Decision will be entered under
P, a domestic corporation, is the parent of numerous wholly owned subsidiaries including L, a Bermudian corporation. P conducted its business through stores owned and operated by its subsidiaries. The other subsidiaries and L entered into contracts pursuant to which each subsidiary paid L an amount, determined by actuarial calculations and an allocation formula, relating to workers' compensation, automobile, and general liability risks, and, in turn, L reimbursed a portion of each subsidiary's claims relating to these risks. P's subsidiaries deducted, as insurance expenses, the payments to L. In notices of deficiency issued to P, R determined that the payments were not deductible.
142 T.C. 1">*1 FOLEY,
RAC, a publicly traded Delaware corporation, is the parent of a group of approximately 15 affiliated subsidiaries (collectively, 142 T.C. 1">*2 petitioner). During the years in issue, petitioner was the largest domestic rent-to-own company. Through stores owned and operated by RAC's subsidiaries, petitioner rented, sold, and delivered 2014 U.S. Tax Ct. LEXIS 1">*3 home electronics, furniture, and appliances. The stores were in all 50 States, the District of Columbia, Puerto Rico, and Canada. From 1993 through 2002, petitioner's company-owned stores increased from 27 to 2,623. During the years in issue, RAC's subsidiaries owned between 2,623 and 3,081 stores; had between 14,300 and 19,740 employees; and operated between 7,143 and 8,027 insured vehicles.
In 2001, American Insurance Group (AIG), in response to a claim against RAC's directors and officers (D&O), withdrew a previous offer to renew RAC's D&O insurance policy. To address this problem, RAC engaged Aon Risk Consultants, Inc. (Aon), which convinced AIG to renew the policy. Impressed with Aon's insurance expertise and concerned about its growing insurance costs, petitioner engaged Aon to analyze risk management practices and to broker workers' compensation, automobile, and general liability insurance. With Aon's assistance, petitioner developed a risk management department and improved its loss prevention program.
Prior to August 2002, Travelers Insurance Co. (Travelers) provided petitioner's workers' compensation, automobile, and general liability coverage 2014 U.S. Tax Ct. LEXIS 1">*4 through bundled policies. Pursuant to a bundled policy, an insurer provides coverage and controls the claims administration process (i.e., investigating, evaluating, and paying claims). Travelers paid claims as they arose and withdrew amounts from petitioner's bank account to reimburse itself for any claims less than or equal to petitioner's deductible (i.e., a portion of an insured claim for which the insured is responsible). Pursuant to a predetermined formula, each store was allocated, and was responsible for paying, a portion of Travelers' premium costs.
In 2001, after receiving a $3 million invoice from Travelers for "claim handling fees", petitioner became dissatisfied with the cost and inefficiency associated with its bundled policies. On August 5, 2002, petitioner, with the assistance of Aon, obtained unbundled workers' compensation, automobile, and 142 T.C. 1">*3 general liability policies from Discover Re. Pursuant to an unbundled policy, an insurer provides coverage and a third-party administrator manages the claims administration process. Discover Re underwrote the policies; multiple insurers provided coverage;3 and Specialty Risk Services, Inc. (SRS),4 a third-party administrator, evaluated 2014 U.S. Tax Ct. LEXIS 1">*5 and paid claims. Petitioner and its staff of licensed adjusters had access to SRS' claims management system and monitored SRS to ensure the proper handling of claims. This arrangement gave petitioner greater control over the claims administration process.
Petitioner, pursuant to the Discover Re policies' deductibles, was liable for a specific amount of each claim against its workers' compensation, automobile, and general liability policies (e.g., pursuant to its 2002 workers' compensation policy, petitioner was liable for the first $350,000 of each claim). Petitioner's retention of a portion of the risk resulted in lower premiums.
Between 1993 and 2002, petitioner rapidly expanded and became increasingly concerned about its growing risk management costs. In 2002, after analyzing petitioner's insurance 2014 U.S. Tax Ct. LEXIS 1">*6 program, Aon suggested that petitioner form a wholly owned insurance company (i.e., a captive). Aon representatives informed David Glasgow, petitioner's director of risk management, about the financial and nonfinancial benefits of forming a captive. Aon convincingly explained that a captive could help petitioner reduce its costs, improve efficiency, obtain otherwise unavailable coverage, and provide accountability and transparency. Mr. Glasgow presented the proposal to petitioner's senior management, who concurred with Mr. Glasgow's recommendation to further explore the formation of a captive. Petitioner's senior management directed Aon to conduct a feasibility study (i.e., relying on petitioner's workers' compensation, automobile, and general 142 T.C. 1">*4 liability loss data) and to prepare loss forecasts and actuarial studies. Petitioner engaged KPMG to analyze the feasibility study, review tax considerations, and prepare financial projections.
Aon, in the feasibility study, recommended that the captive be capitalized with no less than $8.8 million. Before deciding where to incorporate the captive, RAC analyzed projected financial data and reviewed multiple locations. On December 11, 2002, RAC 2014 U.S. Tax Ct. LEXIS 1">*7 incorporated, and capitalized with $9.9 million,5Legacy, a wholly owned Bermudian subsidiary.62014 U.S. Tax Ct. LEXIS 1">*8 Legacy opened an account with Bank of N.T. Butterfield and Son, Ltd., and, on December 20, 2002, filed a class 1 insurance company registration application with the Bermuda Monetary Authority (BMA), which regulated Bermuda's financial services sector. A class 1 insurer may insure only the risk of its shareholders and affiliates; must be capitalized with at least $120,000; and must meet a minimum solvency margin calculated by reference to the insurer's net premiums, general business assets,7 and general business liabilities.
