Tax cases shift the landscape

Two recent court cases have changed the landscape around what constitutes a captive for US tax purposes. This potentially opens the door for some companies to revisit whether they can benefit from such risk transfer structures, as EY Tax and Risk consultants Rob Ollins, Paul Phillips and Jim Bulkowski explain.

Two recent rulings by the US Tax Court have the potential to make it easier for companies to form and use a captive as a risk transfer solution while also benefiting from tax relief on the premiums they pay to these entities, according to experts from EY.

“There have been two specific rulings this year that change the landscape for captives in terms of several specific points around what is acceptable and what is not,” says Paul Phillips, a tax partner in EY’s financial services group.

“For many years, companies have been following guidelines based on so-called safe harbour provisions. These court rulings potentially change this in quite an important way.”

Jim Bulkowski, an EY specialist in the risk structuring for captives, agrees. “These are important judgments that could open the doors for new companies being able to form captives using guidelines and structures that have been revisited in these decisions.”

The Rent-A-Center case

The first ruling, in January 2014, related to US company Rent-A-Center (RAC) and its subsidiaries. The Internal Revenue Service (IRS) had argued that RAC’s captive failed to meet the requirements of risk shifting and risk distribution and that the arrangement did not meet the commonly accepted notions of insurance test.

Specifically, it expressed concerns around risk shifting due to the existence of a limited parental guaranty and circular cash flows, concerns around risk distribution due to the self-insured nature of the risks and thus contended that the premiums paid to the company’s captive insurance company should not be deductible for federal tax purposes.

But the US Tax Court ruled that Legacy Insurance, RAC’s Bermuda-based captive, is an insurance company for tax purposes with real risk transfer taking place between the subsidiaries and the captive. As such, RAC and its subsidiaries are entitled to deduct premiums paid to the company’s captive insurance company and reserves from federal taxes.

“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,” the court’s majority held.

In another key part of the decision, the court also held that adequate risk distribution was being achieved, despite the fact that only three entities were using and benefiting from the captive. But rather than focus on the number of entities involved, the court accepted that the breadth and variety of the underlying risks was the more relevant way of measuring risk distribution.

"Instead of basing risk distribution on the number of legal entities, the IRS is viewing it the way an actuary would, based on the number of independent risks, which in many ways makes more sense." Paul Phillips

In RAC’s case, its subsidiaries operated between 2,623 and 3,081 stores with between 14,300 and 19,740 employees and 7,143 to 8,027 vehicles during the years in question. The court accepted that this meant that genuine risk distribution was achieved in the Legacy captive’s workers’ compensation, automobile and general liability insurance programmes.

“This is an interesting ruling because it changes the way the concept of risk distribution will be viewed,” says Phillips. “Instead of basing risk distribution on the number of legal entities, the IRS is viewing it the way an actuary would, based on the number of independent risks, which in many ways makes more sense.”

The final important part of the judgment involved the court’s view on the arrangements RAC had made to capitalise the captive. The $9.9 million the captive was initially capitalised with included an asset known as Deferred Tax Account (DTA). In order to get RAC’s regulator comfortable with the DTA being included in the captive’s admitted assets, a guarantee was required—which was put in place by RAC.

The court was asked to rule on whether a company guaranteeing an asset of its captive, the purpose of which was to pay claims to the same company, could represent a so-called ‘circular’ transaction, something usually frowned upon by the IRS.

The majority view of the Tax Court, however, was that the guarantee wasn’t really a guarantee that claims would be paid and was instead bolstering another asset. Additionally as no payments were ever made with regard to the guarantee and the guarantee was limited to the value of the asset, the captive was still ultimately responsible for excess losses and the substance of the guarantee did not violate risk shifting.

The Securitas case

More recently, in October 2014, another case backed up this ruling. Securitas Holdings, which provides armoured truck and security services through a number of subsidiaries, owns a captive in Vermont, and has done so since 2002.

The case was very similar to the RAC case in that Securitas also deducted the premiums it paid this captive from its tax bill.

The heart of this dispute also apparently revolved around a guarantee issued by the parent to the captive. It was this that the IRS had real issue with and which resulted in its disallowing over $47 million of the 2003 deductions, and over $41 million of the 2004 deductions.

Securitas says it effectively overpaid the captive to give it additional financial strength and so that money from the platform could be lent out for the use of one of the operating subsidiaries. Critically, Securitas guaranteed the payment of the captive’s claims in what was called a ‘parental’ guarantee.

The IRS argued that this guarantee undermined the captive—again on the basis of the use of these so-called circular transactions.

The Tax Court again rejected the IRS’s arguments on two points. It said the captive was adequately capitalised without the guarantee, and also it was never called upon.

“This new case confirms the RAC rulings, actually quite articulately,” Rob Ollins, senior manager in EY’s financial services assurance group, says in relation to this case.

“In my judgement, this goes even further as the parental guarantee decision was based on the fact that the captive was adequately capitalised and thus the guarantee not needed (versus limited), and the risk distribution decision was really directly stated as distribution across multiple loss events versus legal entities.”

Revisit captives

Commenting on the importance of the two cases more generally, Bulkowski says that there will be many companies that, under the safe harbour provisions previously adopted as guidelines, would have felt they could not form a captive. These companies may now be able to reconsider.

“There were all sorts of roadblocks before around the number of entities involved and the percentage of the premium they would submit, which meant that it was more difficult to make these solutions work,” he says.

“These cases now offer guidance that means corporations could revisit their structures based on the distribution of risk that is allowed—that will create change in the sector.”

He also anticipates changes around the use of the assets used by captives and the use of parental guarantees.

“I have always had the opinion that, for an entity to represent true insurance and risk transfer, it must pool large numbers of independent potential loss events into a single pool. Making this distinction based on the number of regarded legal entities has never made sense to me. The better view is looking at this the way an actuary would look at it.”

Phillips adds that in the past EY has had discussions with many companies which decided not to form a captive because they could not conform within the existing guidelines. They should revisit this now, he says, singling out certain services and retail companies as possible candidates for forming captive structures.

“We would be keen to explore the possibilities now open to some companies,” he says. “There are a number of sectors where a lot of companies could benefit from these rulings.”

Commenting on the shift these cases represent, Bulkowski says that fundamentally the judgment alters the landscape around the way captives are viewed.

The traditional position of the courts was along the lines that captives should be operated along similar lines to non-captive commercial insurance companies.

But this view now seems to be shifting. “The court seems to be indicating that captives are different from commercial insurance companies and the rules can be applied in different ways now.”

Rob Ollins is a senior manager in EY’s financial services assurance group. He can be contacted at rob.ollins@ky.ey.com

Paul Phillips is a tax partner in EY’s financial services group. He can be contacted at: paul.phillips@ey.com

Jim Bulkowski is a senior manager at EY. He can be contacted at:jim.bulkowski@ey.com