The Law of Anomalous Numbers, also known as Benford’s Law,
seeks to explain why the leading digits in any numerical
distribution skew low. In a uniform distribution, each number
(ignoring zero) has an 11.1% chance of being present. But that is
not the way it works out in real life, as the number one has up to
a 30% chance of being the leading digit in any arbitrary integer
base. The number two has an 18% chance of being the leading digit,
and so on. Thus, if the Law of Anomalous Numbers applied to IRS
guidance, the number of insurance tax releases in any given year
would be small. Lucky for us, though, in early 2021, the Internal
Revenue Service (“IRS”) and the Tax Court bucked
Benford’s Law and released a large number of insurance tax
items. The subject matter of the guidance spans a variety of
topics, including (i) the qualification of certain modified
co-insurance agreements as reinsurance, (ii) an analysis of certain
aspects of the base erosion anti-abuse tax (the “BEAT”)
for a domestic entity switching reinsurance counterparties, (iii)
whether a micro-captive arrangement constituted
“insurance” for US federal income tax purposes and (iv)
the taxation of certain annuity advisor fees under the terms of a
variable annuity contract.
I. PLR 202109005: Related-Party Risk Assumption Agreements
Qualify as Reinsurance
PLR 202109005 holds (but with scant discussion) that a
reinsurance contract of related-party risk (stemming from
diversified third-party risk) constitutes “insurance” for
US federal income tax purposes, even when the insured must step up
its premium payments to reimburse the insurer for sustained losses.
The amount of loss and premiums are not specified, however, making
it difficult to determine the actual amount of loss borne by the
risk-assuming party. It is also a straightforward application of
the position of the IRS as expressed in Revenue Ruling 2009-26: A
taxpayer is permitted to determine whether there has been risk
distribution and shifting on a look-through basis when the risk has
already been aggregated by an affiliate. The ruling helpfully holds
(but with scant discussion) that a reinsurance contract of
related-party risk (stemming from diversified third-party risk)
constitutes “insurance” for US federal income tax
purposes.
In the ruling, a non-US corporation regulated as an insurance
company (“Retrocessionare”) owned a domestic corporation
(“Parent”). Retrocessionare itself is owned by a non-US
publicly traded insurance holding company. Parent owns all of the
stock of a non-US reinsurance company, acting as reinsurer, that
elected to be treated as a domestic corporation under Code §
953(d) (“Reinsured”).
Reinsured is regulated as an insurance company in its
jurisdiction of formation. Reinsured entered into various
reinsurance agreements under which it assumed the risk under
deferred and immediate annuity contracts issued by, or in some
cases reinsured by, Reinsured’s affiliates. Reinsured then
insures against its risk with Retrocessionare through a renewable
modified co-insurance contract. (When a reinsurance company insures
itself, the transaction is referred to as “retrocession,”
and the party assuming the reinsurance risk is referred to as the
“retrocessionaire.”) The co-insurance arrangement was
subject to mandatory renewal if the Retrocessionaire’s payments
and payment obligations exceeded the premiums payable by the
Reinsured. The Reinsured could be required to make additional
payments to the Retrocessionaire under the co-insurance payments as
well, raising an issue as to whether the Retrocessionaire truly
bore risk. These payments likely would have been characterized as
additional premiums payable to the Retrocessionaire. The payments
under the co- insurance arrangement were determined by actuarial
analysis.
The arrangement between the parties that is the subject of the
ruling is set forth in Figure 1 below.
The parties sought a ruling that the co-insurance arrangements
would be treated as insurance for federal income tax purposes. Our
speculation is that Reinsured sought a ruling on this question due
to the uncertainty as to whether there was risk shifting in this
transaction due to the fact that premiums could be increased if the
Retrocessionaire experienced losses. If the transaction failed to
be treated as insurance, premiums paid to the Retrocessionaire
could have been subjected to a 30% withholding tax instead of the
much lighter excise tax on insurance premiums.