Legacy planned to insure petitioner's liabilities for the period beginning in 2002 and ending December 31, 2003 (proposed period). Aon informed petitioner that coverage provided 142 T.C. 1">*5 by unrelated insurers would be more costly than Aon's estimate of Legacy's premiums and that some insurers would not be willing to offer coverage. In response to a quote request, Discover Re stated that it was not in the market to provide the coverage Legacy contemplated. Discover Re estimated, however, that its premium (i.e., if it 2014 U.S. Tax Ct. LEXIS 1">*9 were to write one relating to the proposed period) would be approximately $3 million more than Legacy's.
During the years in issue, petitioner obtained unbundled workers' compensation, automobile, and general liability policies from Discover Re. Pursuant to these policies, Discover Re provided petitioner with coverage above a predetermined threshold relating to each line of coverage. In addition, Legacy wrote policies that covered petitioner's workers' compensation, automobile, and general liability claims below the Discover Re threshold. Petitioner, depending on the amount of a covered loss, could seek payment from Legacy, Discover Re, or both companies.
The annual premium Legacy charged petitioner was actuarially determined using Aon loss forecasts and was allocated to each RAC subsidiary that owned covered stores. RAC was a listed policyholder pursuant to the Legacy policies. No premium was attributable to RAC, however, because it did not own stores, have employees, or operate vehicles. RAC paid the premiums relating to each policy,8 estimated petitioner's total insurance costs (i.e., Legacy policies, Discover Re policies, third-party administrator fees, 2014 U.S. Tax Ct. LEXIS 1">*10 overhead, etc.), and established a monthly rate relating to each store's portion of these costs. The monthly rate was based on three factors: each store's payroll, each store's number of vehicles, and the total number of stores. At the end of each year, RAC adjusted the allocations to ensure that its subsidiaries recognized their actual insurance costs. SRS administered all claims relating to petitioner's workers' compensation, automobile,142 T.C. 1">*6 and general liability coverage. During the years in issue, the terms of Legacy's coverage varied, Legacy progressively covered greater amounts of petitioner's risk, and Legacy did not receive premiums from any unrelated entity. From December 31, 2002, through December 30, 2007, Legacy earned net underwriting income of $28,761,402.
Pursuant to the Legacy policies, coverage began on December 2014 U.S. Tax Ct. LEXIS 1">*11 31 of each year. Because petitioner was a calendar year accrual method taxpayer, these policies created temporary timing differences between income recognized for tax purposes and income recognized for financial accounting (book) purposes.9 For example, on December 31, 2002, when Legacy's second policy became effective, Legacy recognized, for tax purposes, the full amount of the premium (i.e., $42,800,300) relating to the taxable year ending December 31, 2002.
Pursuant to the Bermuda Insurance Act, an insurance company must maintain a minimum solvency margin.
In the minimum solvency margin calculation set forth in its insurance company registration application, Legacy treated DTAs as general business assets. On March 11, 2003, Legacy petitioned the BMA for the requisite permission to do so. The following letter from RAC accompanied the request: We write to confirm to you that Rent-A-Center, Inc., * * * will guarantee the payment to Legacy Insurance Company, Ltd. (the "Company"), * * * of all amounts reflected on the projected balance sheets of the Company previously delivered to you as deferred tax assets arising from timing differences in the amounts of taxes payable for tax and financial accounting purposes. This guaranty of payment will take effect in the event of any change in tax laws that would require recognition of an impairment of the deferred tax asset, and will be effective to the extent of the amount of the impairment.
On March 13, 2003, the BMA granted Legacy permission to treat DTAs as general business assets 2014 U.S. Tax Ct. LEXIS 1">*14 on its statutory balance sheet through December 31, 2003.10The BMA also informed Legacy that from December 31, 2002, through March 13, 2003, it "wrote insurance business without being in receipt of its Certificate of Registration and was therefore in violation of the [Bermuda Insurance] Act as it engaged in insurance business without a license." Despite this violation, the BMA registered Legacy as a class 1 insurer effective 142 T.C. 1">*8 December 20, 2002 (i.e., the date Legacy filed its insurance registration request and before it issued policies relating to the years in issue).
In response to the recurring DTA issue, Legacy requested that RAC guarantee DTAs relating to subsequent years. On September 17, 2003, RAC's board of directors authorized the execution of a guaranty of "the obligations of Legacy to comply with the laws of Bermuda." On the same day, RAC's chairman and chief executive officer executed a parental guaranty and sent it to Legacy's board of directors. The parental guaranty provided: The undersigned, Rent-A-Center, Inc. a Delaware corporation ("Rent-A-Center") 2014 U.S. Tax Ct. LEXIS 1">*15 is sole owner of 100% of the issued and outstanding shares in your share capital and as such DOES HEREBY GUARANTEE financial support for you, Legacy Insurance Co., Ltd., * * * and for your business, as more particularly set out below, which is to say: Under the [Bermuda] Insurance Act * * * and related Regulations (the "Act"), Legacy Insurance Co., Ltd., must maintain certain solvency and liquidity margins and, in order to ensure continued compliance with the Act, it is necessary to support Legacy Insurance Co., Ltd. with a guarantee of its liabilities under the Act (the "Liabilities") not to exceed Twenty-Five Million US dollars (US $25,000,000). Accordingly, Rent-A-Center DOES HEREBY GUARANTEE to you the payment in full of the Liabilities of Legacy Insurance Co., Ltd. and further to indemnify and hold harmless Legacy Insurance Co., Ltd. from the Liabilities up to the maximum dollar amount [$25,000,000] indicated in the foregoing paragraph.
