Protected Cell Companies a/k/a Series Business Units (SBUs)

Protected cell captive insurance companies are usually organized as a particular business unit of a Series LLC, and thus are often known as "series business units" or "SBUs").

Revenue Ruling 2008-8 on Protected Cell Captives

Synopsis: Rev.Rul.2008-8 provides guidance on the standards for determining whether an arrangement between a participant and cell of a Protected Cell Company (defined below) constitutes insurance for federal income tax purposes, and whether amounts paid to the cell are deductible as "insurance premiums" under § 162 of the Internal Revenue Code.

Part I

Section 162.--Trade or Business Expenses

26 CFR 1.162-1: Business Expenses. (Also §§ 801, 831)

Rev. Rul. 2008-8

ISSUES

Under the facts described below, do the arrangements entered into with Cell X and Cell Y of Protected Cell Company constitute insurance for federal income tax purposes? If so, are amounts paid to those cells deductible as "insurance premiums" under § 162 of the Internal Revenue Code?

FACTS

Protected Cell Company

Protected Cell Company is a legal entity formed by Sponsor under the laws of Jurisdiction A. Pursuant to the laws of Jurisdiction A, Protected Cell Company has established multiple accounts, or cells, each of which has its own name and is identified with a specific participant, but is not treated as a legal entity distinct from Protected Cell Company. Sponsor owns all the common stock of Protected Cell Company. All of the non-voting preferred stock associated with each cell is owned by that cell’s participant or participants. The terms “common stock” and “preferred stock” as used in the Protected Cell Company and cell instruments do not necessarily reflect the federal income tax status of those instruments.

Each cell is funded by its participant’s capital contribution (the amount paid by the participant for the preferred stock associated with its cell) and by "premiums" collected with respect to contracts to which the cell is a party. Each cell is required to pay out claims with respect to contracts to which it is a party. The income, expense, assets, liabilities, and capital of each cell are accounted for separately from the income, expense, assets, liabilities, and capital of any other cell and of Protected Cell Company generally. The assets of each cell are statutorily protected from the creditors of any other cell and from the creditors of Protected Cell Company. Protected Cell Company maintains non-cellular assets and capital representing the minimum amount of capital necessary to maintain its charter. Each cell may make distributions with respect to the class of stock that corresponds to that cell, regardless of whether distributions are made with respect to any other class of stock. In the event a participant ceases its participation in Protected Cell Company, the participant is entitled to a return of the assets of the cell in which it participated, subject to any outstanding obligations of that cell.

A company like Protected Cell Company is sometimes referred to as a protected cell company, a segregated account company or segregated portfolio company.

Cell X

X, a domestic corporation, owns all the preferred stock issued with respect to Cell X. Each year, X enters into a 1-year contract, or arrangement, whereby Cell X "insures" the professional liability risks of X, either directly or as a reinsurer of those risks. The amounts X pays as "premiums" under the annual arrangement are established according to customary industry rating formulas. In all respects, X and Cell X conduct themselves consistently with the standards applicable to an insurance arrangement between unrelated parties. In implementing the arrangement, Cell X may perform any necessary administrative tasks, or it may outsource those tasks at prevailing commercial market rates. X does not provide any guarantee of Cell X's performance, and all funds and business records of X and Cell X are separately maintained. Cell X does not loan any funds to X. Cell X does not enter into any arrangements with entities other than X. Taking into account the total assets of Cell X, both from capital contributions and from amounts received pursuant to the arrangement with X, Cell X is adequately capitalized relative to the risks assumed under that arrangement.

Cell Y

Y, a domestic corporation, owns all the preferred stock issued with respect to Cell Y. Y also owns all of the stock of 12 domestic subsidiaries that provide professional services. Each subsidiary in the Y group has a geographic territory comprised of a state in which the subsidiary provides professional services. The subsidiaries of Y operate on a decentralized basis. The services provided by the employees of each subsidiary are performed under the general guidance of a supervisory professional for a particular facility of the subsidiary. The general categories of the professional services rendered by each of the subsidiaries are the same throughout the Y group. Together the 12 subsidiaries have a significant volume of independent, homogeneous risks.

Each year, each subsidiary of Y enters into a 1-year contract, or arrangement, with Cell Y whereby Cell Y "insures" the professional liability risks of that subsidiary, either directly or as a reinsurer of those risks. The amounts charged each subsidiary as "premiums" under the annual arrangements are established according to customary industry rating formulas. None of the subsidiaries have liability coverage for less than 5% nor more than 15% of the total risk insured by Cell Y. Cell Y retains the risk that it insures from the subsidiaries. In all respects, Y, Cell Y, and each subsidiary, conduct themselves consistently with the standards applicable to an insurance arrangement between unrelated parties. In implementing the arrangement, Cell Y may perform all necessary administrative tasks, or it may outsource those tasks at prevailing commercial market rates. Neither Y nor any subsidiary of Y guarantees Cell Y's performance, and all funds and business records of Y, Cell Y, and each subsidiary, are separately maintained. Cell Y does not loan any funds to Y or to any subsidiary. Cell Y does not enter into any arrangements with entities other than Y or its subsidiaries. Taking into account the total assets of Cell Y, both from capital contributions from Y and from amounts received pursuant to the arrangements the subsidiaries of Y, Cell Y is adequately capitalized relative to the risks assumed under those arrangements.