The IRS began its analysis with an overview of the guidance on
what constitutes “insurance.” As is oft- repeated by the
IRS and the courts, the US tax law does not provide a definition of
“insurance,” but the Supreme Court has provided four key
features for distinguishing insurance from other arrangements:
- Traditional insurance. An insurance
arrangement is “insurance” in its commonly accepted
sense, generally depending on whether the entity is organized,
operated, and regulated as insurance company, has adequate
capitalization, and receives reasonable arm’s- length premiums,
among other factors;1 - Insurance risk. The arrangement is over an
“insurance risk”; - Risk shifting. The insurance risk is shifted
from one party to the other in the arrangement; and - Risk distribution. The party insures the risk
pools and distributes that risk.2
The Code specifies that “insurance” includes the
issuance of annuity contracts.3 PLR 202109005 concludes
that the Contract constitutes reinsurance. Thus, the first two
tests were clearly met.
The IRS has previously offered guidance on risk distribution for
aggregated risks in Revenue Ruling 2009-26.4 There,
through a single reinsurance contract, a corporation reinsured the
risk to another insurance company of 90% of all losses on insurance
contracts with 10,000 unrelated policyholders.
The Revenue Ruling holds that despite the reinsurer entering
into only one contract, because the risks of each original
policyholder were distributed among the pool of policyholders, the
reinsurer’s risk was distributed through the single contract.
But this look-through rule requires that there be risk
diversification in the original transaction. In Revenue Ruling
2005-40, the IRS held that a purported insurance arrangement
involving an issuer who contracts with only one policyholder does
not qualify as insurance contracts because issuer did not
distribute the risk.5 PLR 202109005 does not specify the
number of annuity policies underlying the Contract, it appears to
be substantial.
II. PLR 202109001: Substituting Related-Party Reinsurers Does
Not Trigger BEAT Payment
The BEAT functions as an alternative minimum tax in that
specified taxpayers must make a parallel calculation to their
regular tax liability and, to the extent such amount is greater
than the taxpayer’s regular tax liability, the BEAT imposes tax
equal to the excess of the BEAT liability over the regular tax
liability. At the heart of the BEAT calculation is the concept of a
base erosion payment and, for each type of base erosion payment,
the corresponding base erosion tax benefit. These concepts
determine whether specified taxpayers are subject to BEAT, and if
so, the amount of the BEAT liability. There are four types of base
erosion payments enumerated in the statute.6 One type of
base erosion payment is an amount paid or accrued by the taxpayer
to a foreign person for reinsurance payments taken into account
under Code § 803(a)(1)(B) or Code § 832(b)(4)(A) (in
which case the base erosion tax benefits are the reduction to gross
income and the deduction provided for in such sections).
The BEAT applies only to taxpayers that are corporations (other
than regulated investment companies, real estate investment trusts,
or S corporations) that have average annual gross receipts of at
least $500 million over a three-year period and, have a base
erosion percentage of at least 3% (or, if they are a domestic bank,
the base erosion percentage during the taxable year is at least
2%).
The BEAT liability, if any, is calculated by adding back to
taxable income a taxpayer’s base erosion tax benefits, plus the
base erosion percentage of the taxpayer’s post-2017 net
operating loss deductions for the taxable year. The result,
referred to as “modified taxable income,” is then
multiplied by an applicable tax rate. For tax years 2019 through
2025, the applicable tax rate is 10% and after 2025, the rate is
12.5%. (These rates are increased by 1% for US banks.) As stated
above, if the BEAT exceeds the regular tax liability reduced by
certain tax credits, the taxpayer will owe the BEAT amount.
In PLR 202109001, the taxpayer, a domestic corporation that was
part of an affiliated group filing a consolidated federal income
tax return, reinsured risk under certain insurance policies that it
had written with another member of the affiliated group (“Corp
A”). The taxpayer ceded a portion of this risk to its indirect
non-US owner, a non-US corporation (“FC1”). The taxpayer
also ceded a portion of this risk to an indirect non-US subsidiary
of FC1 (“FC2”), which ceded the risk to FC1.