On November 12, 2003, the BMA issued a directive which "approved the Parental 2014 U.S. Tax Ct. LEXIS 1">*16 Guarantee from Rent-A-Center, Inc. dated 17th September, 2003 up to an aggregate amount of $25,000,000 for utilization as part of * * * [Legacy]'s capitalization". This approval was granted for the years ending December 31, 2003, 2004, 2005, and 2006. Legacy used the parental guaranty only to meet the minimum solvency 142 T.C. 1">*9 margin (i.e., to treat DTAs as general business assets).11 On December 30, 2006, RAC unilaterally canceled the parental guaranty because Legacy met the minimum solvency margin without it.
Legacy purchased RAC treasury shares during 2004, 2005, and 2006. The BMA approved the purchases and allowed Legacy to treat the shares as general business assets for purposes of calculating its liquidity ratio (i.e., its ratio of general business assets to liabilities). Pursuant to Bermuda solvency regulations, an insurer fails to meet the liquidity ratio if the value of its general business assets is less than 75% of its liabilities.
For 2014 U.S. Tax Ct. LEXIS 1">*17 each policy period, Legacy's auditor, Arthur Morris & Co. (Arthur Morris), prepared, and provided to RAC and the BMA, reports and financial statements. In these reports and statements, Arthur Morris calculated Legacy's DTAs,12 minimum solvency margin,132014 U.S. Tax Ct. LEXIS 1">*18 premium-to-surplus ratio,14 and net underwriting income.15 During each of the years in issue, Legacy's total statutory capital and surplus equaled or exceeded the BMA minimum solvency margin. In calculating total statutory capital and surplus, Arthur Morris took into account the following four components: contributed surplus, statutory surplus, capital stock, and other fixed capital (i.e., assets deemed to be general business assets). During 2003, 2004, and 2005, Legacy included portions of the parental guaranty as general business assets. During the years in 142 T.C. 1">*10 issue, the amounts of Legacy's DTAs exceeded the portions of Legacy's parental guaranty treated as general business assets.
The following table summarizes key details relating to Legacy's policies:
2003 | $42,800,300 | $5,840,613 | $4,805,764 | $5,898,192 |
2004 | 50,639,000 | 6,275,326 | 4,243,823 | 7,036,573 |
2005 | 54,148,912 | 7,659,009 | 3,987,916 | 8,379,436 |
2006 | 53,365,926 | 8,742,425 | -0- | 10,014,206 |
2007 | 63,345,022 | 9,689,714 | -0- | 12,428,663 |
2008 | 64,884,392 | 9,607,661 | -0- | 23,712,022 |
2003 | $5,898,192 | 8.983:1 | $1,587,542 |
2004 | 7,036,572 | 7.695:1 | (982,000) |
2005 | 8,379,435 | 6.369:1 | 8,411,912 |
2006 | 9,284,601 | 6.326:1 | 8,810,926 |
2007 | 10,888,698 | 5.221:1 | 10,933,022 |
2008 | 11,278,359 | 2.538:1 | 18,391,392 |
Respondent sent petitioner, on January 7, 2008, a notice of deficiency relating to 2003; on December 22, 2009, a notice of deficiency 2014 U.S. Tax Ct. LEXIS 1">*19 relating to 2004 and 2005; and on August 5, 2010, a notice of deficiency relating to 2006 and 2007 (collectively, notices). In these notices, respondent determined that petitioner's payments to Legacy were not deductible pursuant to
In determining whether payments to Legacy were deductible, our initial inquiry is whether Legacy was a bona fide insurance company.
After successfully resolving petitioner's D&O insurance problem, Aon evaluated petitioner's risk management department. Petitioner, with Aon's assistance, improved risk management practices, switched from bundled to unbundled policies, and hired SRS as a third-party administrator. Aon proposed that petitioner form a captive, and petitioner determined that a captive would allow it to reduce its insurance costs, obtain otherwise unavailable insurance coverage, formalize and more efficiently manage its insurance program, and provide accountability and transparency relating to insurance costs. Petitioner engaged KPMG to prepare financial projections and evaluate tax considerations referenced in the feasibility study. Federal income tax consequences were considered, but the formation of Legacy was not a tax-driven transaction.
Respondent further contends that Legacy was "not an independent fund, but an accounting device". In support of this contention, respondent cites a purported "circular flow of funds" through Legacy, RAC, and RAC's subsidiaries. Respondent's expert, however, readily acknowledged that he found no evidence of a circular flow of funds, nor have we. Legacy, with the approval of the BMA, purchased RAC treasury shares but did not resell them. Furthermore, petitioner 142 T.C. 1">*12 established that there was nothing unusual about the manner in which premiums and claims were paid. Finally, respondent contends that the netting of premiums owed to Legacy during 2003 is evidence that Legacy was a sham. We disagree. This netting was simply a bookkeeping measure performed as an administrative convenience.
Respondent emphasizes that, during the years in issue, Legacy's premium-to-surplus ratios were above the ratios of U.S. property and casualty insurance companies and Bermuda class 4 insurers16 (collectively, commercial insurance companies). On cross-examination, however, respondent's expert admitted that his analysis of commercial insurance companies contained erroneous numbers. Furthermore, he failed to properly explain the profitability data he cited and did not include relevant data relating to Legacy. Moreover, his comparison, of Legacy's premium-to-surplus ratios with the ratios of commercial insurance companies, was not instructive. Commercial insurance companies have lower premium-to-surplus ratios because they face competition and, as a result, typically price their premiums to have significant underwriting losses. They compensate for underwriting losses by retaining sufficient assets (i.e., more assets per dollar of premium resulting in lower premium-to-surplus ratios) to earn ample amounts of investment income. Captives in Bermuda, however, have fewer assets per dollar of premium (i.e., higher premium-to-surplus ratios) but generate significant underwriting profits 2014 U.S. Tax Ct. LEXIS 1">*23 because their premiums reflect the full dollar value, rather than the present value, of expected losses. Simply put, the premium-to-surplus ratios do not indicate that Legacy was a sham.
