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3 September 2019Law & regulation

It’s time for captives to fight back against regulatory overreach

Johnson & Johnson’s captive, Middlesex Assurance Company, was domiciled in Vermont and made the decision in 2008 to start paying the independent procurement tax (IPT) to New Jersey, the state in which Johnson & Johnson is headquartered. In New Jersey, a 3 percent premium tax is imposed on self-procured policies from a nonadmitted, or out-of-state, insurance company.

“The imposition of a 3 percent to 5 percent additional state tax may negate all or most of the benefit a company may derive from using a captive.”

Johnson & Johnson originally paid self-procurement tax to New Jersey using the portion of premiums it determined were allocable to the state of New Jersey. In 2010, it adjusted its calculation to include all premiums earned in the US per New Jersey’s application of the federal Nonadmitted and Reinsurance Reform Act of 2010 (NRRA). The plaintiff then determined that this application was incorrect, and requested a refund of almost $60 million from the state.

Johnson & Johnson argued that the New Jersey law applying the federal NRRA did not apply to captives or self-procurement taxes as they are not explicitly mentioned in the statute. In a decision that certainly gives grounds for a further appeal, in July 2018 the New Jersey Tax Court held that the New Jersey legislature “intended” to include captives and self-procurement in the law they passed even though they are not mentioned.

The court said: “The New Jersey Legislature intended to incorporate the authority afforded it under the NRRA through the enactment of amendments to both the Surplus Lines Law and the self-procurement statute. Those amendments apply the Home State Rule to all non admitted insurance including self-procured captive insurance. Understandably, the addition of a paragraph in the self-procurement statute relating to surplus lines policies is problematic, as is the failure to remove the original language allocating the IPT to the location of the risk. Nonetheless the Legislature's intent is clear and purposeful. By amending both N.J.S.A. 17:22–6.59 and –6.64, the Legislature kept consistent its equal treatment of nonadmitted insurers, and maximized its nonadmitted IPT revenue stream under the NRRA. Summary Judgment is granted in favor of DOBI and Director, and denied as to J & J.”

It is very problematic for judges to be determining the intent of statutes instead of actually applying the written law.

While Johnson & Johnson has solid grounds to contest this decision, it does seem that it could fairly easily have resolved this issue and reduced the tax problem by redomesticating its captive from Vermont to New Jersey, eliminating the 3 percent independent procurement tax and replacing the Vermont premium tax with an identical New Jersey captive premium tax. In this instance there is a readily available solution to reduce the tax grab by New Jersey.

Another remedy
There is also a possible remedy in the Stewart’s Shops corporation tax appeal, but it is not as simple as a redomestication.

Stewart’s Shops is a New York-based corporation that formed a captive in New York: Black Ridge Insurance Corp (BRIC).

BRIC formed a captive insurance company licensed by the New York State Insurance Department, and provided Stewart’s Shops coverage for:

(1) Losses incurred (a) within policy deductible amounts, and (b) in excess of the maximum losses covered by its outstanding policies with commercial insurance companies;

(2) Its self-insured risks and claims from prior to the formation of BRIC (loss portfolio transfer); and

(3) Other coverages, including pollution, identity theft, and crime, for which it did not have any insurance when it formed BRIC.

In 2010 and 2011, the New York State audited BRIC and Stewart’s Shops. They concluded that BRIC was properly subject to the insurance company tax and could not be included in Stewart’s Shops’ combined corporate tax returns. However, New York disallowed Stewart’s Shops’ deductions for insurance payments to BRIC, concluding that, because the payments would not be valid deductions for federal income tax purposes, they could not be deducted for corporate tax purposes either.

Stewart’s Shops contended that this interpretation of New York law would create an “absurd result” in that the insurance payments would be treated as insurance premiums under the state’s insurance company tax regime, but not under the state’s general corporate tax regime.

Although the tribunal did not seem particularly convinced by this argument, it nonetheless pointed out that such inconsistency had been eliminated because the Insurance Department had previously indicated (and reaffirmed in its briefs to the tribunal) that it would refund the insurance premiums tax paid by BRIC.

This case results in a state taking the position that a company it has licensed as an insurance company under its rules and regulations, does not qualify as an insurance company for premium payments made by its parent.

This is an interesting issue because of the proliferation of states with captive laws that have not always been captive-friendly (eg, New York, New Jersey, and Texas). This decision offered an answer to Stewart Shops stating that it could achieve deductibility if its captive met the federal deductibility risk distribution and risk transfer tests such as third-party business, brother-sister insureds, or sufficient exposures (such as under the Rent-A-Center v Commissioner case).

If you thought that was bad
In May 2018, Washington State issued a cease-and-desist order to Microsoft. This order required that its wholly owned captive, Cypress Insurance Company, to stop selling insurance to its parent company and asked for about $1.4 million in unpaid premium taxes.