FC1 also ceded a portion of the Corp A risks to another non-US
subsidiary (“FC3”). To reduce operational complexity and
administrative burden, the parties desired to remove intervening
step 1 involved FC2 in transferring the Corp A risks from Taxpayer
to FC1. Diagrammatically, the arrangements were as follows:
The issue appeared to be whether the substitution of FC1 for FC2
triggered a sale or exchange of the ceding agreement by the
Taxpayer. See Rev. Rul. 90-109, 1990-2 CB 191 (change of
insured triggered gain or loss inherent in an insurance contract);
Estate of McKelvey v. Comm’r, 906 F3d 26 (2d Cir.
2018) (extension of variable prepaid forward contract triggered a
sale or exchange of the contract). The IRS noted that the
assumption by FC1 is an assumption reinsurance transaction within
the meaning of Treasury Regulation §
1.809-5(a)(7)(ii).7 Case law states that an assumption
reinsurance transaction is treated as a sale by the ceding company
to the reinsuring company.8 If this treatment governed
the consequences for the taxpayer, and the taxpayer had a loss on
such sale, the loss could have been treated as a base erosion
payment.
PLR 202109001, citing Revenue Ruling 82-122, 1982-1 CB 80,
concludes that the substitution of FC1 for FC2 resulted in the sale
of the contract. The IRS highlights that the premiums to be paid by
the Taxpayer were unaltered by changing the counterparty. Because
of this, the IRS concluded that any amount paid on the assumption
should be between FC1 and FC2, not a premium or other deductible
payment made by Taxpayer to a foreign affiliate that could give
rise to a base erosion payment for purposes of the Taxpayer’s
BEAT calculation. In other words, from the perspective of the
Taxpayer, the IRS essentially treated the substitution of
reinsurers as a modification that was not material, given that the
payments to be made by the Taxpayer did not change as a result of
the substitution. The analysis of the IRS appears to dovetail with
the rule in Treasury Regulation § 1.1001-3(e)(4)(iv). Under
that regulation, a change in credit enhancement on a debt
instrument triggers a sale or exchange only if there is a change in
payment expectations. The authors also note that Treasury
Regulation § 1.1001-4, relating the substitutions of
counterparties on derivatives, reaches the same conclusion for the
non-transferring party on those contracts when such contracts are
transferred between dealers or clearinghouses.
III. Caylor Land & Development, Inc. v.
Comm’r, TC Mem. 2021-30 (March 10, 2021)
“Micro-captive” insurance transactions can offer
substantial tax benefits. On one hand, the payment of the premiums
can be deductible to the insured. On the other hand, if the net
written premiums received by the insurance company do not exceed
$2.2 million, the insurance company does not pay tax on the premium
income.9 The IRS has taken a dim view of small insurance
company transactions in which the insurance company is related to
the companies from which it has assumed risk. In Notice 2016-66,
modified by Notice 2017-8, 2017-3 IRB 423, the IRS identified
certain micro-captive insurance transactions as “transactions
of interest.”10 The IRS has been on a tear
litigating, and winning, decisions against micro- captive
transactions. See Avrahami v. Comm’r, 149 T.C. No. 7
(2017); Reserve Mechanical Corp. v. Comm’r, TC Mem.
2018-86; Syzygy Insurance Co. v. Comm’r, TC Mem.
2019-34. On April 9, 2021, the IRS announced that it had formed 12
audit teams dedicated solely to challenging micro-captive
transactions.11 Previously, it had offered a limited
time settlement to taxpayers who participated in these
transactions.12
The IRS’s string of victories against micro-captive insurers
continued into early 2021 with strong decision in the Tax Court in
Caylor Land & Development, Inc. v.
