooled multiple risks of multiple insureds in order to take advantage of “the law of large numbers” by distributing the risk across different business segments, asset types, geographic locations, and lease durations. 
  • Insurance in the commonly accepted sense-To determine whether the arrangement constitutes insurance in its commonly accepted sense, The Tax Court considered the following factors:
     

(1) whether the insurer is organized, operated, and regulated as an insurance company by the States in which it does business;
(2) whether the insurer is adequately capitalized;
(3) whether the insurance policies are valid and binding;
(4) whether the premiums are reasonable in relation to the risk of loss; and
(5) whether premiums are duly paid and loss claims are duly satisfied. 

In determining whether RVI deals with “insurance risks”, the Tax Court, in reliance on taxpayer’s experts, held that RVI was at risk for “significant underwriting losses that were not related to [its] investment returns.” Depending upon the occurrence of fortuitous events, RVI’s loss under a contract could vary from zero to the full insured value. The court analogized the RVI insurance policies to mortgage insurance and municipal bond insurance. For example, the RVI insurance protects its policyholders like municipal bond insurance policies, where the bondholder is insured against loss of profit on its investment by guaranteeing the investor will receive payment of interest and repayment of principal if the issuer fails to pay.

The IRS’ loss in RVI Guaranty Co. Ltd. was another setback in the IRS’ campaign against captive insurers, following its losses in Rent-a-Center and Securitas Holdings Inc. In Rent-A-Center, the taxpayer capitalized its captive, a Bermuda company, with its own deferred tax asset, along with a parental guaranty of the asset’s amount. Rent-A-Center made the guaranty at the request of Bermuda’s insurance regulators, in order to ensure the captive would be adequately capitalized. The IRS challenged the guarantee as a circular flow of funds, where the parent was essentially guaranteeing payment to itself, so that the captive arrangement was not insurance. The Tax Court held that the guarantee was meant to satisfy regulators in Bermuda rather than for tax purposes. Also it stated that the existence of a parental guaranty did not in itself mean a captive was not engaged in an insurance business.

In Securitas, the IRS challenged the taxpayer’s deduction of premiums paid to its captive insurer, where Securitas guaranteed claims made against the captive insurer. The Tax Court held for the taxpayer, finding that the captive was adequately capitalized, and that hypothetical payment of the captive’s liabilities under Securitas’ guarantee was not sufficient to show the captive did more than merely provide tax benefits to its parent.

In Summary

The Tax Court was asked whether the risks in question were mere investment risks or insurance risks.  In response, the Tax Court’s findings stated that certain market risks could be considered insurance risks and noted that mortgage guaranty insurance and municipal bond insurance have been accepted as uninsurable risks in the past.  The Tax Court further noted that for over 80 years a number of state insurance regulators, including those in New York and Connecticut, have accepted the premise that coverages against the decline in market values of assets are insurable risks.

What does CohnReznick Think?
CohnReznick believes the Tax Court through this holding clarifies a number of points related to insurance such as whether we are dealing with (i) insurance risk; (ii) the deference given to insurance regulatory authorities and (iii) the accounting of the premiums and reserves. Note also that the IRS issued a 2011 TAM which concluded that residual value insurance is NOT insurance. The Tax Court did not address the relevance or continued viability of that guidance in its decision. Further, the Tax Court favored the testimony of the petitioner’s experts rather than those of the IRS, highlighting the importance of experts in insurance matters. In another recent Tax Court decision (Acuity & Subsidiaries v. Commissioner, TC Memo 2013-209), the court allowed the petitioner’s carried loss reserves based on signed actuarial reports, based upon professional actuarial rules, relied upon by the petitioner to support Petitioner’s pricing and reserve amounts.  Under the Acuity decision, a taxpayer’s reasonable reliance on an actuary is not subject to challenge by the IRS.

Contact

For more information, please contact Jonathan Babu, senior manager, at jonathan.babu@cohnreznick.com or 301-664-8111; James Wall, principal, at james.wall@cohnreznick.com or 646-254-7460.


Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

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