LAW

Section 162(a) of the Code provides, in part, that there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Section 1.162-1(a) of the Income Tax Regulations provides, in part, that among the items included in business expenses are insurance premiums against fire, storms, theft, accident or other similar losses in the case of a business.

Neither the Code nor the regulations define the terms insurance or insurance contract. The United States Supreme Court, however, has explained that in order for an arrangement to constitute insurance for federal income tax purposes, both risk shifting and risk distribution must be present. Helvering v. LeGierse, 312 U.S. 531 (1941).

Risk shifting occurs if a person facing the possibility of an economic loss transfers some or all of the financial consequences of the potential loss to the insurer, such that a loss by the insured does not affect the insured because the loss is offset by the insurance payment. Risk distribution occurs when the party assuming the risk distributes its potential liability among others, at least in part. Beech Aircraft Corp.v. United States, 797 F.2d 920, 922 (10th Cir. 1986). Risk distribution “emphasizes the broader, social aspect of insurance as a method or dispelling the danger of a potential loss by spreading its cost throughout a group”, Commissioner v. Treganowan, 183 F.2d 288, 291 (2d Cir. 1950), and “involves spreading the risk of loss among policyholders.” Ocean Drilling & Exploration Co.v. United States, 24 Cl. Ct.714, 731 (1991) aff’d per curiam, 988 F.2d 1135 (Fed. Cir. 1993). Risk distribution necessarily entails a pooling of premiums, so that a potential insured is not in significant part paying for its own risks. See Humana, Inc. v. Commissioner, 881 F.2d 247, 257 (6th Cir. 1989).

A transaction between a parent and its wholly-owned subsidiary does not satisfy the requirements of risk shifting and risk distribution if only the risks of the parent are insured. See Stearns-Roger Corp. v. United States, 774 F.2d 414 (10th Cir. 1985); Carnation Co.v. Commissioner, 640 F.2d 1010 (9th Cir. 1981), cert. denied 454 U.S.965 (1981). However, courts have held that an arrangement between a parent and its subsidiary can constitute insurance because the parent’s premiums are pooled with those of unrelated parties if (i) insurance risk is present, (ii) risk is shifted and distributed, and (iii) the transaction is of the type that is insurance in the commonly accepted sense. See, e.g., Ocean Drilling & Exploration Co.; AMERCO, Inc. v. Commissioner, 979 F.2d 162 (9th Cir. 1992); Rev. Rul. 2002-89, 2002-2 C.B. 984. An arrangement between an insurance subsidiary and other subsidiaries of the same parent may qualify as insurance for federal income tax purposes, even if there are no insured policyholders outside the affiliated group, provided the requisite risk shifting and risk distribution are present. See, e.g., Humana, Inc. v. Commissioner, 881 F.2d 247 (6th Cir.1989); Kidde Industries v. U.S., 40 Fed. Cl. (1997); Rev. Rul. 2002-90, 2002-2 C.B. 985.

The qualification of an arrangement as an insurance contract does not depend on the regulatory status of the issuer. See, e.g., Commissioner v. Treganowan, 183 F.2d 288 (2d Cir. 1950) (arrangement with stock exchange "gratuity fund" treated as life insurance because the requisite risk shifting and risk distribution were present). See also Rev. Rul. 83-172, 1983-2 C.B. 107 (group issuing workmen's compensation insurance taxable as an insurance company even though not recognized as an insurance company under state law); Rev. Rul. 83-132, 1983-2 C.B. 270 (non-corporate business entity taxable as an insurance company if it is primarily engaged in the business of issuing insurance contracts). Accordingly, the same principles apply to determine the insurance contract status of an arrangement involving a cell of a protected cell company as apply to determine the status of an arrangement with any other issuer.

ANALYSIS

In order to determine the nature of an arrangement for federal income tax purposes, it is necessary to consider all the facts and circumstances in a particular case, including not only the terms of the arrangement, but also the entire course of conduct of the parties. Thus, an arrangement that purports to be an insurance contract but lacks the requisite risk distribution may instead be characterized as a deposit arrangement, a loan, a contribution to capital (to the extent of net value, if any) an indemnity arrangement that is not an insurance contract, or otherwise, based on the substance of the arrangement between the parties. The proper characterization of the arrangement may determine whether the issuer qualifies as an insurance company and whether amounts paid under the arrangement may be deductible.