Commissioner.13
In Caylor, a family owned a variety of entities in the
business of commercial construction. The Caylors historically
purchased third-party insurance (and continued to do so during the
years at issue) but decided to also form a captive insurance
company in Anguilla with an election for the company to be a Code
§ 953(d) company. The premiums deducted by the Caylor entities
and paid to the captive were $1.2 million in each year covered by
the decision (the then maximum amount permissible for the captive
to pay no tax on premiums received). Although twelve Caylor
entities paid premiums to the captive, the Tax Court observed that
one Caylor entity, Caylor Land, was the revenue generator for the
family of affiliates, and all funds to pay the insurance premiums
ultimately flowed from Caylor Land. The premiums in each year were
paid before contracts for each year outlining the insurance
policies were drafted. During the three year period of coverage,
the captive paid four claims that amounted to $43,000. The captive
paid the claims without receiving requested information about the
claims, an action which the court noted is not standard practice
for an insurance company. Across the entities, the insurance
covered 34 different exposures.
The Tax Court begins its analysis with the four Le
Gierse factors discussed above, concluding that the
arrangement did not satisfy the requirement that the captive
distribute its risk and the requirement that the arrangement was
insurance in its commonly accepted sense. On risk distribution, the
Tax Court examined whether the captive distributed the risk among a
sufficient number of unrelated risks for the law of large numbers
to predict expected losses (as in other Tax Court precedent). In
finding the captive did not, the Tax Court first emphasized in
cases where a captive arrangement was respected, captives insured
risks in the thousands.14 This leaves a grey area
between the thirty-four independent exposures assumed by the
captive in Caylor and the thousands accepted as satisfying
the law of large numbers in the Tax Court’s other precedents.
Second, the Tax Court reasoned that risk distribution is better
supported where the risks are more independent than under the facts
of Caylor, where all risks insured by the captive were
related to the real estate business in a single geographic
area.
Although in Revenue Ruling 2005-40, the IRS interpreted risk
distribution to require both many insureds and many risks, the Tax
Court has been less clear. Both Rent-A-Center and at least
one other case presented instances of many risks but only one or
two insureds. In Avrahami, the court said without any
analysis (or mention of Rent-A-Center) that three insureds
are insufficient. The court in Caylor refrains from
clearly adopting the IRS’s requirement of many insureds but
satisfies itself by saying the law of large numbers means more than
the 30 or so risks involved in that caser. We are still waiting for
the Tax Court to agree or disagree with whether the IRS’s
position in Revenue Ruling 2005-40 that 10,000 risks from only one
customer does not accomplish risk distribution.
In finding that the captive arrangement in Caylor was
not insurance in its commonly accepted sense, the Tax Court held
that (a) the captive did not act as an insurance company and the
Caylor entities did not act as insureds, since the parameters of a
policy were not established for a taxable year until after premiums
had been paid and claims were paid on the policies without the
captive receiving requested information about the claims, and (b)
the premiums paid to the captive were far in excess of any expected
loss and were calculated by including an adjustment mechanism meant
to reach the then-$1.2 million cap under Code § 831(b).
Since the Tax Court found that the captive arrangement was not
insurance in the commonly accepted sense and that it lacked risk
distribution, the Court held that the arrangement between the
Caylor entities and the captive was not insurance.
Caylor highlights some bad facts to watch out for when
structuring a captive arrangement meant to be characterized as
insurance.
IV. Annuity Adviser Fees Paid Net Not Taxable to the Annuity
Owner
One of the tax benefits of whole life insurance and variable
annuities (together, variable contracts) is that the investment
component of the contracts can be taxed in the same manner as death
benefits and periodic payments. In other words, variable contracts
offer investment returns on these products that are taxed much more
favorably than if the insured or annuitant held the same
investments outside of an insurance product. In order for the
investment component of a variable contract to receive this
favorable tax regime, the insurance contract must meet certain
diversification and investor control requirements. The
diversification requirements are spelled out in Treasury Regulation
§ 1.817-5. The IRS has spelled out the investor control
requirements, however, through a series of rulings and other
authorities. See Webber v. Commissioner, 144 TC 324 (2015)
(IRS position on investor control adopted by Tax Court).