Petitioner presented convincing, and essentially uncontradicted, evidence that Legacy was a bona fide insurance company. As respondent concedes, petitioner faced actual and 142 T.C. 1">*13 insurable risk. Comparable coverage with other insurance companies would have been more expensive, and some insurance companies (e.g., Discover Re) would not underwrite the coverage provided by Legacy. In addition, RAC established Legacy for legitimate business reasons, including: increasing the accountability and transparency of its insurance operations, accessing new insurance markets, and reducing risk management costs. Furthermore, Legacy entered into bona fide arm's-length contracts with petitioner; charged actuarially determined premiums; was subject to the BMA's regulatory control; met Bermuda's minimum statutory 2014 U.S. Tax Ct. LEXIS 1">*24 requirements; paid claims from its separately maintained account; and, as respondent's expert readily admitted, was adequately capitalized.
The Code does not define insurance. The Supreme Court, however, has established two necessary criteria: risk shifting and risk distribution.
Respondent concedes that petitioner faced insurable risk relating to all three types of risk: workers' compensation, automobile, and general liability. Petitioner entered into contracts with Legacy and Discover Re to address these three types of risk. Thus, insurance risk was present in the arrangement between petitioner and Legacy.
We must now determine whether the policies at issue shifted risk between RAC's subsidiaries and Legacy. This requires a review of our cases relating 2014 U.S. Tax Ct. LEXIS 1">*26 to captive insurance arrangements.
In 1978, we analyzed parent-subsidiary captive arrangements for the first time.
In We found in the insuring parent corporation and its domestic subsidiaries, and the wholly owned "insurance" subsidiary, though separate corporate entities, represent one economic family with the result that those who bear the ultimate economic burden of loss are the same persons who suffer the loss. To the extent that the risks of loss are not retained in their entirety by * * * or reinsured with * * * insurance companies that are unrelated to the economic family of insureds, there is no risk-shifting or risk-distributing, and no insurance, the premiums for which are deductible under
142 T.C. 1">*16 The Court of Appeals for the Ninth Circuit affirmed our decision in [W]e examine the economic consequences of the captive insurance arrangement to the "insured" party to see if that party has, in fact, shifted the risk. In doing so, we look only to the insured's assets, i.e., those of Clougherty, to determine whether it has divested itself of the adverse economic consequences of a covered workers' compensation claim. Viewing only Clougherty's assets and considering only the effect of a claim on those assets, it is clear that the risk of loss 2014 U.S. Tax Ct. LEXIS 1">*30 has not been shifted from Clougherty.
In
We held that the parent-subsidiary premiums were not deductible because Humana did not shift risk to the captive. "True insurance relieves the firm's balance sheet of any potential impact of the financial consequences of the insured peril. For the price of the premiums, the insured rids itself of any economic stake in whether or not the loss occurs. * * * [However] as long as the firm deals with its captive, its balance sheet cannot be protected from the financial vicissitudes of the insured peril."
Seven Judges concurred with the opinion of the Court's parent-subsidiary holding but disagreed with the brother-sister holding. The theory of
The Court of Appeals for the Sixth Circuit affirmed our decision relating to the parent-subsidiary arrangement, but reversed our decision relating to the brother-sister arrangement.18 Such an argument provides no
The Court of Appeals held that "[t]he test to determine whether a transaction under the The tax court cannot avoid direct confrontation with the separate corporate existence doctrine of 2014 U.S. Tax Ct. LEXIS 1">*37 The tax court misapplies this substance over form argument. The substance over form or economic reality argument is not a broad legal doctrine designed to distinguish between legitimate and illegitimate transactions and employed at the discretion of the tax court whenever it feels that a taxpayer is taking advantage of the tax laws to produce a favorable result for the taxpayer. * * * The substance over form analysis, 142 T.C. 1">*20 rather, is a distinct and limited exception to the general rule under
We find persuasive the Court of Appeals for the Sixth Circuit's critique of our analysis of the brother-sister arrangement in
Second, the opinion of the Court's extensive reliance on Plotkin's report to analyze the brother-sister arrangement was inappropriate. The report in Even though the brother, the captive, and the parent are in the same economic family, to the extent that a brother has no ownership interest in the captive, the results of the parent-captive analysis do not apply. It is not the presence or absence of unrelated business, nor the number of other insureds (be they affiliates or non-affiliates), but it is the absence of ownership, the captive's capital, and the number of statistically independent risks (regardless of who owns them) that enables the captive to provide the brother with true insurance as a matter of economics and finance.
Third, we did not properly analyze the facts and circumstances.
In determining whether Legacy's policies shifted risk, we narrow our scrutiny to the arrangement's economic impact on RAC's subsidiaries (i.e., the insured entities).
The policies at issue shifted risk from RAC's insured subsidiaries to Legacy, which was formed for a valid business purpose; was a separate, independent, and viable entity; was financially capable of meeting its obligations; and reimbursed RAC's subsidiaries when they suffered an insurable loss. [Petitioner's counsel:] But if the loss gets paid, whose balance sheet gets affected 2014 U.S. Tax Ct. LEXIS 1">*42 in that case? [Respondent's expert:] What's hanging me up is that I don't know whether--I guess you're right, because * * * [RAC's subsidiary] will treat the payment from--the payment that it expects from Legacy as an asset, so the loss would hit Legacy's [balance sheet]. [Petitioner's counsel:] But it wouldn't hit * * * [RAC's subsidiary's] balance sheet. [Respondent's expert:] I would think that's right. * * * [Petitioner's counsel:] Why is that not risk-shifting? [Respondent's expert:] That's an--why is that not risk-shifting? [Petitioner's counsel:] Yes. Why is that not risk-shifting? Why hasn't [RAC's subsidiary] shifted its risk to Legacy? Its insurance risk--why hasn't it shifted to Legacy in that scenario? [Respondent's expert:] I mean, I would say from an accounting perspective, it has managed to have--is it--if we're going to respect all these [corporate] forms, then it will have shifted that risk.
