Parent’s captive arrangement was insurance; premiums were deductible
Parent’s captive arrangement was insurance; premiums were deductible
Securitas Holding, Inc. and Subsidiaries, TC Memo 2014-225
The Tax Court has held that a captive insurance arrangement between a parent corporation and its wholly owned subsidiary constituted insurance, and that premiums paid pursuant to the arrangement were deductible under Code Sec. 162. Among other things, the Court found that the fact that the parent executed a guarantee with respect to the subsidiary’s performance on certain policies didn’t preclude a finding that risk shifting had occurred.
Background. Premiums for insurance against various types of business risks, such as property damage or professional liability, are generally deductible as business expenses. (Code Sec. 162; Reg. § 1.162-1(a)) However, where certain insurance “arrangements” lack the elements of risk-sharing and risk-distribution, payments usually aren’t deductible.
A captive insurance arrangement generally refers to the attempt by a taxpayer, usually a large corporation, to secure the traditional benefits of insurance coverage, including tax benefits, while placing its insurance business with a corporate entity owned by or related to the taxpayer. Payments to captive insurance subsidiaries or other similar arrangements are not deductible where there’s no true risk-shifting.
Neither the Code nor the regs define the terms “insurance” or “insurance contract.” The U.S. Supreme Court has said, however, that both risk shifting and risk distribution must be present for an arrangement to be treated as insurance. (Helvering v. LeGierse, (1941) 25 AFTR 118125 AFTR 1181) Over time, courts have looked primarily to four criteria in deciding whether an arrangement constitutes insurance for Federal income tax purposes:
- 1. the arrangement must involve insurable risks;
- 2. the arrangement must shift the risk of loss to the insurer;
- 3. the insurer must distribute the risks among its policyholders; and
- 4. the arrangement must be insurance in the “commonly accepted sense.”
In determining whether an arrangement constitutes insurance in the commonly accepted sense, the Tax Court has looked to factors such as whether: (i) the insurer was organized, operated, and regulated as an insurance company; (ii) the insurer was adequately capitalized; (iii) the insurance policies were valid and binding; (iv) the premiums were reasonable; and (v) the premiums were paid and the losses were satisfied. (Rent-A-Center, (2014) 142 TC No. 1142 TC No. 1)
Facts. Securitas AB is a public Swedish company that first entered the U.S. security services market in ’99 when it established Securitas Holdings, Inc. (SHI). SHI is the parent company of an affiliated group of U.S. corporations (SHI Group). During 2003 and 2004 (the years in issue), SHI had no employees and did not provide any security services itself.
In ’99 through 2001, SHI acquired a number of security companies, including two publicly traded companies and their subsidiaries with offices around the world. During the years in issue, Securitas AB and its subsidiaries (the Securitas AB Group) employed over 200,000 people in 20 countries. In mid-2003, many of the SHI subsidiaries providing guarding services were consolidated into a newly formed corporation and subsidiary of SHI, Securitas Security Services USA, Inc. (SSUSA).
Protectors Insurance Co. of Vermont (Protectors), a licensed captive insurance company, was acquired by the SHI Group in early 2000 and became a direct, wholly-owned subsidiary in January of 2003. None of the U.S. operating subsidiaries of SHI or the non-U.S. operating subsidiaries of Securitas AB owned any interest in Protectors during the years at issue.
Also in 2000, the SHI Group acquired Centaur Insurance Co. (Centaur) as part of a larger acquisition. Centaur claims to be tax-exempt under Code Sec. 501(c)(15) because it hasn’t received any premium income. To preserve this status, which could otherwise be jeopardized by Protectors’ activities (since certain tests are applied on a controlled group basis), SHI executed a parental guaranty in 2002 guaranteeing the performance of Protectors with respect to a policy written by it to the SHI Group’s subsidiaries and other agreements regarding risks of the Group’s operating subsidiaries. No amounts were actually paid out under the guaranty.
In 2002, Securitas AB established a new captive reinsurance company in Ireland (Securitas Group Reinsurance Ltd., or SGRL), which operated as a wholly owned subsidiary of Securitas AB. During 2003 and 2004, none of the U.S. operating subsidiaries of SHI and none of the non-U.S. operating subsidiaries of Securitas AB owned any interest in SGRL.
After wages, the cost of risk is the second largest cost for the Securitas AB Group. In 2002 through 2004, the SHI Group obtained insurance coverage from third-party insurers. Insurance rates rose in the early 2000s, so to reduce costs, the Securitas AB Group implemented a captive insurance program (which included some of the steps described above) to insure the risks within the deductible layers of the existing third-party policies. A captive insurance program was attractive to the Securitas AB Group because it was cost effective, it allowed Securitas AB to centralize risks, and it allowed the subsidiaries to know their cost of risk in advance. It was part of the implementation of this program that Securitas AB formed SGRL in 2002, but because SGRL was a reinsurance company and could not issue policies directly, Protectors provided insurance for U.S. subsidiaries, and XL Insurance Co. Ltd. (XL Insurance), a U.K. company, provided insurance to the non-U.S. subsidiaries.