Traditionally, the IRS interpreted the investor control
requirement in a rigid manner. In Rev. Rul. 77-85, 1977-1 C.B. 12,
the IRS concluded that an individual purchaser of a variable
annuity contract who retained “significant incidents of
ownership” over the assets held in the custodial account was
treated as the owner of those assets for federal income tax
purposes. In Rev. Rul. 80- 274, 1980-2 C.B. 27, the IRS applied
Rev. Rul. 77-85 to conclude that if a purchaser of an annuity
contract could select and control the certificates of deposit
supporting the contract, then the purchaser was considered the
owner of the certificates of deposit for federal income tax
purposes. Similarly, in Rev. Rul. 81-225, 1981-2 C.B. 12, which was
clarified and amplified by Rev. Rul. 2003-92, 2003-2 C.B. 350, the
IRS concluded that investments in mutual fund shares that funded
annuity contracts were considered to be sub-accounts. Each
sub-account invested in interests in a partnership. The IRS held
that in situations in which the sub-accounts held interests in
partnerships available for purchase other than by purchasers of
annuity or variable contracts from an insurance company, the
contract-holder was the owner of the interests in the partnerships
held by the sub-accounts for federal income tax purposes.
In recent years, the IRS has relented on this rigid approach and
has been issuing private letter rulings to taxpayers that variable
contract holders would not be treated as the owner of the
underlying investments where the underlying investments can be
chosen by a licensed investment advisor chosen by the insured. The
rulings even permit the investment advisor to be affiliated with
the issuer of the variable contract. The issuing insurer will pay
fees to the adviser for investment advice that the adviser provides
to the variable contract owner with respect to the variable
contract. The variable contracts offered numerous investment
options for the insured or annuitant where the advisor, in
consultation with the insured, allocated the contract corpus among
these investment choices. The IRS recently issued a number of
private rulings holding that these advisory schemes did not violate
the investor control requirement. See e.g., PLR 202104001,
PLR 20205004, PLR 20205006, PLR 202024008, and more.
In March and April 2021, the IRS released several private letter
rulings holding that annuity advisor fees under a variable annuity
contract which were deducted from the cash value of the annuity
contract for investment advisory services rendered to the insured
under variable contracts did not constitute deemed distributions to
the contract owner.15 As part of the contract, the
Adviser provided ongoing investment advice to contract owners in
exchange for a fee. Rather than charge the owner a fee directly or
from any distribution from the variable contract to the owner, the
Adviser was paid by the insurer from the cash value of the annuity
contract.
Economically, it could have been viewed as though the owner was
distributed cash which was then paid to the Adviser for the
adviser’s services under the contract.
The IRS held the amounts withdrawn as advisory fees should not
be treated as an “amount received” by the beneficial
owner of the contract. The ruling concludes that the beneficial
owner should not treat the advisory fees as an amount received from
the annuity contract. Taking an “entity-level” approach
to the fees, the rulings find that the fees are an expense of the
investment contract, not the beneficial owner, because (a) the
contract was designed to depend on the ongoing investment advice,
(b) the fees will only be used to pay for advisory services under
the contract and will not be consideration for any other service,
and (c) the fees were reasonable at 1.5%. The structure of this
transaction effectively allows the investor to deduct the cost of
the investment manager’s fees despite the 2% floor and the
suspension of Code § 67 deductions subject to the 2% floor
through 2025.
Although the PLRs are noticeably silent on the investor control
requirement, they assume without discussion that the arrangements
will not violate such requirement. The advisor works directly with
the variable contract owner to determine the allocation among
investment strategies available within the segregated accounts held
by the insurance company that are dedicated to the variable
contract and are paid by the insurer. Under prior IRS guidance,
variable contract owners would have been concerned that this type
of arrangement would have caused the contract owner to have control
over the assets held by the insurer. The fact that the IRS is now
issuing rulings on this structure is likely to further enhance the
market for variable contracts.
