The Tax Court has held that payments made by a parent corporation’s wholly owned subsidiaries to another wholly owned subsidiary were deductible as insurance expenses.
The court abandoned its previous position that there could not be risk shifting in brother-sister corporate arrangements (Rent-A-Center and Affiliated Subsidiaries v. Commissioner, 142 TC No 1, Jan. 14, 2014).
Rent-A-Center, Inc. (RAC) is the parent of a group of approximately 15 affiliated subsidiaries. RAC and its subsidiaries rented, sold and delivered home electronics, furniture and appliances. RAC’s wholly owned subsidiary, Legacy Insurance Co., Ltd., is a Bermuda corporation.
Legacy and RAC’s other wholly owned subsidiaries entered into contracts under which each subsidiary paid Legacy an amount – determined by actuarial calculations and an allocation formula – relating to workers’ compensation, automobile and general liability risks. In turn, Legacy reimbursed a portion of each subsidiary’s claims relating to these risks.
On their consolidated returns, RAC’s subsidiaries deducted the payments to Legacy as insurance expenses. On audit, the IRS determined that the payments were not deductible. In its majority opinion, the Tax Court concluded that the payments by RAC’s subsidiaries to Legacy were deductible as insurance expenses.
In making this determination, the court found that RAC presented convincing evidence that:
- Legacy was a bona fide insurance company.
- RAC faced actual and insurable risk.
- Comparable coverage with other insurance companies would have been more expensive.
- Some insurance companies would not underwrite the coverage provided by Legacy.
- RAC established Legacy for legitimate business reasons, including increasing the accountability and transparency of its insurance operations, accessing new insurance markets and reducing risk management costs.
The court concluded that Legacy was not a sham. It reasoned that, while federal income tax consequences were considered, the formation of Legacy was not a tax-driven transaction.
Legacy entered into bona fide arm’s-length contracts with RAC, charged actuarially determined premiums, was subject to the regulatory control of the Bermuda Monetary Authority and met Bermuda’s minimum statutory requirements. It also paid claims from its separately maintained account and was adequately capitalized.
The court noted that, to be deductible, an arrangement must involve insurance risk and meet commonly accepted notions of insurance. And, there must be risk shifting and risk distribution.
The court then determined that the arrangement in this case satisfied the following requirements:
- Insurance risk policies. RAC faced insurable risk relating to all three types of insured risk – workers’ compensation, automobile and general liability. RAC entered into contracts with Legacy and an independent insurance company to address these risks.
- Risk shifting. The court repudiated its 1987 Humana Inc. decision with regard to brother-sister arrangements and concluded that a balance sheet and net worth analysis, looking at the arrangement’s economic impact on the insured entities, were the proper analytical framework to determine risk shifting in brother-sister arrangements. It found that the policies shifted risk from RAC’s insured subsidiaries to Legacy, and that Legacy:
- Was formed for a valid business purpose
- Was a separate, independent and viable entity
- Was financially capable of meeting its obligations
- Reimbursed RAC’s subsidiaries when they suffered an insurable loss
A payment from Legacy to RAC’s subsidiaries did not reduce the net worth of RAC’s subsidiaries because, unlike RAC, the subsidiaries did not own stock in Legacy.
- Distributed risk. RAC’s subsidiaries owned more than 2,500 stores, had more than 14,000 employees and operated more than 7,000 insured vehicles. RAC’s subsidiaries had a sufficient number of statistically independent risks. Thus, by insuring RAC’s subsidiaries, Legacy achieved adequate risk distribution.
- Insurance in the commonly accepted sense. Legacy was adequately capitalized, regulated by the Bermuda Monetary Authority, and organized and operated as an insurance company. It issued valid and binding policies, charged and received actuarially determined premiums, and paid claims.