Under the facts presented, all the income, expense, assets, liabilities and capital of Cell X are separately accounted for and, upon liquidation, become the property of X, who is the sole shareholder with respect to Cell X. The amounts X pays as premiums under the 1-year agreement to "insure" its professional liability risks are held by Cell X, together with any capital and surplus, for the satisfaction of X's claims. The premiums that Cell X earns from its arrangement with X constitute 100% of its total premiums earned during the taxable year; the liability coverage Cell X provides to X accounts for all the risks borne by Cell X. In the event of a claim, payment will be made to X out of X's own premiums and contributions to the capital of Cell X; no amount may be paid out of any other cell in satisfaction of any claims by X. The arrangement between X and Cell X is akin to an arrangement between a parent and its wholly-owned subsidiary, which, in the absence of unrelated risk, lacks the requisite risk shifting and risk distribution to constitute insurance. Because Cell X does not enter into arrangements with any policyholders other than X, the arrangement between X and Cell X is not an insurance contract for federal income tax purposes, and X may not deduct amounts paid pursuant to the arrangement as "insurance premiums" under § 162. See Rev. Rul. 2005-40, 2005-2 C.B. 4 (arrangement lacks necessary risk distribution, and therefore does not qualify as insurance, if the issuer of the arrangement contracts with only a single policyholder); Rev. Rul. 2002-89, 2002-2 C.B.984 (amounts paid by a domestic parent corporation to its wholly owned insurance subsidiary are not deductible as insurance premiums if the parent's premiums are not sufficiently pooled with those of unrelated parties).

All the income, expense, assets, liabilities and capital of Cell Y likewise are separately accounted for, and upon liquidation, become the property of Y, who is the sole shareholder with respect to Cell Y. Under the arrangements between the 12 subsidiaries of Y and Cell Y, the subsidiaries shift to Cell Y their professional liability risks in exchange for premiums that are determined at arms-length. Those premiums are pooled such that a loss by one subsidiary is not in substantial part, paid from its own premiums. The subsidiaries of Y and Cell Y conduct themselves in all respects as would unrelated parties to a traditional insurance relationship. Had the subsidiaries of Y entered into identical arrangements with a sibling corporation that was regulated as an insurance company, the arrangements would constitute insurance and amounts paid pursuant to the arrangements would be deductible as insurance premiums under § 162. See Rev. Rul. 2002-90, 2002-2 C.B. 985. The fact that the subsidiaries' risks were instead shifted to a cell of a protected cell company, and distributed within that cell, does not change this result. Accordingly, the arrangements between Cell Y and each subsidiary of Y are insurance contracts for federal income tax purposes; amounts paid pursuant to those arrangements are insurance premiums, deductible under § 162 if the requirements for deduction are otherwise satisfied.

HOLDINGS

The annual arrangement between Cell X and X does not constitute insurance for federal income tax purposes. The arrangements between Cell Y and each subsidiary of Y, however, do constitute insurance for federal income tax purposes; amounts paid pursuant to those arrangements are deductible as insurance premiums under § 162 if the requirements for deduction are otherwise satisfied.

ADDITIONAL GUIDANCE

The Internal Revenue Service and the Treasury Department are aware that further guidance may be needed in this area. Notice 2008-19, this Bulletin, requests comments on further guidance that addresses when a cell of a Protected Cell Company is treated as an insurance company for federal income tax purposes.

DRAFTING INFORMATION

The principal author of this revenue ruling is Chris Lieu of the Office of the Associate Chief Counsel (Financial Institutions & Products). For further information regarding this revenue ruling contact Mr. Lieu at (202) 622-3970 (not a toll-free call).

Notice 2008-19

Part III - Administrative, Procedural, and Miscellaneous

Cell Captive Insurance Arrangements: Insurance Company Characterization and Certain Federal Tax Elections.

Notice 2008-19

SECTION 1. PURPOSE

Rev.Rul.2008-8, this Bulletin, provides guidance on the standards for determining whether an arrangement between a participant and cell of a Protected Cell Company (defined below) constitutes insurance for federal income tax purposes, and whether amounts paid to the cell are deductible as "insurance premiums" under § 162 of the Internal Revenue Code. The purpose of this notice is to request comments on further guidance to address issues that arise if those arrangements do constitute insurance, specifically (a) the status of such a cell as an insurance company within the meaning of §§ 816(a) and 831(c), and (b) some of the consequences of a cell’s status as an insurance company.

SECTION 2 .BACKGROUND

.01 Under §§ 816(a) and 831(c), an insurance company is any company more than half the business of which during the taxable year is the issuing of insurance or annuity contracts or the underwriting of risks underwritten by insurance companies. Although its name, charter powers, and subjection to State insurance laws are significant in determining the business which a company is authorized and intends to carry on, it is the character of the business actually done in the taxable year which determines whether a company is taxable as an insurance company under the Internal Revenue Code. Treas. Reg. § 1.801-3(a)(1).

.02 A taxpayer that qualifies as an insurance company is treated as a corporation under § 7701 (a)(3), even if it would not otherwise be classified as a corporation for state law purposes or under other provisions of the Code. Thus, for example, in Rev. Rul. 83-132, 1983-2 C.B. 270, a non-corporate business entity was held to be an insurance company, and therefore a "corporation" within the meaning of § 7701(a)(3), because its primary and predominant business activity was underwriting insurance risks.

.03 An insurance company is subject to tax under either Part I or Part II of Subchapter L, as applicable, and is eligible to make a number of elections. For example, § 831(b) permits certain small insurance companies other than life insurance companies to elect to be taxed only on taxable investment income (and not on underwriting income); § 846(e) permits an insurance company to compute discounted unpaid losses using the company's historical payment patterns, rather than the historical payment patterns determined by the Secretary under § 846(d); and § 953(d) generally permits a controlled foreign corporation to elect to be treated as a domestic corporation if it would qualify to be taxed under subchapter L (that is, as an insurance company) if it were a domestic corporation. See also Rev. Proc. 2003-47, 2003-2 C.B. 55 (setting forth procedural rules regarding the election under § 953(d)).

