On September 21, 2015, the U.S. Tax Court released its decision in R.V.I. Guaranty Co. v. Commissioner (RVI), 145 T.C. No. 9, and ruled that the taxpayer’s residual value insurance contracts constituted insurance for U.S. federal income tax purposes. As a result, the taxpayer was able to more closely match premium inclusions with loss deductions. This case represents a third victory for taxpayers with respect to the definition of insurance for tax purposes, following Rent-A-Center v. Commmissioner, 142 T.C. 1 (2014), and Securitas Holdings, Inc. v. Commissioner, T.C. Memo. 2014-225.
R.V.I. Guaranty Co. Ltd. (RVIG), is a Bermuda corporation registered and regulated as an insurance company under the Bermuda Insurance Act of 1978. As an electing domestic taxpayer under Internal Revenue Code (Code) § 953(d), RVIG is the common parent of an affiliated group of corporations that includes R.V.I. American Insurance Company (RVIA), a property and casualty insurance company domiciled in Connecticut. RVIG and RVIA are together referred to as the “taxpayer.”
During the years at issue, the taxpayer sold residual value insurance. Residual value insurance policies are generally offered to leasing companies, manufacturers and financial institutions, and cover assets such as passenger vehicles, commercial real estate and commercial equipment.
The policies operate to protect the insured against the risk that the value of the insured asset at the end of the lease term will be lower than the expected value. For example, an insured may be a vehicle leasing company. In setting the periodic lease payments, the insured must estimate the residual value of the vehicles on termination of the lease. A residual value insurer covers against the risk that the actual value of the vehicles upon termination of the lease will be lower than the expected value.
During RVIG’s 2006 audit, the Internal Revenue Service (IRS) concluded that the policies were not “insurance” for U.S. federal income tax purposes, based largely on the IRS’s determination that the policyholders were purchasing protection against investment or business risk rather than insurance risk. The IRS assessed a deficiency of more than $55 million, and the taxpayer timely petitioned the Tax Court for redetermination of this deficiency.
U.S. Federal Tax Definition of Insurance
The fundamental issue addressed by the Tax Court was whether the residual value insurance contracts protected the insured against an investment risk or an insurance risk. Neither the Code nor the Treasury Regulations define the term “insurance,” but over the years a body of law has developed, and the following guiding principles have emerged:
- Insurance involves both risk shifting and risk distribution. The risk of loss must shift from the insured to the insurer, and the insurer must pool multiple risks of multiple insureds in order to diversify its exposure; this is known as the “law of large numbers.”
- The transaction must constitute insurance in its commonly accepted sense.
- Especially relevant to the R.V.I. decision, the risk transferred must be an “insurance risk.”
Against that framework, and notwithstanding the fact that commercial insurance companies have offered residual value insurance for more than 80 years, the IRS concluded that the contracts protected the insureds against investment risk and thus were not insurance for tax purposes.
At trial, the taxpayer’s experts concluded that the policies covered an insurance risk, much like mortgage guaranty insurance. The taxpayer’s experts also concluded that the risks were distributed in the same way as any other property and casualty carrier, that the taxpayer was subject to underwriting risk and that the risk was transferred.
The IRS countered with three experts who concluded that the policies covered a speculative risk, much like a stock investment. While the IRS’s experts acknowledged that the risks were distributed, they also concluded that the risks were highly correlated, thus challenging the notion that the aggregate risk was truly distributed.
After admitting to a methodological error, the IRS’s experts seemingly conceded that the taxpayer had a significant risk of loss. Nevertheless, the experts concluded that the policies were not typical insurance policies, i.e., not insurance in the commonly accepted sense, because they did not insure against a fortuitous event and the insurer did not face any timing risk.
The Tax Court dispensed with the IRS’s contentions regarding risk shifting and risk distribution by concluding that the taxpayer’s actual loss experience demonstrated that it bore a significant risk of loss (thus, risk had been shifted) and that there was meaningful risk distribution. There were more than two million separate risk units of varying types (passenger vehicles, real estate properties and commercial equipment), and the risk units were distributed over varying lease terms.
While the court acknowledged that the risks could be correlated to, for example, a recession, the court noted that the diversification achieved within the asset pool and lease terms mitigated any systemic risk. Moreover, the court observed that many insurers face systemically correlated risks. The taxpayer’s business model was not materially different than the business model of those insurers.
Investment or Insurance Risk
The court then rejected the IRS’s contention that the policies covered an uninsurable “investment risk.” The court considered first whether the contracts were insurance in the commonly understood sense of the word.
It framed its analysis by considering five factors:
- Whether the insurer was organized and operated as an insurance company by the states in which it conducted business (taxpayer was)
- Whether the insurer was adequately capitalized (taxpayer was)
- Whether the insurance policies were valid and binding (taxpayer’s contracts were)
- Whether the premiums were reasonable in relation to the risk of loss (premiums were negotiated at arm’s length between taxpayer and its insureds)
- Whether premiums were duly paid and loss claims were duly satisfied (when losses occurred, insureds filed claims and taxpayer paid those claims)
Even though the taxpayer readily met the five requirements, the IRS concluded that the policies did not qualify as insurance because they differed from policies with which most people are familiar. The IRS noted that the policies did not pay on the occurrence of a “fortuitous event,” such as a car crash. Rather, the policies paid, if at all, at the end of the lease term, which was not random or fortuitous. The court, however, held that losses under the policies were caused by fortuitous events outside the control of the taxpayer. The fact that a loss must persist to the end of the term of the lease does not make the events that cause the loss (e.g., recession, interest rate spikes, bank failures) any less fortuitous, the court stated. Thus, the Tax Court concluded that the contracts were insurance in the commonly accepted sense.
The court next considered whether the contracts covered insurance risk. The court acknowledged that there was little guidance with respect to the difference between “insurance risk” and “investment risk.” The court determined that the policies involved insurance risk from the taxpayer’s perspective.
The taxpayer’s business model depended upon more than investment returns; its model depended on the ability of its underwriters to price the risks to derive a sufficient pool of premiums to cover the aggregate losses. This is the same pricing model used by insurance companies generally.
The court also determined that the policies were insurance risk from the perspective of the insureds. The court first looked to state law and noted that New York and Connecticut had defined residual value policies as a form of “insurance” since 1989, and in 1991 the Washington Supreme Court had reached the same conclusion.
The taxpayer’s regulators and external auditors uniformly reached the same conclusion. The court then scrutinized the nature of the risk itself. The court declined to accept the narrow definition of risk offered by the IRS and instead looked to the more practical guidance offered by the taxpayer.
The insured simply has to shift to the insurer the risk from a “hazard,” a “specific contingency,” or some “direct or indirect economic loss.” The residual value insurance contracts offered by the taxpayer did just that. The insured shifted to the taxpayer the risk that the covered property would decline in value. The types of events that resulted in a loss under the policies closely resembled the losses under, for example, mortgage guaranty insurance—a product long accepted as insurance.
Having concluded that the policies had the hallmark features of insurance (risk shifting, risk distribution, commonly accepted notions of insurance, and insurance risk) the court determined that the policies were insurance for U.S. federal income tax purposes.