Davis Smith, Bradley
14 September 2020Accounting & tax analysis

GAO report on abusive tax schemes perpetuates misunderstandings of captives

On August 31, 2020, the US Government Accountability Office (GAO) released its reported prepared at the behest of Senator Charles Grassley, chairman of the Finance Committee, on the uses of certain captive insurance companies and life insurance products in offshore domiciles that are categorised in this report as abusive tax schemes.

Actual risk

The report provides a general overview of captive insurance arrangements where a section 831(b) election has been made. The report does not add much new in terms of substance other than to provide brief summaries from the most recent Tax Court cases, Avrahami v Commissioner, Reserve Mechanical v Commissioner, and Syzygy Insurance v Commissioner.

In reality, the report fails to provide the nuanced analysis necessary to distinguish a legitimate captive insurance structure from those established without proper economic purposes.

“The Tax Court’s analysis in the three cases cited ignores the ability of insurance companies to distribute risk properly through a reciprocal reinsurance arrangement.”

The report summarises the four-step legal analysis commonly applied to determine whether a transaction qualifies as insurance for federal income tax purposes. First, it asks whether there is actual, and thus insurable, risk. The report proposes that “actual risks are those that are truly faced by the insured, and insurable risks are those that can only result in a loss if the event occurred”.

With respect to whether “actual risks” are present, the report points to the analysis provided by the Tax Court in Reserve Mechanical to find the risks involved to be too remote to be considered actual, insurable risk because there has not been an insurable loss from such risks in 10 years. Unfortunately, the report does not continue to the logical conclusion of this analysis, which would require a holding that the risk of losing your house to fire is not an actual, insurable risk even though standard homeowners’ insurance policies provide coverage for that exact event.

Speculative risk

The report also contrasts what it calls “speculative risks” which could result in either gain or loss, and “insurable risk” which results only in a loss. The risk of whether a business will recuperate its investment in new equipment is offered as an example of speculative risks.

Unfortunately, the report makes no mention of the RVI Guaranty v Commissioner case. In that case the Tax Court held that residual value insurance, which helps companies manage asset value risk by guaranteeing that an asset will have a specified value at a future date, provides coverage for an insurable risk. The report’s gross oversimplification of the definition of insurable risk perpetuates, rather than resolves, confusion in this space.

Bona fide insurance

The second criterion offered by the report combines two separate tests, risk shifting and risk distribution, but the focus of the report’s analysis is on risk distribution.

The report points to the Tax Court findings in Avrahami, Reserve Mechanical, and Syzygy for the proposition that an intermediary entity used to accommodate risk pooling for risk distribution among multiple insurance companies must also be a “bona fide insurance company”.

While it is true that the Tax Court has adopted this bona fide insurance company analysis in each of the three cited cases, it is unfortunate because that standard in each case was misapplied.

First, the bona fide insurance company standard is properly applied as the first step of an analysis of a captive insurance arrangement to determine whether the captive is a sham. If the captive lacks a true business purpose, then the transaction can be disregarded before the court even proceeds to a review of the three criteria cited in the report. The bona fide insurance company analysis is the first step in the analysis, not a supplement to the risk distribution test.

Second, the Tax Court’s analysis in the three cases cited ignores the ability of insurance companies to distribute risk properly through a reciprocal reinsurance arrangement where there is in fact no entity (other than an attorney-in-fact) that sits between the various counterparties.

The insurance companies distribute risk by swapping contractual obligations to cover risks underwritten by each other. The absence of an insurance company between the reinsuring parties should not minimise the fact that the insurance companies are indeed shifting risk via contract.

Again, if the risk pooling structure is a sham, then the court should be able to reach this result without confusing the issue by shoehorning the bona fide insurance company standard into a risk distribution analysis.

Notions of insurance

The report moves on to describe the final criterion: whether the captive product fits commonly accepted notions of insurance. The report explains that this is a fact-based analysis that focuses on certain questions such as whether the captive is regulated under the insurance laws of its jurisdiction, whether it is adequately capitalised, whether premiums charged were reasonable and the result of arm’s length transactions, and whether the insurer has paid any claims.

The report points to the Syzygy case, where the Tax Court found the captive did not operate like an insurance company due to unreasonable premiums and late-issued policies with ambiguous terms.

However, the report did not address some of the more controversial factors that the Tax Court has relied on to hold the transactions did not fit commonly accepted notions of insurance, namely the terms of the policies were not the same as commercial policies and the captive had no employees.

These factors show a misunderstanding of common captive insurance structures, where a benefit of the captive is the ability to manuscript polices to address specific needs of the insured and the fact that captives are usually managed by third party captive managers who have expertise in this area.

The report does not appear to add much clarity to the current disagreements between the Internal Revenue Service (IRS) and taxpayers over what constitutes a valid captive insurance company that makes a section 831(b) election.

In fact, it may exacerbate the issue by shining the light on some of the factors that the IRS is relying upon to invalidate many captives structures even though such factors evidence a clear misunderstanding of common insurance industry practice.

Davis Smith is a partner at Bradley. He can be contacted at: dhsmith@bradley.com