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Who Dares Wins - Ian Bridges' article in Captive Insurance Times

14 September 2014

 
Who Dares Wins 
 

What happened in the Securitas case and what are its implications for the industry? 

 

This is the second in line of taxpayer-favour-able cases that have come out this year and another feather in the cap of those trying to set up captive insurance companies in the face of the various ruling put in place by the Internal Revenue Service (IRS). The Securi-tas case relies on the outcome of the Rent-A-Center case from earlier this year. In both cases, the entities were not set up in a way that would meet the safe harbour rules that were introduced by the IRS in 2002. These rules focused on risk transfer and risk distribution and were and continue to be an obstacle to setting up new captives—which includes making sure the for-profit insureds are eligible for a tax deduction for premiums paid to the captive.

 

Typically, to obtain insurance treatment for tax purposes, there are a few factors. First-ly, it is important that you have an insurable risks and secondly that you are shifting these risks from one entity to another, in a balance sheet analysis. The third factor is the distribution of risk that is viewed in the eyes of the insurer—the more risk it has and can distribute amongst independent loss events, the less chance there is that one claim, when it is paid out, will exceed the premiums of all the policyholders.

 

The last factor is this notion of an ‘insurance company’ in the commonly accepted sense, meaning the entity has a separate balance sheet, income statement, management and follows the correct regulatory restrictions and requirements.

 

Over the past 10 years, many of the small- and medium-sized companies have been tripped up by the 2002, and subsequent, revenue rulings on how they can attain both risk transfer and risk distribution. When a potential client comes to GCM, one of the first things we do is analyse if the pro-gramme can fit into one of the three 2002 safe harbor revenue rulings: either the “par-ent/sub”, the “brother/sister”, or a “group captive” model. Typically, with these small and privately-owned captives, they fall into the parent/sub model but are unable to bring in third-party risk which is problematic.

 

Their parent/sub models is where you will find third-party risk from the use of reinsurance pool structures. Usually these pools are designed to take a parent/sub captive and cede some level of risk into a third-party reinsur-ance pool then in turn the captive will reinsure the pool. The reinsurance assumed by the captive is likely to be considered third party risk to the extent it is not the captives own risk being reinsured. That is how the parent/sub captives attempt to meet the risk distribution hurdle from the IRS revenue rulings.

 

In the case of Securitas, the US parent of foreign company Securitas had bought a number of companies and, for business purposes, had merged them during the years under examination. The programme went from having 11 insureds, one of which had 37 percent of the business in 2003, to having only 4 insureds in  2004 after a number of these consolidations took place, with one insured having 88 per-cent of the business.

 

Under the Revenue Ruling 2002-90, you would need 12 brother/sister corporations in order to meet the safe harbour. Interestingly, the court never acknowledged this IRS requirement for risk distribution even though it appears the taxpayer never met the safe harbour ruling in 2003 nor in 2004.

 

In the eyes of the court, risk distribution is determined actuarially as evidenced by the number if independent loss events such as more than 200,000 employees and 2000 vehicles insured under five types of risk: workers’ compensation, automobile, employment practice, general and fidelity liabilities. As the size of the pool increases, the potential for the loss per policy to deviate from the expected loss by a given amount declines. The court highlighted this position: “This [the risk] does not change, merely because multiple companies merged into one. The risks associated with those companies did not vanish once they all fell under the same umbrella.”

 

This quote really sums up the court’s opinion of what constitutes risk distribution. Hopefully it will force the IRS out of the opinion of ‘the more insured corporations/policyholders, the better’. Could clients then use this case as a motive to do things they may have been reluctant to beforehand? Absolutely. If this judicial trend continues, we could really see a significant increase in new captive formations, particularly among those parent-sub captives who were hesitant on using pooling facilities. Many possible captives have been shelved over the past few years because those stakeholders involved were reluctant to enter a pooling facility and did not think they could meet the IRS’ risk distribution requirements in another manner.

 

I am ready back on the phone with these potential clients relaying the significance of Securitas and Rent-A-Center and how they can benefit.

 

Clearly these cases can go on for some time but, considering that victories for Rent-A-Center and Securitas have been less than a year apart, could this be the last one for a while? Perhaps, however if the next case that arises is also a taxpayer favorable decision I would think this would change the land-scape in captive taxation if it has not been done so already. We knew last year, from hearing a number of the captive taxation experts at the Cayman Captive Forum, that there were a couple of cases to come. If the trend continues and the IRS continues to lose these cases in the courts, I think the IRS may need to revisit these safe harbor revenue rulings similar to what the IRS did in 2001 to the economic family theory in Revenue Ruling 2001-31.

 

In 2002, we as an industry were trying to figure out how to make captives work under the then new rulings. Since then, with the advent of pooling facilities as a potential stop-gap, we are finally beginning to see cases in favour of the taxpayer against the rulings.

 

As a former tax practitioner and someone whose business is trying to set up and man-age captives effectively, I really see this as a big positive for the industry.

 

 

Ian Bridges

Cayman Islands GCM