Legacy, in March 2003, petitioned the BMA and received approval, through December 31, 2003, to treat DTAs as general business assets. On September 17, 2003, RAC issued the parental guaranty to Legacy, which petitioned, and received 2014 U.S. Tax Ct. LEXIS 1">*43 permission from, the BMA to treat DTAs as general business assets through December 31, 2006. Respondent contends that the parental guaranty abrogated risk shifting between Legacy and RAC's subsidiaries. We disagree. First, and most importantly, the parental guaranty did not affect the balance sheets or net worth of the subsidiaries insured by Legacy. Petitioner's expert, in response to a question the Court posed during cross-examination, convincingly countered respondent's contention: [The Court]: * * * [W]hat impact does the corporate structure have on the effect of the parental guarantee? [Petitioner's expert]: I think it has a great impact on it. None of the subs, as I understand it, are entering in or [are] a part of that guarantee. Only the subs are effectively insureds under the policy. They are the only ones who produce risks that could be covered. The guarantee in no way vitiates the completeness of the transfer of their uncertainty, their risk, to the insuring subsidiary. 142 T.C. 1">*23 Even if one assumes that the guarantee increases the capital that the captive could use to pay losses, none of those payments would go to the detriment of the sub as a separate legal entity.
Second, the cases 2014 U.S. Tax Ct. LEXIS 1">*44 upon which respondent relies are distinguishable. Respondent cites
Third, RAC guaranteed 2014 U.S. Tax Ct. LEXIS 1">*45 Legacy's "liabilities under the Act [(i.e., the Bermuda Insurance Act and related regulations)]", pursuant to which Legacy was required to maintain "certain solvency and liquidity margins". RAC did not pay any money pursuant to the parental guaranty and Legacy's "liabilities under the Act" did not include Legacy's contractual obligations to RAC's affiliates or obligations to unrelated insurers. For purposes of calculating the minimum solvency margin, Legacy treated a portion of the parental guaranty as a general business asset.
Risk distribution 2014 U.S. Tax Ct. LEXIS 1">*46 occurs when an insurer pools a large enough collection of unrelated risks (i.e., risks that are generally unaffected by the same event or circumstance).
Legacy insured three types of risk: workers' compensation, automobile, and general liability. During the years in issue, RAC's subsidiaries owned between 2,623 and 3,081 stores; had between 14,300 and 19,740 employees; and operated between 7,143 and 8,027 insured 2014 U.S. Tax Ct. LEXIS 1">*47 vehicles. RAC's subsidiaries operated stores in all 50 States, the District of Columbia, Puerto Rico, and Canada. RAC's subsidiaries had a sufficient number of statistically independent risks. Thus, by insuring RAC's subsidiaries, Legacy achieved adequate risk distribution.
Legacy was adequately capitalized, regulated by the BMA, and organized and operated as an insurance company. Furthermore, Legacy issued valid and binding policies, charged and received actuarially determined premiums, and paid 142 T.C. 1">*25 claims. In short, the arrangement between RAC's subsidiaries and Legacy constituted insurance in the commonly accepted sense.
The payments by RAC's subsidiaries to Legacy are, pursuant to
Contentions we have not addressed are irrelevant, moot, or meritless.
To reflect the foregoing,
Reviewed by the Court.
THORNTON, VASQUEZ, WHERRY, HOLMES, BUCH, and NEGA,
GOEKE,
BUCH,
At the same time the IRS abandoned the economic family theory, it made clear that it would "continue to challenge certain captive insurance transactions based on the facts and circumstances of each case."
142 T.C. 1">*26 The 2014 U.S. Tax Ct. LEXIS 1">*49 concise opinion of the Court sets forth facts and circumstances supporting its conclusion. I write separately to respond to points made in Judge Lauber's dissent.
Taking into account the nature of risks that Legacy insured, Legacy was sufficiently capitalized.
During each of the years in issue Legacy insured three types of risk: workers' compensation, automobile, and general liability. Policies relating to these risks are generally referred to as long-tail coverage because "claims may involve damages that are not readily observable or injuries that are difficult to ascertain."
Rent-A-Center did not obtain insurance solely from Legacy; Rent-A-Center also obtained insurance from multiple unrelated third parties. Legacy was responsible for only a portion of each claim (e.g., the first $350,000 of each workers' compensation claim during 2003). To the extent that a claim exceeded Legacy's coverage, a third-party insurer was responsible for paying the excess amount. Rent-A-Center obtained coverage from unrelated third-party insurers for claims of up to approximately $75 million. Therefore, extraordinary losses would not affect Legacy's ability to pay claims because they would be covered by unrelated third parties.
Premiums were actuarially determined. At trial respondent conceded that Aon "produced reliable and professionally produced and competent actuarial studies." Legacy relied on these studies to set premiums. Once Legacy determined the premium, Rent-A-Center allocated it to each operating subsidiary in the same manner that it allocated premiums relating to unrelated insurers. In a captive arrangement, a parent may allocate a premium among its subsidiaries. 2014 U.S. Tax Ct. LEXIS 1">*51
Citing a footnote in
As the opinion of the Court finds, the parental guaranty was created to convert deferred tax assets into general business assets for regulatory purposes.
In contrast, the cases that have found that a parental guaranty eliminates any risk shifting involved either a blanket indemnity or a capitalization agreement that resulted in a capital infusion in excess of premiums received. And even then, the indemnity or capitalization agreement was coupled with an undercapitalized captive. Accordingly, those cases are distinguishable from the situation presented here.
The facts in
Those cases are distinguishable because they all involved undercapitalized captives. As explained previously, the opinion of the Court found that Legacy was adequately capitalized. Further, in each of the three cases above, the parent provided either indemnification or additional capitalization in order to persuade a third-policy insurer to issue insurance policies. Here, Discover Re provided insurance before Legacy's inception and continued providing coverage after Legacy was formed. The parental guaranty was issued to Legacy for the singular purpose of allowing Legacy2014 U.S. Tax Ct. LEXIS 1">*56 to treat the DTAs as general business assets. Additionally, the guaranty amounted to only $25 million. This small fraction of the $264 million in premiums for policies written by Legacy during the years in issue does not rise to the level of protection provided by the total indemnities in
When we consider the totality of the facts, the parental guaranty appears to have been immaterial. This conclusion 142 T.C. 1">*30 is bolstered by the facts that the parental guaranty was unilaterally withdrawn by Rent-A-Center in 2006 and that Rent-A-Center never contributed any funds to Legacy pursuant to that parental guaranty.
Judge Lauber's dissent refers to a hodgepodge of facts about how Rent-A-Center operated its consolidated group as evidence that Legacy's status as a separate entity should be disregarded. Examples of the facts cited in that dissent are that Legacy had no employees and that payments between it and other members of the Rent-A-Center consolidated group were handled through journal entries.
In the real world of large corporations, these practices are commonplace. For ease of operations, including running payroll, companies create 2014 U.S. Tax Ct. LEXIS 1">*57 a staff leasing subsidiary and lease employees companywide. Or they hire outside consultants to handle the operations of a specialty business such as a captive insurer. Legacy, like Humana, hired an outside management company to handle its business operations.
Corporations filing consolidated returns are to be treated as separate entities, unless otherwise mandated.
The issue presented in these cases is ultimately a matter of when, not whether, Rent-A-Center is entitled to a deduction relating to workers' compensation, automobile, and general liability losses.2 Because the IRS has conceded in its rulings that insurance premiums paid between brother-sister corporations may be insurance 2014 U.S. Tax Ct. LEXIS 1">*59 and the Court determined that, under the facts and circumstances of these cases as found by the Judge who presided at trial, the policies at issue are insurance, Rent-A-Center is entitled to deduct the premiums as reported on its returns.
FOLEY, GUSTAFSON, PARIS, and KERRIGAN,
HALPERN,
"'The principle of judicial parsimony' (L. Hand, J., in
These cases are before the Court Conference for review,
And I believe that Judge Foley could have steered clear of
LAUBER,
LAUBER,
142 T.C. 1">*34 In
The opinion of the Court (majority) adopts the reasoning and result of the Sixth Circuit, overrules
The captive insurance issue has a rich history to which the majority refers only episodically. It has been clear from the outset of our tax law that taxpayers (other than insurance companies) cannot deduct contributions to an insurance reserve.
One strategy by which taxpayers sought to avoid this nondeductibility rule was to place their self-insurance reserve into a captive insurance company. In cases involving "classic" captives--i.e., captives that have no outside owners and insure no outside risks--the courts have uniformly held that this strategy does not work. Employing various legal theories, every court to consider the question has held that 142 T.C. 1">*35 amounts paid by a parent to a classic captive do not constitute "insurance premiums."12014 U.S. Tax Ct. LEXIS 1">*66
Insurance and tax advisers soon devised an alternative strategy for avoiding the bar against deduction of contributions to a self-insurance reserve--namely, adoption of or conversion to a holding company structure. In essence, an operating company would drop its self-insurance reserve into a captive; drop its operations into one or more operating subsidiaries; and have the purported "premiums" paid to the captive by the sister companies instead of by the parent. In
While the Commissioner had success litigating the parent-captive pattern, he had surprisingly poor luck litigating the brother-sister scenario. The Tenth Circuit, like our Court, agreed that brother-sister payments to a classic captive are not deductible as "insurance premiums."2 By contrast, the 142 T.C. 1">*36 Sixth Circuit in
The Commissioner had even less success persuading courts to adopt the "single economic family" theory enunciated in
Assessing this track record, the Commissioner made a strategic retreat. In 2001 the IRS announced that it "will no longer invoke the economic family theory with respect to captive insurance transactions."
We decided
Respondent's position in the instant cases is consistent with the ruling position the IRS has maintained for the past 12 years--namely, that characterization of intragroup payments as "insurance premiums" should be determined on the basis of 2014 U.S. Tax Ct. LEXIS 1">*71 the facts and circumstances of the particular case.
Although I do not believe it necessary or proper to overrule P provides S adequate capital * * *. S charges the 12 [operating] subsidiaries arms-length premiums, which are established according to customary industry rating formulas. * * * There are no parental (or other related party) guarantees of any kind made in favor of S. * * * In all respects, the parties conduct themselves in a manner consistent with the standards applicable to an insurance arrangement between unrelated parties.
The facts of the instant cases, concerning both "risk shifting" and conformity to arm's-length insurance standards, differ substantially from the facts assumed in
The majority makes certain findings of basic fact, which I accept for purposes of this dissenting opinion. In many instances, however, the majority makes no findings of basic fact to support its conclusory findings of ultimate fact. In other instances, the majority does not mention facts that tend to undermine its ultimate conclusions. In my view, the undisputed facts of the entire record warrant the opposite conclusion from that reached by the majority and justify a ruling that the Rent-A-Center arrangements do not constitute "insurance" for Federal income tax purposes.
Rent-A-Center, the parent, issued two types of guaranties to Legacy, its captive. First, it guaranteed the multimillion-dollar 142 T.C. 1">*39 "deferred tax asset" (DTA) on Legacy's balance sheet, which arose from timing differences between the captive's fiscal year and the parent's calendar year. Normally, a DTA cannot be counted as an "asset" 2014 U.S. Tax Ct. LEXIS 1">*74 for purposes of the (rather modest) minimum solvency requirements of Bermuda insurance law. The parent's guaranty was essential in order for Legacy to secure an exception from this rule.