.04 A number of jurisdictions have statutes that provide for the chartering of a legal entity commonly known as a protected cell company, segregated account company or segregated portfolio company (“Protected Cell Company”). Rev. Rul. 2008-8, this Bulletin, sets forth facts that are typical of arrangements involving Protected Cell Companies and provides guidance on how to determine whether such an arrangement qualifies as insurance for federal income tax purposes.

.05 Section 3 of this Notice sets forth proposed guidance that would address (a) when a cell of a Protected Cell Company is treated as an insurance company for federal income tax purposes, and (b) some of the consequences of the treatment of a cell as an insurance company. The proposed guidance, if adopted, may take the form of a regulation, revenue ruling, revenue procedure, or other Internal Revenue Bulletin publication.

SECTION 3.PROPOSED GUIDANCE

.01 In general. The proposed guidance would include a rule to the effect that a cell of a Protected Cell Company would be treated as an insurance company separate from any other entity if:

(a) the assets and liabilities of the cell are segregated from the assets and liabilities of any other cell and from the assets and liabilities of the Protected Cell Company such that no creditor of any other cell or of the Protected Cell Company may look to the assets of the cell for the satisfaction of any liabilities, including insurance claims (except to the extent that any other cell or the Protected Cell Company has a direct creditor claim against such cell); and

(b) based on all the facts and circumstances, the arrangements and other activities of the cell, if conducted by a corporation, would result in its being classified as an insurance company within the meaning of §§ 816(a) or 831(c).

.02 Effect of insurance company treatment at the cell level. Consistent with the proposed rule:

(a) Any tax elections that are available by reason of a cell’s status as an insurance company would be made by the cell (or, in certain circumstances, by the parent of a consolidated group) and not by the Protected Cell Company of which it is a part;

(b) The cell would be required to apply for and receive an employer identification number (EIN) if it is subject to U.S. tax jurisdiction;

(c) The activities of the cell would be disregarded for purposes of determining the status of the Protected Cell Company as an insurance company for federal income tax purposes;

(d) The cell (or, in certain circumstances, the parent of a consolidated group) would be required to file all applicable federal income tax returns and pay all required taxes with respect to its income; and

(e) A Protected Cell Company would not take into account any items of income, deduction, reserve or credit with respect to any cell that is treated as an insurance company under section 3.01.

.03 No inference. No inference should be drawn regarding the treatment of a cell that does not meet the requirements to be treated as an insurance company separate from any other entity under section 3.01 or regarding the treatment of the Protected Cell Company of which it is a part.

.04 Effective date. The proposed guidance would be effective for the first taxable year beginning more than 12 months after the date the guidance is published in final form.

SECTION 4. REQUEST FOR COMMENTS

Statutes under which Protected Cell Companies are chartered differ among various jurisdictions, and cell arrangements differ among taxpayers due to variations in contractual terms. In order to ensure that entity classification and federal tax elections for Protected Cell Companies are both legally correct and administrable in all cases, the Service requests comments on the proposed guidance described in section 3 of this Notice. In particular, the Service requests comments on (a) what transition rules may be appropriate or necessary for Protected Cell Companies, or cells of such companies, if a Protected Cell Company is not currently following the rule in section 3.01, or if a cell of such a company qualifies as an insurance company for some taxable years but not for others; (b) what reporting, if any, would be necessary on the part of an individual cell to ensure that a Protected Cell Company has the information needed to comply with section 3.02(c) and (e); (c) whether different or special rules should apply with respect to foreign entities, including controlled foreign corporations; (d) whether further guidance would be needed concerning the proper treatment of Protected Cell Companies and their cells under the rules regarding consolidated returns. The Service also requests comments on what guidance, if any, would be appropriate concerning similar segregated arrangements that do not involve insurance. Written comments may be submitted to the Office of the Associate Chief Counsel (Financial Institutions & Products), Attention: Chris Lieu (Notice 2007-YY), Room 3552, CC:FIP:4, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC 20224. Alternatively, taxpayers may submit comments electronically to Notice.Comments@irscounsel.treas.gov The Service requests any comments by May 5, 2008.

DRAFING INFORMATION

The principal author of this notice is Chris Lieu of the Office of the Associate Chief Counsel (Financial Institutions & Products). For further information regarding this notice, contact Mr. Chris Lieu at (202) 622-3970 (not a toll-free call).

 

Technical Advisory Memorandum 200849013

Office of Chief Counsel

Internal Revenue Service

Memorandum

Number: 200849013

Release Date: 12/5/2008

CC:FIP:B04:CLieu

POSTF-103847-08

UILC: 831.00-00

date: July 24, 2008

to: Associate Area Counsel

(Large & Mid-Size Business)

from: Sheryl B. Flum

Branch Chief, Branch 4

(Financial Institutions & Products)

subject: -

This Chief Counsel Advice responds to your request for assistance. This advice may not be used or cited as precedent.