The insurance commissioner contended that:

(a) Cypress should have paid a 2 percent premium tax to the state of Washington;

(b) Cypress did not hold a certificate of authority to sell insurance in the state of Washington; and

(c) That the insurance provided by Cypress should have been placed through a surplus lines broker licensed in the state of Washington.

There are many potential arguments against these contentions, starting with:

(a) Why is Cypress doing business in Washington when it is domiciled in and regulated by Arizona?

(b) Why would Cypress need a licensee from Washington when it is operating in and licensed by Arizona?

(c) Cypress is not acting as a surplus lines insurer so why does it need to pay for a service it does not need?

(d) What is the purpose of the Washington action other than a good old-fashioned tax shakedown? Who is Microsoft impacting?

(e) Doesn’t Microsoft have the absolute right to buy insurance from whomever it wants per Allgeyer v Louisiana (due process under the 14th amendment to the Constitution).

Unfortunately for the captive industry, Microsoft, swiftly followed by Costco, settled for what to them is small change—and left the commissioner looking for new victims to extort money from.

We do not know all the facts regarding how the Microsoft captive was operating. It may be that Microsoft presented a poor fact pattern as to where the decision-making and actual day-to-day administration of the captive took place. But we can only hope that a captive, perhaps backed by an association such as the Self-Insurance Institute of America, the Captive Insurance Companies Association or the Vermont Captive Insurance Association, takes on this assault on our industry.

It seems that the commissioner wants to go after any captive that, in his viewpoint, is “doing business in the state of Washington” which means covering any risk in the state and not just for companies headquartered in Washington with captives. This would run headlong into a fight with, say, Johnson & Johnson, which is being taxed by New Jersey as its home state on its total premium written across the country.

If Washington contends that Johnson & Johnson is doing business in Washington and the reply from Johnson & Johnson is: “we pay our taxes to New Jersey”, will Washington back off?

What do captives need to do to manage these risks?

(a) Review domicile options
Unfortunately for domiciles like Vermont, Bermuda, and Cayman, the first thing a captive can do to mitigate some of these risks is to look at its home state, which could be by share of risk or location of headquarters, and see whether its captive could redomesticate and pay its premium taxes there.

We have already seen ATT move its captive to Texas, and Coca-Cola move to Georgia; many others have moved already or are looking at their options. By being located in a state that can meet the NRRA definition of home state, the captive has a much stronger position to counter self-procurement or other tax grabs.

(b) Document where you do business
The 30-minute fly-in-and-fly-out-again annual meeting needs to go the way of the dodo. Companies need to pay much more attention to the trail of documents and the business activity of the captive and make a far greater effort to execute and make business decisions regarding the captive in the state of domicile.

This again leads to an advantage in being domiciled in a home state wherever possible, in that the directors and officers are much more likely to be located in the state of their captive’s operations. But there are still large states where this is not an option, such as California, Pennsylvania, and Washington.

(c) Walk like a duck, talk like a duck.
There have been arguments made on both sides regarding whether acting like an insurance company or intentionally failing to be an insurance company is a tactic for minimising federal and state tax issues. If you intend to take deductions for the premiums paid to your captive at either state or federal tax level it is highly recommended you look at some of the recent 831(b) Tax Court cases (Avrahami, Reverse Mechanical, Syzergy) and learn from some of the many pointers that can be gleaned from these decisions:

  • Polices should be issued promptly and be properly prepared and executed with appropriate language.
  • Insurance companies pay claims—it is not a good fact pattern to have potential claims and not submit them for payment by your captive.
  • An insurance company has a liquid and diverse investment portfolio so that it can pay claims when needed in a timely manner without significant investment losses.
  • Board minutes should be prepared and reflect the needed review of financials, claims, service providers, business plans and enterprise risk evaluations.

If you do not want to be treated as an insurance company it may be appropriate to have intercompany loans, parental guarantees, and other documentation that the programme is intended as a risk financing tool and not as an insurance company. This might be appropriate for non-profits and companies with poor risk distribution fact patterns. This was a possible argument for Microsoft but it was not argued or fully flushed out as they chose to settle rather than litigate.

(d) Review effectiveness of your captive
The imposition of a 3 percent to 5 percent additional state tax may negate all or most of the benefit a company may derive from using a captive. Even if a company is a staunch believer in the captive concept, it may be appropriate to consider shutting it down if a state tries to impose a self procurement (or a made-up assessment, like Washington) tax and home state redomestication is not available.

A captive remains a valuable tool in the risk manager’s toolbox to address costs, capacity and control. However, many states see an opportunity to find taxes for their states, and with the cost and time involved in litigation they are all too likely to be  rewarded for their regulatory overreach.

It’s time for captive owners to be proactive and look at their fact pattern and determine whether they could stand up to the sort of scrutiny put on their fellow captive owners by New York, New Jersey, and Washington.

Gary Osborne is vice president at Risk Partners. He can be contacted at: