The captive insurance world is all aflutter about the decision in favor of the taxpayer in the Rent-A-Center v. Commissioner opinion. While Rent-A-Center certainly holds some good lessons for larger corporate captive, how much comfort does it give to smaller captive arrangements that are aggressively utilized for purposes other than risk management? Maybe not as much as some are hoping.
Suffice it to say that Rent-A-Center (which I’ll shorten to “RAC”) had a lot of legitimate, non-tax reasons for forming a captive insurance company, not the least of which that it was being hammered on increasing insurance costs and large claims-handling fees. RAC undertook a feasibility study to explore the possible effectiveness of a captive, and then acted on the advice of its professional advisors in making the decision to form one, which would be called Legacy.
The idea was that Legacy would administer and pay RAC’s claims up to the first $350,000 and then a big reinsurance company, Discovery Re, would take over liabilities exceeding $350,000. This sort of arrangement works well for companies such as RAC that have claims of low severity, but high frequency, since through their captive they can deal with these claims themselves at a lower cost than if they paid a third-party commercial insurance company to do it for them. Also, the arrangement gave RAC more control over the claims-resolution process, and let RAC start building reserves against the day they would take over even greater of their own liabilities through their captive.
The world’s most popular captive domicile, Bermuda, was chosen to give birth to the new captive. Lest anybody think that RAC’s had some sort of sinister motivation to evade taxes in a known tax haven, RAC made an election under Section 953(d) of the U.S. Tax Code to be treated as a U.S. company for all federal tax purposes. Bermuda requires at a minimum that a captive maintain assets that exceed the captive’s general business assets by the greater of $120,000 -or- 10% of the captive’s loss and loss expense provisions plus reserves -or- 20% of the first $6 million of net premiums plus 10% of net premiums exceeding $6 million.
RAC’s captive, Legacy, was capitalized according to this formula with $9.9 million, which — though a large amount — was close to the minimum. But to even get to this amount, RAC had to juggle the books and contribute to Legacy a somewhat dubious asset known as a “Deferred Tax Account”, which was more of a book asset than a hard asset that one could take to the Bank. To use the Deferred Tax Account as an asset, Legacy had to obtain the permission of the Bermuda Monetary Authority, which it did — with a caveat. The caveat imposed by Bermuda was that the Deferred Tax Account, being such an ephemeral asset, need to be bolstered by a guarantee — so RAC guaranteed the Deferred Tax Account.
It is here that we need to step back from this Rube Goldberg capitalization scheme and see what is happening: RAC is guaranteeing the primary asset which Legacy would use in the event of bad claims experience to pay the claims, which would be the claims of RAC’s operating subsidiaries — or in other words, when you collapse all this down, to a significant extent RAC was guaranteeing itself. That of course seems pretty circular, and circular transactions usually lead to difficulties with the IRS, which challenged the guarantee in U.S. Tax Court.
The majority view of the Tax Court was that RAC’s guarantee wasn’t really a guarantee that claims would be paid (which could upset the captive applecart from a tax perspective), but instead the guarantee was only bolstering another asset (the Deferred Tax Account) which was the primary asset that would be used to pay claims. Or, as the Court stated: “The parental guarantee was created to convert deferred tax assets into general business assets for regulatory purposes.” In other words, it was certainly a hinky transaction, but only a hinky transaction to make the Bermuda captive regulators more comfortable, and not for tax purposes. Plus, as a purely practical matter, Legacy never actually called RAC’s guarantee, and RAC never actually paid any money on the guarantee.
The dissent pointed out that the fact that the guarantee was never actually called, didn’t make the transaction any less questionable from a tax perspective. Since numerous U.S. Courts of Appeals (whose decisions are binding on the U.S. Tax Court) have held that “parental guarantees”, i.e., guarantees from the owner of the captive that it would guarantee the claims paid to its own operating subsidiaries, would negate the arrangement being considered “insurance” for tax purpose, the existence of the guarantee here was a major fail.
If this case goes up on appeal, as so many captive cases do (and particularly the first significant one in over a decade), the RAC guarantee will likely be the central issue. How might that come out? In my humble opinion, it would be a coin-toss, since although the Courts of Appeals have traditionally favored the taxpayer against the IRS in captive cases, at the end of the day there is scarcely little practical difference between the parent guaranteeing the captive’s primary asset, as opposed to guaranteeing the captive itself. Stay tuned.
A similar issue was whether Legacy was adequately capitalized. In a nutshell, if a captive is not adequately capitalized, then there is no true “insurance” arrangement because the captive will not have the resources to satisfy its policy liabilities. In English, for a captive arrangement to qualify for tax purposes, the captive must have some “skin in the game” other than just the premiums it takes in — the captive must have a risk of loss in excess of its premiums, and must have the financial strength to cover that loss should it occur.