ISSUES

I. Is the revenue agent’s approach to aggregating the premiums of an “insured group” [FN1] correct?

[ FN1 For purposes of this memorandum, an “Insured Group” may consist of a single corporation, which Parent wholly owns and which receives insurance coverage from Cell 1. In addition, an “insured group” may consist of a corporation (which Parent wholly owned), a subsidiary of that corporation and a division/disregarded entity of that subsidiary, which received insurance coverage from Cell 1. The term “insured group” is not defined in any document that the taxpayer has produced, and the taxpayer does not use that term when describing the entities that received insurance coverage from Cell 1. ]

II. How do we apply facts relating to homogeneity of risks in analyzing whether there is sufficient risk shifting and risk distribution to merit insurance treatment?

III. Do the facts indicate that risk was adequately shifted and distributed if each Insured [FN2] is a brother/sister corporation of Cell 1?

[ FN2 Defined below. ]

IV. Do the facts indicate that risk was adequately shifted and distributed if each Insured is not a brother/sister corporation of Cell 1?

V. Do the facts indicate that the risk was adequately shifted and distributed if each Insured is treated as an owner of Cell 1 solely for the purpose of determining whether an insured/policyholder has an equity interest in Cell 1?

CONCLUSIONS

I. The revenue agent’s approach to aggregating the premiums of an “insured group” is incorrect.

II. We are not able to provide you with advice on the application of homogeneity to the insurance analysis.

III. The facts indicate that risk may have been adequately shifted and distributed if each Insured of Parent is a brother/sister corporation of Cell 1.

IV. The facts indicate that risk may have been adequately shifted and distributed if each Insured is not a brother/sister corporation of Cell 1.

V. The facts indicate that the risk may have been adequately shifted and distributed if each Insured is treated as an owner of Cell 1 solely for the purpose of determining whether an insured/policyholder has an equity interest in Cell 1.

FACTS

The Year 1 and Year 2 tax years of Y are under examination. Y is a calendar year taxpayer.

X was incorporated in FC 1. X is a mutual insurance company that provides insurance coverage to (and is owned and controlled by) its members, who are policyholders (each a “Member”). A Member has voting rights in X (as a result of a policyholder’s ownership interest in X). X elected to be treated as a United States domiciled taxpayer pursuant to I.R.C. § 953(d) for the years under examination.

X owned a 100 percent interest in Y during the years under examination (i.e., Year 1 and Year 2). Y was incorporated under the laws of FC 2 on Date 1. Y elected to be treated as a United States domiciled taxpayer pursuant to I.R.C. § 953(d). That election was in effect during the years under examination.

Y was a segregated cell company during the years under examination. Y formed segregated cells for each Member with which it conducted business; each cell was set up as a captive. Each cell has its own name and is identified with a specific Member with which Y conducted business; however, a cell is not treated as a distinct legal entity under the laws of FC 2, however for the purposes of this advice we will assume that it is nonetheless a separate taxable entity.

If either X or Y is liquidated, a Member receives the assets upon liquidation.

Typically, an “insured” party related to the Member would enter into a contract with Y for their respective cell to “insure” or “reinsure” certain risks. Y would receive the premiums from the “insured” party and would distribute those premiums to the account of the “insuring” cell.

The “insured” party did not receive a direct ownership interest in their respective cell under the terms of the contract. In addition, the “insured” party did not have any ownership rights in Y. Instead, the “insured” party could appoint advisors to Y’s advisory committee (i.e., the advisory board). Furthermore, the “insured” party was entitled to the residual profits of the cell if any profits were allocated to the policyholder surplus of the cell and were available for distribution by Y as policyholder dividends with respect to that cell. [FN3] Y would pay the policyholder dividend to a single entity. The policyholder dividend would then be distributed among each of the “insureds” that received “insurance” from the cell.

[ FN3 A Member of X is not entitled to a cell’s surplus. ]

Retained earnings of each cell were used to offset future operational losses of the cell.

If a deficit arose, claim payments to the “insured” parties were reduced accordingly. An “insured” party could not make a policy claim on the assets of Y, other than those assets related to the cell that was the subject of the contract. In addition, losses were limited to the cell’s assets (and not to all of Y’s assets).

Parent is a Member of X. Parent filed a consolidated income tax return with its subsidiaries in Year 1 and Year 2. Y created Cell 1 to provide “insurance” coverage to any “corporations, subsidiaries, firms or individuals past, present or future or hereafter acquired, organized or controlled” by Parent In Year 1, it is believed that Parent owned between a Number 3 and Number 4 percent membership interest in X. In Year 2, Parent owned approximately a Number 5 percent membership interest in X. Accordingly, Parent has voting rights in X (as a result of Parent’s ownership interest in X). In addition, if X or Y is liquidated, then Parent would receive a portion of the assets upon liquidation.

