Opinion ID: 548352
Heading Depth: 1
Heading Rank: 3

Heading: captive insurance

Text: 52 Both parties appeal from the Tax Court's decisions involving payments of insurance premiums by Gulf and its domestic affiliates to Gulf's wholly-owned foreign subsidiary, Insco, in tax years 1974 and 1975. Gulf deducted these insurance premiums as Sec. 162 ordinary and necessary business expenses, but the Commissioner disallowed these deductions and instead determined that both premium payments from Gulf's foreign affiliates and claims paid by Insco to Gulf and its domestic affiliates represented constructive dividends to Gulf. The Tax Court--in a majority opinion and numerous concurring opinions--found that the insurance premiums paid by Gulf and its domestic affiliates that were ceded to Insco were not deductible insurance premiums. The court also held that neither the portions of the insurance premiums paid by Gulf's foreign affiliates that were ceded to Insco nor claims paid by Insco relative to the reinsurance of the risks of Gulf and its domestic affiliates were constructive dividends to Gulf. We will affirm on both issues.
53 The parties generally stipulated to the operative facts on the issues before the Tax Court, which the court set forth at length in its opinion of Gulf Oil Corp. v. Comm'r, 89 T.C. 1010 (1987). We repeat only those most important to our resolution. 54 Through the late 1960's, Gulf and its affiliates were able to obtain insurance coverage at acceptable rates from commercial insurers. The general policy of Gulf and its affiliates was to self-insure risks up to $1 million. For those risks in excess of $1 million, including catastrophic risks, i.e., risks in excess of $10 million, Gulf obtained insurance coverage from primary insurance carriers and reinsurers in both the United States and world-wide markets. 55 Several incidents occurred in the late 1960's 29 which caused commercial insurance carriers to increase the rates charged to the oil industry and either limit or altogether eliminate coverage for certain types of risks. Gulf decided that the higher rates for the coverages made available to it did not adequately reflect its claims history. Therefore, in late 1970, Gulf participated with several other major independent oil companies in the creation of Oil Insurance Ltd. (OIL). 30 Gulf also created Insco, Ltd., its own subsidiary insurance company authorized to conduct general insurance business under the laws of Bermuda. 31 Initial capitalization for Insco was authorized at $10 million. However, Insco originally issued 1,000 shares valued at $1,000 per share, of which only 12% was paid. Marsh & McLennan, Incorporated, an insurance brokerage and consulting firm, agreed to provide Insco with all underwriting and related services. 56 Generally, Gulf and its affiliates entered into insurance contracts with and paid premiums to third-party commercial carriers. Although Gulf and its affiliates paid premiums directly to third-party commercial carriers, a significant portion of the primary carrier's exposure was reinsured with Insco. 32 On December 20, 1973, Gulf executed guarantees in favor of American International Group, Inc. (AIG) 33 and of Oil Industry Association that obligated Gulf to indemnify these insurers should Insco be unable to meet its obligations with regard to its reinsured risks. These guarantees were in effect during the tax years at issue. 57 In 1975, Gulf shifted ownership of Insco to Transocean Gulf Oil Co., a wholly owned Gulf holding company incorporated in Delaware. Insco collected its shares of non-paid-up stock, while Transocean contributed $880,000 in capital. Simultaneously, Insco distributed 9,000 new shares at $1,000 par, which Transocean purchased as fully paid. This increased Insco's paid-in capital to $10 million. Gulf and its affiliates then began to place catastrophic risk coverage directly with Insco which, in turn, reinsured those risks. Gulf also commenced withdrawal from OIL over the minimum five-year period required. Also in 1975, Insco first began insuring risks of unrelated parties. Over subsequent years, Insco increased underwriting risks for unrelated parties and continued to underwrite additional risks of Gulf and its affiliates. 58 In tax years 1974 and 1975, Gulf reported ordinary and necessary business expense deductions pursuant to I.R.C. Sec. 162 for insurance premiums, which the Commissioner challenged. The Commissioner disallowed $10,285,330 and $10,900,081, respectively, representing the amounts of insurance premium payments made by Gulf and its domestic affiliates to primary insurers that the insurers subsequently ceded to Insco. In addition, the Commissioner recharacterized, as constructive dividends, the amounts of insurance premium payments ($4,029,646 and $4,662,192, respectively) made by Gulf's foreign affiliates that were subsequently ceded to Insco. Finally, the Commissioner treated claims paid by Insco in these tax years ($1,001,441 and $3,059,194, respectively), relative to the reinsurance of the risks of Gulf and its domestic affiliates, as constructive dividends directly to Gulf or to Gulf through Transocean. However, the Commissioner also determined that Gulf and its domestic affiliates sustained deductible uninsured losses under I.R.C. Sec. 165 for the same amounts, $1,001,441 and $3,059,194, respectively. 