In Chief Counsel Advice (CCA) memorandum 201511021, the Internal Revenue Service (IRS) considered whether a contractual arrangement transferring foreign currency (FX) risk to a captive insurance company resulted in insurance for federal income tax purposes. After considering the tax definition of insurance, the IRS concluded that the arrangement should be taxed as a foreign currency derivative—rather than insurance—based largely on its view that the FX risk at issue did not qualify as an “insurance risk.”
The FX Arrangement
The Taxpayer Group in the CCA is described as a group of related entities engaged in the design, manufacture, etc., of products and services in the environmental and life sciences sectors. The Taxpayer Group includes a regulated state law captive insurance company (“Captive”) that provides coverage to the Taxpayer Group for a variety of risks.
Members of the Taxpayer Group engaged in sales and purchases in multiple currencies and were therefore exposed to risk of exchange rate fluctuations relative to the US Dollar (USD) that could adversely impact their results of operations and financial condition. To manage their FX risks, members of the Taxpayer Group entered into two types of contracts with Captive (“Contracts”). In exchange for a premium, Captive agreed to indemnify participating members for the “loss of earnings” resulting from a decrease (“Contract 1”), or an increase (“Contract 2”), as the case may be, in the rate of exchange of the USD against the specified foreign currency during the term of the contract up to the stated coverage limit. The loss of earnings provision did not measure the actual loss suffered by a participating member as a result of exchange rate fluctuations, but rather provided a reasonable approximation of the participating member’s actual loss. The CCA notes that no individual participant was expected to account for more than 15 percent of the premiums paid to Captive with respect to the Contracts.
The CCA indicates that the Contracts included many features commonly found in insurance policies. The Contracts excluded any loss otherwise covered under property insurance or business interruption insurance. There is no mention of any parental guarantee, premium loan back, or any other aspect of the arrangement that could be viewed as inconsistent with a bona fide insurance arrangement. The Contracts included an endorsement pursuant to which coverage was extended monthly. This monthly endorsement apparently operated to stagger coverage for twelve separate annual policies, which provided protection against a trend of a strengthening or weakening dollar (depending on which side the coverage related to).
Participating members of the Taxpayer Group paid deposit premiums to Captive upon entering into the Contracts. Deposit premiums were determined by multiplying the “rate of premium” by the coverage limit, with the rate of premium being set at twice the amount of the premium, as quoted by Bloomberg on the effective date, as a percentage of “notional” for a 12-month call option contract to purchase USD against the specified foreign currency. The actual premium was calculated after the Contract expired, based on the actual loss experience, as the lower of the “retrospective adjusted premium” (determined by reference to a specified percentage of the deposit premium less paid losses in excess of a specified percentage of the deposit premium) and the deposit premium. If the retrospective adjusted premium was less than the deposit premium, Captive refunded the difference to the participant; if the retrospective adjusted premium was greater than the deposit premium, however, the participant was not required to pay an additional premium to Captive.
Tax Definition of Insurance
The CCA summarizes existing guidance for determining whether an arrangement can be classified as insurance for federal income tax purposes, which has largely been developed by the courts due to the absence of an insurance definition in the Internal Revenue Code or the Treasury regulations. The courts have generally defined insurance as an arrangement involving (1) an insurance risk; (2) risk shifting and risk distribution; and (3) insurance in its commonly accepted sense.
Under the relevant authorities, the existence of an insurance risk is a prerequisite to classifying an arrangement as insurance for tax purposes. An insurance risk requires an element of fortuity or hazard, as opposed to a “risk of another nature, such as investment, or perhaps synonymously, ‘business risk.’” The CCA notes that failure to achieve a desired investment return is “investment risk,” not “insurance risk.”
In evaluating the character of the underlying risk in a purported business insurance arrangement, all of the facts and circumstances associated with the parties and the context within which the arrangement was constructed are to be taken into account. This includes the nature of activities considered typically attendant to the operation of the business, what activities are in control of the parties, whether the risk at issue is a market risk, whether the insured is required by law to pay for the covered claim, and whether the action is willful or inevitable.
Classification of the Contracts
The IRS concluded that the Contracts did not satisfy the tax definition of “insurance” as established by the courts, based on its determinations that the Contracts lacked an insurance risk and failed to constitute insurance within the commonly accepted meaning.
Lack of Insurance Risk
Noting generally that contracts that transfer risk are not automatically classified as insurance for tax purposes, the CCA concludes that the Contracts transferred investment (or business) risk, as opposed to insurance risk, as the FX risk underlying the Contracts “is solely the manifestation of fiat currency valuation.” It noted that while Statement of Statutory Accounting No. 60, Financial Guaranty Insurance, describes protection against currency exchange rate risk as insurance, FX insurance does not appear to be commonly available from major carriers, and FX risks are typically managed with derivative contracts. The CCA states that the Contracts resemble notional principal contracts or other section 988 transactions rather than insurance contracts. The CCA cites for support the fact that Contract premiums were determined by reference to commercially available pricing information for currency options (derivatives) and that the Contracts were “layered” through endorsements that expired monthly, producing periodic monthly settlements based on the trailing 12 months’ results. The CCA also notes that retrospective rating is common but observed that it was not clear that the formula in the Contracts was consistent with common retrospective rating methodologies. It appears that the IRS was influenced by the fact that the taxpayer represented that the Contract’s loss of earnings provision did not measure actual losses suffered by participating members as a result of changes in FX exchange rates, but rather provides a reasonable approximation” of actual losses.