Sub 1 is a wholly-owned subsidiary of Parent and is a member of Parent’s consolidated group. Sub 1 acted as the agent for Parent for executing “insurance” policies with respect to Parent. Policies were executed between Cell 1 and Sub 1, for itself and as an agent for Parent and any “corporations, subsidiaries, firms or individuals past, present or future or hereafter acquired, organized or controlled.” Cell 1 is a segregated cell of Y. [FN4]

[ FN4 Sub 1 entered into a participation agreement with Y which provided for the establishment of Cell 1. The participation agreement defines the rights of participants. A participation agreement provides, among other things, for the administration of the insurance program, the purchase of insurance coverage, the allocation of the net profits distributed with respect to the insurance program and identification of persons serving on Y’s advisory board. ]

The entities that Parent either directly or indirectly owned and that received “insurance” coverage paid their respective portions of their “insurance” premiums. Accordingly, if the entities “insured” by Cell 1 (each an “Insured” and collectively the “Insureds”) and owned by Parent either directly or indirectly were entitled to the residual profits of Cell 1 (which were available for distribution by Y as policyholder dividends with respect to Cell 1), then Y would pay the policyholder dividend to a single entity for distribution among each Insured that actually received “insurance” coverage from Cell 1.

For the tax years Year 1 and Year 2, Cell 1 received premiums (from entities that Parent either directly or indirectly owned) in its account for the following lines of insurance:

Lines. Parent either directly or indirectly owned each Insured that received “insurance” coverage. A separate “insurance” policy was issued for each line of “insurance”.

None of the Number 1 Insured paid premiums that accounted for more than 15% of the gross premiums received by Cell 1 (for all lines of “insurance” combined) during Year 1.

One Insured paid premiums that accounted for Number 2 percent of gross premiums received by Cell 1 (for all lines of “insurance” combined) during Year 2. No other subsidiary paid premiums that accounted for more than 15% of gross premiums received by Cell 1 during Year 2. In both years, several of the subsidiaries are “insured” for risks that account for more than 15% of the total risk “insured” by Cell 1 for particular lines of “insurance.” In one case, a single subsidiary accounts for 100% of the risk “insured” by Cell 1 for a particular line of “insurance” in Year 2.

LAW AND ANALYSIS

Insurance company defined: For the purposes of this section, the term “insurance company” has the meaning given such term by section 816(a). IRC § 831(c).

IRC § 816(a): … [T]he term “insurance company” means any company more than half of the business of which during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies. IRC § 816(a).

Neither the Code nor the regulations define the terms insurance or insurance contract.

The United States Supreme Court, however, has explained that in order for an arrangement to constitute insurance for federal income tax purposes, both risk shifting and risk distribution must be present. Helvering v. LeGierse, 312 U.S. 531 (1941).

Risk shifting occurs if a person facing the possibility of an economic loss transfers some or all of the financial consequences of the potential loss to the insurer, such that a loss by the insured does not affect the insured because the loss is offset by the insurance payment. Risk distribution occurs when the party assuming the risk distributes its potential liability among others, at least in part. Beech Aircraft Corp. v. United States, 797 F.2d 920, 922 (10th Cir. 1986). Risk distribution “emphasizes the broader, social aspect of insurance as a method or dispelling the danger of a potential loss by spreading its cost throughout a group”, Commissioner v. Treganowan, 183 F.2d 288, 291 (2d Cir. 1950), and “involves spreading the risk of loss among policyholders.” Ocean Drilling & Exploration Co. v. United States, 24 Cl. Ct. 714, 731 (1991) aff’d per curiam, 988 F.2d 1135 (Fed. Cir. 1993). Risk distribution necessarily entails a pooling of premiums, so that a potential insured is not in significant part paying for its own risks. See Humana, Inc. v. Commissioner, 881 F.2d 247, 257 (6th Cir. 1989).

A transaction between a parent and its wholly-owned subsidiary does not satisfy the requirements of risk shifting and risk distribution if only the risks of the parent are insured. See Stearns-Roger Corp. v. United States, 774 F.2d 414 (10th Cir. 1985); Carnation Co. v. Commissioner, 640 F.2d 1010 (9th Cir. 1981), cert. denied 454 U.S. 965 (1981). However, courts have held that an arrangement between a parent and its subsidiary can constitute insurance because the parent’s premiums are pooled with those of unrelated parties if (i) insurance risk is present, (ii) risk is shifted and distributed, and (iii) the transaction is of the type that is insurance in the commonly accepted sense. See, e.g., Ocean Drilling & Exploration Co.; AMERCO, Inc. v. Commissioner, 979 F.2d 162 (9th Cir. 1992); Rev. Rul. 2002-89, 2002-2 C.B. 984.

An arrangement between an insurance subsidiary and other subsidiaries of the same parent may qualify as insurance for federal income tax purposes, even if there are no insured policyholders outside the affiliated group, provided the requisite risk shifting and risk distribution are present. See, e.g., Humana, Inc. v. Commissioner, 881 F.2d 247 (6th Cir. 1989); Kidde Industries v. U.S., 40 Fed. Cl. (1997); Rev. Rul. 2002-90, 2002-2 C.B. 985.

The qualification of an arrangement as an insurance contract does not depend on the regulatory status of the issuer. See, e.g., Commissioner v. Treganowan, 183 F.2d 288 (2d Cir. 1950) (arrangement with stock exchange "gratuity fund" treated as life insurance because the requisite risk shifting and risk distribution were present). See also Rev. Rul. 83-172, 1983-2 C.B. 107 (group issuing workmen's compensation insurance taxable as an insurance company even though not recognized as an insurance company under state law); Rev. Rul. 83-132, 1983-2 C.B. 270 (non-corporate business entity taxable as an insurance company if it is primarily engaged in the business of issuing insurance contracts). Rev. Rul. 2008-8, 2008-5 IRB 340 (an arrangement that would otherwise be treated as an insurance contract will not fail to be treated as an insurance contract merely because the risks were shifted to a cell of a protected cell company and distributed within that cell).

Issue I

You have asked us to consider whether the revenue agent’s aggregation approach (aggregating all coverage with respect to an Insured Group) is correct. The revenue agent has aggregated all premiums paid by the divisions, subsidiaries and disregarded entities owned by the direct subsidiaries of Parent.

Generally speaking, separate entities must be respected as such for tax purposes but may be disregarded where it is a sham or unreal. In such situations the form is a bald and mischievous fiction. See Moline Properties, Humana. You have indicated that the lower tier subsidiaries are not shams or unreal. Therefore, the insurance activity of lower tier subsidiaries should not be aggregated with the insurance activity of direct subsidiaries of Parent for the purposes of determining risk distribution. The insurance activity of divisions within a taxable entity and the disregarded entities of that taxable entity should be aggregated for the purposes of determining risk distribution. See Rev. Rul. 2005-40 situations 3 and 4.

Issue II

You have asked us to consider whether the risk shifting and risk distribution analysis should be performed for each line of insurance issued by Cell 1 or whether all lines of insurance should be aggregated for this analysis.

We have mentioned homogeneity in several revenue rulings without addressing the relevance of homogeneity as a factor in the subsequent insurance analysis. See Rev. Rul 2002-89, Rev. Rul. 2002-90, Rev. Rul. 2005-40, Rev. Rul. 2008-8. In 2005, we issued a notice asking for comments regarding the relevance of homogeneity in determining whether risks are adequately distributed for an arrangement to qualify as insurance. Notice 2005-49, 2005-2C.B. 14. We have not yet published guidance expressing our position on this issue.

Issue III

You have asked us whether the facts indicate that risk was adequately shifted and distributed if each Insured is a brother/sister corporation of Cell 1.

In Rev. Rul. 2002-90, P, a domestic holding company owned all of the stock of 12 domestic operating subsidiaries that operated on a decentralized basis. Together the 12 subsidiaries have a significant volume of independent, homogeneous risks. P, for a valid non-tax business purpose, formed S as a wholly-owned insurance subsidiary. P provides S with adequate capital. S directly insures the professional liability risks of the 12 operating subsidiaries owned by P. S charges the 12 subsidiaries arms-length premiums, which are established according to customary industry rating formulas.

There are no parental (or other related party) guarantees of any kind made in favor of S.

S does not loan any funds to P or to the 12 operating subsidiaries. In all respects, the parties conduct themselves in a manner consistent with the standards applicable to an insurance arrangement between unrelated parties. S does not provide coverage to any entity other than the 12 operating subsidiaries. None of the operating subsidiaries have liability coverage for less than 5%, nor more than 15%, of the total risk insured by S. S retains the risks that it insures from the 12 operating subsidiaries.

In Rev. Rul. 2005-40, situation 2, X, a domestic corporation, entered into an arrangement with Y, an unrelated domestic corporation, whereby in exchange for an agreed amount of "premiums," Y "insures" X against the risk of loss arising out of its business operations. The amounts Y earns from its arrangements with X constitute 90% of Y's total amounts earned during the taxable year on both a gross and net basis.

The arrangement with X accounts for 90% of the total risks borne by Y. Y also enters into arrangements with Z which account for the remaining 10% of amounts earned and risks borne by Y. In this situation, we found that the arrangements between X and Y lack the requisite risk distribution to constitute insurance.

In Rev. Rul. 2008-8, Protected Cell Company is formed by Sponsor and has established multiple accounts, or cells, each of which has its own name and is identified with a specific participant, but is not treated as a legal entity distinct from Protected Cell Company. Sponsor owns Protected Cell Company. The income, expense, assets, liabilities, and capital of each cell are accounted for separately from the income, expense, assets, liabilities, and capital of any other cell and of Protected Cell Company generally. In Situation 1, X, a domestic corporation is the participant with respect to Cell X. X enters into an arrangement, whereby Cell X “insures” the professional liability risks of X. Cell X does not enter into any arrangements with entities other than X. The ruling adopted the rationale of Rev. Rul. 2005-40 and Rev. Rul. 2002-89 and found that the arrangement between X and Cell X is akin to an arrangement between a parent and its wholly-owned subsidiary, which, in the absence of unrelated risk, lacks the requisite risk shifting and risk distribution to constitute insurance. In Situation 2, The facts are the same as in Situation 1, except that Y, a domestic corporation, owns all the preferred stock issued with respect to Cell Y. Y also owns all of the stock of 12 domestic subsidiaries. Each subsidiary in the Y group enters into an arrangement with Cell Y whereby Cell Y “insures” the professional liability risks of that subsidiary. None of the subsidiaries have liability coverage for less than 5% more than 15% of the total risk insured by Cell Y. Cell Y does not enter into any arrangements with entities other than Y or its subsidiaries. Adopting the rationale of Rev. Rul. 2002-90, Rev. Rul 2008-8 found that had the subsidiaries of Y entered into identical arrangements with a sibling corporation that was regulated as an insurance company, the arrangements would constitute insurance. The fact that the subsidiaries' risks were instead shifted to a cell of a protected cell company, and distributed within that cell, does not change this result.