59 The Tax Court held that the portions of the insurance premiums paid by Gulf and its domestic affiliates that were ceded to Insco were not deductible insurance premiums. Gulf appeals, claiming the Tax Court committed legal error because the court allegedly based the decision on a substance over form analysis that ignores the separate existence of Gulf and its affiliates, including Insco. 60 The Tax Court rejected the Commissioner's position and found that insurance premiums paid by the foreign affiliates could not be considered constructive dividends under the test in Sammons v. Comm'r, 472 F.2d 449 (5th Cir.1972), since those payments were for the affiliates' benefit, i.e., providing risk coverage, rather than for a shareholder purpose. In addition, the claims paid by Insco to Gulf and its domestic affiliates were not constructive dividends since the claims were paid in consideration for the premiums paid. 61 The Commissioner appeals, contending that, under Helvering v. Le Gierse, 312 U.S. 531, 61 S.Ct. 646, 85 L.Ed. 996 (1941), the transaction at issue does not constitute insurance for federal tax purposes and must be considered as constructive dividends to Gulf. 62
Subsidiary 63 Under I.R.C. Sec. 162(a), insurance premiums are deductible as ordinary and necessary business expenses. The premium is the means by which two unrelated parties measure the cost of the risk-shifting. Whereas insurance premiums are deductible expenses, amounts entered into self-insurance funds are not. Clougherty Packing Co. v. Comm'r, 811 F.2d 1297, 1300 (9th Cir.1987). As the Supreme Court stated in Le Gierse, both [h]istorically and commonly insurance involves risk-shifting and risk-distributing. Le Gierse, 312 U.S. at 539, 61 S.Ct. at 649. Thus, to be permitted to take an insurance deduction, the relationship between the parties must actually result in a shift of risk. Id. at 540-41, 61 S.Ct. at 649-50. 64 Gulf asserts that it meets this standard because it created a separate legal identity in Insco for risk shifting and, in fact, Insco insured the risks of unrelated parties, evidence of risk distributing. (In tax year 1975, 2 percent of Insco's premium income came from unrelated parties.) 65 The threshhold question we must address is whether Insco's insurance coverage to Gulf and its affiliates satisfies both the element of risk transfer and that of risk distribution, regardless of whether Insco insured risks of unrelated parties, if Gulf and its affiliates, both domestic and foreign, are each viewed as separate entities. Where separate agreements are interdependent, they must be considered together so that their overall economic effect can be assessed. Clougherty Packing Co., 811 F.2d at 1301. 66 In Moline Properties v. Comm'r, 319 U.S. 436, 439, 63 S.Ct. 1132, 1134, 87 L.Ed. 1499 (1943), the Court held that a corporation must be recognized as a separate taxable entity if that corporation's purpose is the equivalent of a business activity or is followed by the carrying on of a business. The Court of Appeals for the Sixth Circuit relied on this proposition in Humana Inc. v. Comm'r, 881 F.2d 247, 252 (6th Cir.1989), when it held that fellow subsidiaries of a captive insurer, i.e. in a brother-sister relationship, could properly deduct insurance premium payments to that insurer. 67 In Humana, the Tax Court expressly recognized the legal, financial and economic substance of insurance provided by a wholly owned insurance subsidiary to its brother-sister affiliates. Humana Inc. v. Comm'r, 88 T.C. 197 (1987). Nonetheless, on appeal, the court of appeals suggested that a parent's insured loss paid by the insurance subsidiary would have a dollar-for-dollar impact on the parent's net worth. Although many of the facts in Humana are similar to those in this case, critical distinguishing facts exist. In contrast to the facts here, (1) the captive insurer in Humana was fully capitalized initially; (2) no agreement ever existed under which Humana, Inc. or any Humana subsidiary would contribute additional capital to the insurer; and (3) Humana, Inc. and the hospital subsidiaries never contributed additional amounts to the insurer nor took any steps to insure the insurer's performance. In contrast, Insco began as an undercapitalized subsidiary and Gulf executed guarantees in effect during the tax years at issue to protect its primary insurers, AIG and OIA, should Insco fail to meet its obligations as reinsurer. It is thus difficult to see that Gulf truly transferred the risk to Insco during the years in question. 68 We conclude that the Tax Court did not err in finding that the risk was not here appropriately shifted to the insurance subsidiary during 1974 and 1975. Gulf's arguments that it actually paid premiums to Insco, that Insco was required to establish and maintain appropriate reserves and to satisfy other regulatory requirements imposed by Bermuda law, that each insured had rights against Insco under insurance contracts, and that the source for payment of their claims included premiums paid by others and Insco's capital, do not address the crucial question of whether there was transfer of financial risk. Le Gierse, 312 U.S. at 540, 61 S.Ct. at 649, Clougherty Packing Co., 811 F.2d at 1300. 