From 2002 to 2004, Protectors issued a loss portfolio transfer policy to SHI and several subsidiaries to cover the unresolved or unreported losses for the insurable risks of most of the SHI Group’s operating subsidiaries up to the deductibles or self-insured retentions of the third-party policies (for which the subsidiaries were responsible).
All of the insurable risks covered under the two main loss protection policies and the prospective insurance policies were reinsured with SGRL. In 2003 and 2004, SGRL received premiums from over 25 and over 45 entities, respectively. No guaranty was ever provided to SGRL by any party for any of the risks reinsured under the agreement with Protectors.
In 2003, SSUSA paid the premiums on behalf of the other SHI group subsidiaries and recorded general ledger amounts payable to SGRL for their payment. A wire transfer was made in July and August 2003 to Protectors, which then paid that amount to SGRL (less a commission). Ultimately, of the 2003 premiums, slightly over $56 million was paid and deducted for tax purposes in 2003 and slightly over $5 million was paid and deducted in 2004, and the premiums were allocated among the various subsidiaries. SSUSA paid the 2004 premiums in a similar manner.
During 2003 and 2004, XL Insurance issued insurance policies to cover general liability insurance risks for the non-U.S. subsidiaries of Securitas AB (which, like the Protectors policies, provided only the first layer of coverage). A portion of the risk was reinsured with SGRL, and the premiums for such totalled over $9 million during the years at issue.
IRS’s position. IRS issued a notice of deficiency to the SHI group on July 1, 2010, disallowing portions of the Group’s deductions for interest expenses and insurance premiums and making other computational adjustments that resulted in tax increases of nearly $14 million for 2003 and $16.5 million for 2004. At issue in the Tax Court case is whether the SHI Group is entitled its full deductions for insurance premiums paid.
IRS asserted that the guaranty from SHI to Protectors prevented risk from shifting from the SHI Group subsidiaries to SGRL because SHI bore the ultimate risk of loss, citing three cases in support. It also asserted that Protectors was undercapitalized and that the financial arrangement in this case (under which SSUSA paid the claims of the operating subsidiaries then sought reimbursement from SGRL) prevented the risk from shifting.
IRS also asserted that risk distribution wasn’t present in this case because most of the premiums paid to SGRL were attributable to Protectors, and after mid-2003, most of those premiums were attributable to SSUSA.
Arrangement is insurance; deductions allowed. The Tax Court found that the captive arrangement in this case shifted risks, distributed risks, and constituted insurance in the commonly accepted sense. (The remaining factor—that the arrangement involved insurable risks—wasn’t disputed.) Accordingly, the Court held that the arrangement was insurance for Federal tax purposes, and the SHI Group was entitled to the deductions claimed under Code Sec. 162 for insurance expenses.
The Court found that the three cases cited by IRS were all distinguishable. Two of them involved undercapitalized captives where the parent provided indemnification or additional capitalization in order to persuade a third-party insurer to issue policies, and the third case involved the parent’s indemnification of two third-party insurers. In contrast, the guaranty in this case was provided to preserve the tax-exempt status of Centaur, and further, no amounts were actually paid out pursuant to it. The Tax Court also disagreed with IRS’s alternative arguments, finding that Protectors was adequately capitalized and that the SHI Group’s manner of paying the claims and premiums didn’t prevent the risk from shifting.
The Court then turned to risk distribution, stating that an insurer “achieves risk distribution when it pools a large enough collection of unrelated risks, those that are not generally affected by the same circumstance or event.” ( Rent-A-Center ) The Court noted that Protectors, and ultimately SGRL, insured five types of risks; that during the years in issue, Securitas AB Group employed over 200,000 people and the SHI Group employed approximately 100,000 people; and that SGRL received premiums from over 25 separate entities in 2003 and over 45 in 2004. Thus, statistically, the Court concluded that SGRL was exposed to a large pool of statistically independent risk exposures, and the associated risks didn’t change as a result of multiple companies being merged into one.
Finally, in determining whether the captive arrangement constituted insurance in the commonly accepted sense, the Court examined the relevant factors (seeBackground, above) and found that Protectors and SGRL were both organized, operated, and regulated as insurance companies; each was subject to regulation and kept its own books and records, maintained separate bank accounts, prepared financial statements, and held meetings of its board of directors; Protectors was adequately capitalized; the insurance and reinsurance policies issued by Protectors and SGRL were valid and binding; the premiums were reasonable; and the premiums were paid and the losses were satisfied. Thus, the Court found that the arrangement constituted insurance in the commonly accepted sense.
Accordingly, given that the arrangement was insurance for tax purposes, the Court held that the premiums paid by the SHI Group were deductible under Code Sec. 162 as insurance expenses.
References: For insurance and risk sharing, see FTC 2d/FIN ¶ L-3517 et seq.; United States Tax Reporter ¶ 1624.032 ; TaxDesk ¶ 304,425 et seq.; TG ¶ 16281 .