Second, the parent subsequently issued an all-purpose guaranty by which it agreed to hold Legacy harmless for its liabilities under the Bermuda Insurance Act up to $25 million. These liabilities necessarily included Legacy's liabilities to pay loss claims of its sister corporations. This all-purpose $25 million guaranty was eliminated at year-end 2006, but it was in existence for the first three tax years at issue.
When approving the brother-sister premiums in
By guaranteeing Legacy's liabilities, Rent-A-Center agreed to step into Legacy's shoes to pay its affiliates' loss claims. In effect, the parent thus became an "insurer" of its subsidiaries' risks. The majority cites no authority, and I know of none, for the proposition that a holding company can "insure" the risks of its wholly owned subsidiaries. The presence of this parental guaranty argues strongly against the existence of "risk shifting" here.
142 T.C. 1">*40 The majority asserts that Rent-A-Center's parental guaranty "did not vitiate risk shifting" and offers three rationales for this conclusion.
The majority contends that the judicial precedents cited above "are distinguishable" because the guaranty issued by Rent-A-Center "did not shift the ultimate risk of loss; did not involve an undercapitalized captive; and was not issued to, or requested by, an unrelated insurer."
As the "most important[]" ground for deeming the guaranty irrelevant, the majority asserts that the parental guaranty "did not affect the balance sheets or net worth of the 142 T.C. 1">*41 subsidiaries insured by Legacy."
When blessing the brother-sister premium payments in
The majority bases its conclusion that Legacy was "adequately capitalized" on the fact that Legacy "met Bermuda's minimum statutory requirements" once the parental guaranty of the DTA is counted.
In fact, Legacy's capital structure was extremely questionable during 2003-06. The only way that Legacy was able to meet Bermuda's extremely thin minimum capitalization requirement was by counting as general business assets its DTAs, and those DTAs could be counted only after Rent-A-Center issued its parental guaranty. The DTAs were essentially a bookkeeping entry. Without treating that bookkeeping entry as an "asset," Legacy would have been undercapitalized even by Bermuda's lax standards.
142 T.C. 1">*42 The extent of Legacy's undercapitalization is evidenced by its premium-to-surplus ratio, which was wildly out of line with the ratios of real insurance companies. The premium-to-surplus ratio provides a good benchmark of an insurer's ability to absorb risk by drawing on its surplus to pay incurred losses. In this ratio, "premiums written" serves as a proxy for the losses to which the 2014 U.S. Tax Ct. LEXIS 1">*80 insurer is exposed. Expert testimony in these cases indicated that U.S. property/casualty insurance companies, on average, have something like a 1:1 premium-to-surplus ratio. In other words, their surplus roughly equals the annual premiums for policies they write. By contrast, Legacy's premium-to-surplus ratio--ignoring the parental guaranty of its DTA--was 48:1 in 2003, 19:1 in 2004, 11:1 in 2005, and in excess of 5:1 in 2006 and 2007. In other words, Legacy's surplus covered only 2% of premiums for policies written in 2003 and only 5% of premiums for policies written in 2004, whereas commercial insurance companies have surplus coverage in the range of 100%. Even if we allow the parental guaranty to count toward Legacy's surplus, its premium-to-surplus ratio was never better than 5:1.
Legacy's assets were undiversified and modest. It had a money market fund into which it placed the supposed "premiums" received from its parent. This fund was in no sense "surplus"; it was a mere holding tank for cash used to pay "claims." Apart from this money-market fund, Legacy appears to have had no assets during the tax years at issue except the following: (a) the guaranties issued by its parent; 2014 U.S. Tax Ct. LEXIS 1">*81 (b) the DTA reflected on its balance sheet; and (c) Rent-A-Center treasury stock that Legacy purchased from its parent. For Federal tax purposes, the parental guaranties cannot count as "assets" in determining whether Legacy was adequately capitalized. They point in the precisely opposite direction.
The DTA and treasury stock have in common several features that make them poor forms of insurance capital. First, neither yields income. The DTA was an accounting entry that by definition cannot yield income, and the Rent-A-Center treasury stock paid no dividends. No true insurance company would invest 100% of its "reserves" in non-income-producing assets. With no potential to earn income, the "reserves" could not grow to afford a cushion against risk.
142 T.C. 1">*43 Moreover, neither the DTA nor the treasury stock was readily convertible into cash. The DTA had no cash value. The treasury stock by its terms could not be sold or alienated, although the parent agreed to buy it back at its issue price. In effect, Legacy relied on the availability of cash from its parent, via repurchase of treasury shares, to pay claims in the event of voluminous losses.82014 U.S. Tax Ct. LEXIS 1">*82
Finally, Legacy's assets were, to a large degree, negatively correlated with its insurance risks. During 2004-06, Legacy purchased $108 million of Rent-A-Center treasury stock, while "insuring" solely Rent-A-Center risks. Thus, if outsized losses occurred, those losses would simultaneously increase Legacy's liabilities and reduce the value of the Rent-A-Center stock that was Legacy's principal asset. No true insurance company invests its reserves in assets that are both undiversified and negatively correlated to the risks that it is insuring.
In sum, when one combines the existence of the parental guaranty, Legacy's extremely weak premium-to-surplus ratio, the speculative nature and poor quality of the assets in Legacy's "insurance reserves," and the fact that Legacy without the parental guaranty would not even have met "the extremely thin minimum capitalization required by Bermuda law,"
When blessing the brother-sister premiums in
Several facts discussed above in connection with "risk shifting" show that the Rent-A-Center arrangements do not comport with normal insurance industry practice. These include the facts that Legacy was poorly capitalized; that its premium-to-surplus ratio was way out of line with the ratios of true insurance companies; and that is "reserves" consisted of assets that were non-income-producing, illiquid, undiversified, and negatively correlated to the risks it was supposedly "insuring." No true insurance company would act this way.
It appears that Legacy had no actual employees during the tax years at issue. It had no outside directors, and it had no officers apart from people who were also officers of Rent-A-Center, its parent. Legacy's "operations" appear to have been conducted by David Glasgow, an employee of Rent-A-Center, its parent. "Premium payments" and "loss reimbursements" were effected through bookkeeping entries made by accountants at Rent-A-Center's corporate headquarters.
Legacy was in practical effect an incorporated pocketbook that served as a repository for what had been, until 2003, Rent-A-Center's self-insurance reserve. 2014 U.S. Tax Ct. LEXIS 1">*85 Legacy issued its first two "insurance policies" before receiving a certificate of registration from Bermuda insurance authorities. According to those authorities, Legacy was therefore in violation of Bermuda law and "engaged in the insurance business without a license." (Bermuda evidently agreed to let petitioners fix this problem retroactively.)
For the first three months of its existence, Legacy was in violation of Bermuda's minimum capital rules because the DTA was not cognizable in determining capital adequacy. 142 T.C. 1">*45 Only upon the issuance of the parental guaranty in March 2003, and the acceptance of this guaranty by Bermuda authorities, was Legacy able to pass Bermuda's capital adequacy test.
There was no actuarial determination of the premium payable to Legacy by each operating subsidiary based on the specific subsidiary's risk profile. Rather, an outside insurance adviser estimated the future loss exposure of the affiliated group, and Rent-A-Center, the parent, determined an aggregate "premium" using that estimate. The parent paid this "premium" annually to Legacy. The parent's accounting department subsequently charged portions of this "premium" to each subsidiary, in the same manner 2014 U.S. Tax Ct. LEXIS 1">*86 as self-insurance costs had been charged to those subsidiaries before Legacy was created. In other words, in contrast to the facts assumed in
From Legacy's inception in December 2002 through May 2004, Legacy did not actually pay "loss claims" submitted by the supposed "insureds." Rather, the parent's accounting department netted "loss reimbursements" due to the subsidiaries from Legacy against "premium payments" due to Legacy from the parent. Beginning in July 2004, the parent withdrew a fixed, preset amount of cash via weekly bank wire from Legacy's money-market account. These weekly withdrawals depleted Legacy's money-market account to near zero just before the next annual "premium" was due. This modus operandi shows that Rent-A-Center regarded Legacy not as an insurer operating at arm's length but 2014 U.S. Tax Ct. LEXIS 1">*87 as a bank account into which it made deposits and from which it made withdrawals.
These facts, considered in their totality, lead me to disagree with the majority's conclusory assertions that "Legacy entered into bona fide arm's-length contracts with [Rent-A-Center]"; that Legacy "charged actuarially determined premiums"; that Legacy "paid claims from its separately maintained account"; and that Legacy "was adequately142 T.C. 1">*46 capitalized."
COLVIN, GALE, KROUPA, and MORRISON,
1. Respondent, in his amended answer, asserted an additional $2,603,193 deficiency relating to 2003.↩
2. Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.↩
3. The following insurers provided coverage: U.S. Fidelity & Guarantee Co., Fidelity & Guaranty Insurance Co., Discover Property and Casualty Insurance Co., St. Paul Fire & Marine Co. of Canada, and Fidelity Guaranty Insurance Underwriters Inc.↩
4. SRS was affiliated with the Hartford Insurance Co., a well-established insurer, and did not have a contract with Discover Re.↩
5. RAC contributed $9.9 million of cash and received 120,000 shares of Legacy capital stock with a par value of $1.↩
6. Legacy elected, pursuant to
7. The Bermuda Insurance Act, the Insurance Accounts Regulations, and the Insurance Returns and Solvency Regulations reference "general business", "admitted", and "relevant" assets.
8. From December 31, 2002, through September 12, 2003, Legacy incurred a $4,861,828 liability relating to claim reimbursements due petitioner. This amount was netted against petitioner's September 12, 2003, premium payment (i.e., petitioner paid a net premium of $37,938,472 rather than the $42,800,300 gross premium).↩
9. Each premium was generally paid in September of the year following the year in which the policy became effective. Use of the recurring item exception allowed petitioner to claim a premium deduction relating to the year in which the policy became effective, rather than the following year when the premium was actually paid.
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14. Premium-to-surplus ratio is one measure of an insurer's economic performance. On Legacy's reports and statements, Arthur Morris referred to Legacy's premium-to-surplus ratio as the "premium to statutory capital & surplus ratio". For purposes of this Opinion, there is no significant difference between these terms.↩
15. Net underwriting income equals gross premiums earned minus underwriting expenses.↩
16. A class 4 insurance company may carry on insurance business, including excess liability business or property catastrophe reinsurance business.
17. Our Opinion emphasized that the "operative" facts related to the "interdependence of all of the agreements" as confirmed by the "execution dates".
18. We need not defer to the Court of Appeals for the Sixth Circuit's holding because this matter is appealable to the Court of Appeals for the Fifth Circuit, which has not addressed this issue.
19. Legacy used a portion of the parental guaranty as a general business asset.
1. Legacy's premiums attributable to workers' compensation liability were $28,586,597 in 2003; $35,392,000 in 2004; $36,463,579 in 2005; $39,086,374 in 2006; and $45,425,032 in 2007.
2. If the Court had determined that the policies were not insurance, then Rent-A-Center would nevertheless have been entitled to deduct the losses as they were paid or incurred.
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8. Because Legacy "insured" losses only below a defined threshold, there was a cap on the size of any individual loss that it might have to pay.