The majority took the position that the regulatory authority, here Bermuda, set the minimum capital requirements, implicitly held that they were reasonable, and that so long as Legacy met Bermuda’s requirements then it was adequately capitalized. The majority rejected arguments that Legacy had a higher ratio of premiums that it was taking in against the assets it had to pay claims, as measured against normal commercial insurance companies (think State Farm or CNA), since commercial carriers face competition and are forced to price their premiums more competitively.
The dissent jumped all over this issue, and stated that the regulatory requirements of a known tax haven (again, Bermuda) should not dictate what constitutes adequate capitalization from the viewpoint of U.S. tax law. Bermuda had a relatively minimal capital requirement (doubtless, to attract captive business to Bermuda), and the analysis should look past Bermuda’s minimal requirements to what the captive really needed to cover its policy liabilities. But, the dissent also noted that Legacy didn’t even live up to Bermuda’s minimal capital requirements by the posting of the Deferred Tax Account, a dubious asset even to Bermuda, but had required RAC’s guarantee of that asset.
Moreover, the dissent complained at length that Legacy’s premium-to-surplus (read, though not exactly correct, to mean assets) ratio was way out of whack with what commercial insurance companies (again, think State Farm and CNA) typically maintained. Those companies typically have a 1:1 premium-to-surplus ratio, while Legacy’s premium-to-surplus ratio was never better than 5:, and was a jaw-dropping 48:1 in 2003. About as bad, commercial insurance companies have numerous diverse assets, while here Legacy had only a single asset, the (dubious) Deferred Tax Account, which itself was little more than a bookkeeping trick.
While the dissent’s position was of course a loser in this particular case, there is a caution here for those captives that skirt the line by being very thinly capitalized, or go to other offshore jurisdictions with de minimis capital requirements. While RAC’s Legacy squeaked by on this issue, other captives which meet only the minimum capital requirements in jurisdictions that are even less restrictive than Bermuda are quite possibly skating on thin ice. By contrast, there is almost an implicit assumption by both the majority and the minority, that if Legacy had been following the minimal capital requirements required by a U.S. state regulator — say, Vermont’s captive regulator — this might not even have been much of an issue.
It is on this issue that the majority and the dissenting judges had a major spat. The position of the dissent (actually, there were several dissents, but I’m sort of rolling them all together), was that captive insurance companies need to be operated in a very similar matter to non-captive commercial insurance companies. If a captive gets too far afield of what commercial insurance companies do, then the captive arrangement is invalid. The majority rejected this view, and essentially took the position that captives are much different in several respects than commercial insurance companies, so while the typical activities of commercial insurance companies create a broad highway that can easily be followed, that doesn’t mean that captives can’t go down similar side roads that end up in different places.
Having said that, the “best practice” for a captive will always be to follow what commercial insurance companies do whenever possible, and when forced by the circumstances to deviate from such practices, to do so only after much analysis and advice by tax counsel and not in anything like a cavalier fashion.
This is why, as noted captive tax attorney Chaz LaVelle in a conference call of the American Bar Association’s Committee on Captive Insurance (which, by way of full disclosure, I am the current Chair), that the Rent-A-Center case might not be of much comfort to captives that are being operated in an aggressive fashion and far differently than from how commercial insurance companies are operated. While a captive is not limited to what the “big insurance companies” are doing, it still needs to be going in the same direction, and stick to their practices in as many aspects as possible whenever possible.
Finally, it must be noted that Rent-A-Center was a large company with oodles of risks through its many locations and operations — it had many “points of insurance” such that the critical issue of risk distribution (almost always a touchy issue for smaller organizations) was not a salient factor in this Opinion. Rent-A-Center was also able to fund multi-million dollar litigation against the IRS stretching over many years; litigation that would annihilate the economics of the average small captive.
Thus, as with nuclear war, the only way to “win” in any meaningful sense is to avoid the fight entirely, and the practical upshot of this is that smaller captives must be more conservative in their structure and operations than the large corporate captives so that they sail through IRS audits and don’t get caught up in prolonged litigation.
Will the IRS appeal the Rent-A-Center decision? We’ll know in a couple of months. The big advantage the IRS has is that it is able to pick and choose the cases that it wants to take up on appeal, and can select only the cases that it thinks will be winners (taxpayers only have one choice — appeal or pay). The existence of lengthy and well-considered dissents from a Tax Court that strives for unanimous decisions probably makes it more likely that the IRS will appeal, but only time will tell — the Courts of Appeals have not been kind to the IRS in captive cases, so they may be gun shy about taking this case up, and the Rent-A-Center asset guarantee situation is very rare and not one that the IRS is facing pressure to put the kabosh on.
So, we’ll have to wait and see what happens.
Original article posted on Forbes.com.