You have provided us with extensive information regarding the amount and percentage of premiums paid by each of the “insureds” in the aggregate and for each line of insurance. In several instances, these percentages do not fall within the safe harbor percentages of Rev. Rul. 2002-90. For the purposes of this analysis we will assume that each insured is a brother/sister corporation of Cell 1. You have not asked us to opine on whether the other factors in Rev. Rul. 2002-90 have been met and whether premiums paid are an accurate reflection of the risk insured by Cell 1.

Rev. Rul. 2002-90 provided a framework for insurance analysis where a captive company covered the risks of brother/sister corporations. It provided a safe harbor where at least 12 brother/sister insureds each accounted for no more than 15% and no less than 5% of the covered risk if other factors were satisfied. Rev. Rul. 2002-90 also posited a situation where the captive was covering a large number of independent homogenous risks; however, we have already expressed our inability to offer you advice on the homogeneity issue. Rev. Rul. 2008-8 extended this analysis to cell captives.

If you determine that homogeneity is not a significant factor and that all lines of insurance should be aggregated for the purposes of determining whether there has been sufficient risk shifting and risk distribution, then the facts of the present case (in both years) do not fall into any of the fact patterns where we found a lack of sufficient risk shifting and risk distribution in Rev. Rul. 2005-40.

The facts do not precisely meet the requirements of the safe harbor in Rev. Rul. 2002- 90. However, the logical reason for imposing a lower limit on the level of risk insured among 12 sister subsidiaries in the rulings is to exclude situations where fewer than 12 subsidiaries meet the 15% limit and the captive “insurance” company meet the requirement for 12 insured subsidiaries by “insuring” relatively small amounts of risk from other entities (i.e., less than 5%). In Year 1, Number 6 Insureds paid more than 5% and less than 15% of the total premiums received by Cell 1. These Number 6 Insureds paid Number 7% of total premiums paid and the remaining Number 8 Insureds paid the remaining Number 9% of the premiums. In Year 1, Cell 1 has not met the requisite number of subsidiaries with at least 5%; however they have fulfilled the purpose of the 5% threshold. In Year 2, Number 10 Insureds paid more than 5% and all but one paid less than 15% of total premiums received by Cell 1 (one Insured paid Number 11% of total premiums received by Cell 1, which falls outside the safe harbor of 15%). These Number 10 Insureds paid Number 12% of total premiums paid to Cell 1 and the remaining Insureds paid the remaining Number 13%, therefore Cell 1 has fulfilled the purpose of the 5% threshold in Year 2. Accordingly, if you find that homogeneity is not a significant factor, then the facts indicate that the requirements of the safe harbor in Rev. Rul. 2002-90 have been met in Year 1 and have not been met in year 2 (however, the differences in Year 2 are minimal).

If you determine that homogeneity is a significant factor and that all lines of insurance should be analyzed separately for purposes of determining whether there has been sufficient risk shifting and risk distribution, then several lines of “insurance” do not fall within the safe harbor of Rev. Rul. 2002-90. Furthermore, the facts of the case indicate that at least one line of insurance during one of the years under audit, the taxpayer falls into one of the fact patterns where we found a lack of sufficient risk shifting and risk distribution in Rev. Rul. 2005-40. [FN5]

[ FN5 The entire Line 1 risk covered by Cell 1 in Year 2 was covering the risk of a single insured. ]

Issue IV

You have asked us whether the facts indicate that risk was adequately shifted and distributed if Insureds are related to each other but not related to Cell 1.

Under the principles of Rev. Rul. 2008-8, we would either treat Cell 1 as a sibling of the Insureds or as a group captive of the Insureds.

Issue V

You have asked us whether the facts indicate that the risk was adequately shifted and distributed if each Insured is treated as an owner of Cell 1 solely for the purpose of determining whether an insured/policyholder has an equity interest in Cell 1.

We have not published guidance on the required level of risk distribution for a group captive among related Insureds. [FN6] It does not seem appropriate to apply typical parent subsidiary captive criteria where the captive is owned by more than one entity, even if those entities are related to each other. Under the assumed facts of this Issue V we would find it appropriate to apply the analysis of Rev. Rul. 2002-90 and follow the same analysis as we did above under Issue III.

[ FN6 We have addressed the required level of risk distribution for a group captive where the insureds are unrelated to each other in Rev. Rul. 2002-91. ]

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS

This writing may contain privileged information. Any unauthorized disclosure of this writing may undermine our ability to protect the privileged information. If disclosure is determined to be necessary, please contact this office for our views.

Please call Chris Lieu at (202) 622-3970 if you have any further questions.

/S/

_____________________________

Sheryl B. Flum

Branch Chief, Branch 4

(Financial Institutions & Products)

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