69 Our decision is consistent with previous opinions of the Tax Court. The Tax Court has held that payments to a captive subsidiary, designated as premiums, whether from the parent corporation or from other subsidiaries, did not represent payments for insurance. See Carnation Co. v. Comm'r, 71 T.C. 400 (1978), aff'd, 640 F.2d 1010 (9th Cir.1981); Clougherty Packing Co., 84 T.C. 948 (1985); Humana v. Comm'r, 88 T.C. 197 (1987), aff'd in part, rev'd in part, 881 F.2d 247 (6th Cir.1989) (disallowing insurance premium deductions on the parent-subsidiary relationship, allowing brother-sister subsidiary to deduct the insurance premiums). Thus, the Tax Court has plainly held that where the captive was wholly owned by its parent, and the captive insured risks only within the affiliated group, the risk is not truly distributed. 70 We recognize that with regard to the tax year 1975, the majority of the Tax Court held that the 2% net premiums from unrelated parties was de minimis and did not demonstrate the existence of a true transfer of risk. One concurring judge of the Tax Court warns that the court's opinion will create a problem because at some point the majority's analysis will require a line to be drawn as to when third party premiums are no longer de minimis. He argued that, as far as risk transfer is concerned, there can be no true risk transfer when a captive insurance company is involved. In response, another concurring judge rejected that analysis as not invoking insurance law principles but relying, rather, on economic theory. The lone dissenter would have adopted the concurring economic theory, but disagreed with the majority's overreaching opinion. 71 We need not reach the issue which divided the judges of the Tax Court--whether the addition of unrelated insurance premiums into the insurance pool for tax year 1975 establishes risk transfer and justifies the deduction of insurance premiums paid by the unrelated party to the insurance pool. It is clear to us that, because of the guarantee to the primary insurers, Gulf and Insco did not truly transfer the risk, nor was there a de facto risk distribution to third parties, elements crucial to the allowance of a premium deduction.C. Constructive Dividends 72 We turn now to the insurance premiums paid by Gulf's foreign affiliates to Insco and to the claims paid by Insco to Gulf and its domestic affiliates, which the Commissioner argues constitute constructive dividends to Gulf. His theory is that where funds are transferred from one such sibling corporation to another, ... the funds pass from the transferor to the common stockholder as a dividend and then to the transferee as a capital contribution. Sammons, 472 F.2d at 453. 73 In Sammons, the Court of Appeals for the Fifth Circuit formulated a two-part test to determine whether a transfer of property from one corporation to another corporation constitutes a constructive dividend to a common shareholder in both corporations. The first prong of the test is objective and requires a determination that there was a distribution of funds. 74 A transfer of funds by a corporation to another corporation which the former owns directly or indirectly can be a constructive dividend to the individual controlling stockholder only if (1) the funds are diverted from the parent-subsidiary corporate structure and come within the control of the stockholder, and (2) no adequate consideration for the diversion passes from the stockholder to the corporation, i.e., there must be a net distribution. 75 Sammons, 472 F.2d at 453-54. The second prong of the Sammons test is a subjective determination. Thus, a constructive dividend will be found where, in addition to the determination of distribution, the business justifications [for the transfer] put forward are not of sufficient substance to disturb a conclusion that the distribution was primarily for shareholder benefit. Sammons, 472 F.2d at 452 (emphasis in original). 76 The Tax Court found that the second prong was not met since the insurance premium payments in question were for the benefit of the affiliates, i.e., the affiliates were provided risk coverage. In other words, there was an adequate business reason for the payment of funds, here risk insurance, by the affiliates to Insco. The benefit to Gulf was tangential, the same benefit it would have received if an outside third-party insurer were to insure the losses of Gulf's affiliates. 77 The Commissioner provides no strong reason, support or authority to compel us to overturn either the Tax Court's factual determination of an adequate business reason for the transfer or the legal conclusion that the payments in question do not constitute constructive dividends to Gulf. D. Conclusion 78 The Tax Court did not err in denying a Sec. 162 business expense deduction for insurance premiums paid to Gulf's captive insurance subsidiary (Insco) by Gulf and its domestic affiliates or in refusing to categorize the insurance premiums paid by Gulf's foreign affiliates to Insco and claims paid by Insco to Gulf's domestic affiliates as constructive dividends. 79 We will thus affirm the Tax Court's decision on these cross-appeals.