Footnotes
* Brennan and Mark are both tax lawyers
with the New York office of Mayer Brown. Mark and Brennan each work
with insurance tax issues on a regular basis. Mark and Brennan
express their thanks to George “Buz” Craven, Mayer
Brown’s insurance tax guru, for his thoughts and comments on an
earlier version of this Legal Update. Mistakes and omissions,
however, remain the sole responsibility of the authors. The views
expressed herein are solely those of the authors and should not be
imputed to Mayer Brown.
1. See, e.g.,
Avrahami v. Commissioner, 149 T.C. 144 (2017).
2. Helvering v. E. Le Gierse,
312 U.S. 351 (1941)
3. See Code section 816(a),
where a life insurance company is defined as an insurance company
which is engaged in the business of issuing life insurance and
annuity contracts with corresponding reserves in excess of 50% of
its total reserves.
4. Rev. Rul. 2009-26, 2009-39 IRB 366
(2009).
5. Rev. Rul. 2005-40, 2005-2 CB 4
(2005).
6. The term “base erosion tax
benefit” also includes amounts paid to related foreign persons
to acquire depreciable property (in which case the base erosion tax
benefit is the depreciation deductions), amounts paid to related
foreign persons for reinsurance payments taken into account under
Code § 803(a)(1)(B) or Code § 832(b)(4)(A) (in which case
the base erosion tax benefits are the reduction to gross income and
the deduction provided for in such sections), and amounts paid or
accrued by a taxpayer that result in reductions in gross receipts
if the payment is to a related “surrogate foreign
corporation” or to a foreign person in the same expanded
affiliated group as the surrogate foreign corporation (in which
case the base erosion tax benefit is the reduction in gross
receipts).
7. Under that regulation, assumption
reinsurance as an arrangement whereby another person (the
reinsurer) becomes solely liable to the policyholders on the
contracts transferred by the taxpayer (not including indemnity
reinsurance or reinsurance ceded).
8. Beneficial Life Ins. v.
Commissioner, 79 T.C. 627 (1982), nonacq. on other
grounds, 1982-2 C.B. 1.
9. Code section 831(b)(1).
10. Notice 2016-66, 2016-47 IRC 745
(2016). A transaction of interest is a “reportable
transaction,” which generally requires all participants to the
transaction (and their material advisers) to file forms with the
IRS describing the transaction. A failure to properly report a
transaction of interest results in penalties of up to $10,000 for
natural persons and $50,000 for all other taxpayers. See
Code section 6707A(b)(2)(B).
11. See IRS News Release,
IRS urges participants of abusive micro-captive insurance
transactions arrangements to exit from arrangements (IR-
2021-82) (Apr. 9, 2021).
12. See Clock Ticking for
Micro-Captives Considering IRS Settlement Offer (2) (Bloomberg News
Sep. 17, 2019).
13. Caylor Land & Development,
Inc. et. al. v. Commissioner, T.C.M. 2021- 30 (March 10,
2021)
14. See Harper Grp. v.
Commissioner, 96 T.C. 45 (1991), aff’d 979 F. 2d
1341 (9th Cir. 1992) (captive insured 7,500 customers covering more
than 30,000 different shipments and 6,722 special cargo policies);
Rent-A-Center, Inc. v. Commissioner, 142 T.C. 1 (2014)
(captive insured three types of risks covering 14,000 employees,
7,000 vehicles, and 2,600 stores); and R.V.I. Guar Co. v.
Commissioner, 145 T.C. 209 (2015) (captive insured one type of
risk through 951 policies covering 714 insured parties with more
than 754,000 passenger vehicles, 2,00 individual real-estate
property, and 1.3 million commercial-equipment assets).
15. See, e.g., PLR 202109002,
PLR 202109003, PLR 202114005, and PLR 202114006.
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