The IRS also was influenced by its belief that the participants were primarily interested in making a profit, noting that failing to achieve a profit is an investment risk and the purchase of FX protection does not change the underlying nature of the risk but rather “only reduces or eliminates that risk.”
Commonly Accepted Definition of Insurance
In addition to concluding that the Contracts lacked insurance risk, the CCA also concludes that the Contracts were not insurance in its commonly accepted sense. While the CCA acknowledges that the Contracts had many features typically found in insurance policies, according to the CCA, the Contracts did not contemplate a casualty (fortuitous) event, but instead indemnified participants for loss of earnings due to changes in FX exchange rates. The IRS’s analysis of whether the Contracts constituted insurance within the commonly accepted definition was largely limited, however, to a discussion of its views on whether the underlying risk was an insurance risk.
Observations on the CCA’s Analysis of Insurance
The CCA should be taken for what it’s worth, which is a one-sided expression of the IRS’s views as to the proper tax characterization of particular transactions. Nevertheless, the CCA is important in that it reflects the IRS’s current thinking on the issue of whether contractual protection can give rise to insurance risk rather than business or investment risk. This issue currently is being addressed in R.V.I. Guaranty Co., Ltd. v. Comm’r (Docket No. 27319-12) (RVI). The primary issue in RVI is whether residual value insurance policies issued to unrelated insureds result in insurance for federal income tax purposes. Residual value insurance is generally purchased by the owner of leased property and protects against decline in value of such property at the end of the lease term. The IRS’s position in RVI is that the policies are not insurance because, among other things, they do not cover insurance risk but rather merely operate to protect policyholders against market risk and as a result lack the element of fortuity. In other words, the loss protected by the policies is not a casualty loss but rather is an economic loss arising at the end of the lease itself. In contrast, the taxpayer in RVI argues that the policies relate to an insurance risk because the requisite fortuity is present and the lease agreements give rise to more than mere speculative or investment risk. The taxpayer finds fortuity in the multitude of events potentially leading to the end of the lease agreement. RVI was tried before the Tax Court in September 2014. As of the date of this article, the Tax Court had not issued its opinion.
The CCA’s insurance classification analysis is also important in that it appears to be the first administrative guidance relating to the definition of insurance for tax purposes following the Tax Court’s decisions in Rent-A-Center, 142 T.C. No. 1 (January 14, 2014), and Securitas, T.C. Memo 2014-225. In considering whether the arrangements at issue resulted in insurance for federal income tax purposes, in both cases the Tax Court viewed risk distribution from the perspective of the insurer rather than the insured. The question was whether the captive insurer was exposed to a sufficiently large pool of risks and whether the risks were statistically independent (rather than focusing on the number of insured affiliates). Although neither of these cases was appealed by the IRS, to date the IRS has not acquiesced to the decisions.
The CCA reflects the IRS’s litigating position with respect to insurance risk versus investment or business risk. Whether the CCA will influence the market for contracts such as those considered in the CCA may depend in large part on the Tax Court’s decision in RVI and any subsequent appeal.
Beyond the insurance classification issues addressed by the CCA, it is important to consider the impact of these issues on the parties’ resulting tax consequences. If the Contracts are properly classified as insurance, participating members would be entitled to claim expense deductions for premiums paid to Captive, typically deducted over the life of the contract, and payouts received by participating members of the Taxpayer Group from Captive would be classified as tax-free insurance proceeds.
By contrast, characterizing the Contracts as FX derivatives would mean that participating members would take payouts received from Captive into account in determining whether any such Contracts result in taxable income or loss (with such gain or loss equaling the difference between any payouts received by a participating member and premiums paid to Captive). The Contracts likely would be characterized, for tax purposes, either as options or potentially as currency swaps (due to the monthly endorsements potentially resulting in periodic settlements). It would be expected that any such FX “derivatives” would be classified as “section 988 transactions,” resulting in ordinary gain or loss under section 988 and the regulations thereunder.From Captive’s perspective, if the Contracts are properly classified as insurance, Captive would generally take premiums received into income over the life of the Contracts, and would take an actuarially determined deduction for payouts. By contrast, classifying the Contracts as FX derivatives would result in ordinary gains or losses to Captive under section 988, with income or loss being taken into account under the general timing rules for the type of derivative (which as noted above, would likely result in the Contracts being classified as either options or currency swaps).
Derivative classification also raises an additional question of whether Captive could be considered a dealer in securities under section 475 and the regulations thereunder, which provide that a taxpayer may be considered a dealer in securities even if its only customers are related parties, to the extent such customers include related entities that are not part of the taxpayer’s U.S. consolidated federal income tax group. Securities dealer classification would subject Captive to mark to market accounting under section 475, which could have potential consequences to Captive beyond the Contracts themselves.