In a Technical Advice Memorandum (“TAM”) released by the IRS in July, the IRS determined that a large retailer’s purchase of warranty reimbursement policies from a related captive insurance subsidiary that reimburse the retailer for expenses incurred under its manufacturer’s warranty obligations did not constitute an insurable risk for federal tax purposes. The TAM differentiated between a manufacturer’s warranty (not insurance) and a separate extended warranty which the IRS has previously ruled is insurance for tax purposes.
The retailer sold manufacturer branded products automatically subject to a manufacturer’s warranty. The retailer also sold retailer branded products made by various manufacturers. The manufacturer’s warranty obligations for the retailer branded products were assumed by the retailer in exchange for lower prices through supply agreements with the various manufacturers. To cover the warranty obligations, the retailer entered into expense reimbursement policies with a wholly owned captive insurance subsidiary of the retailer that is domiciled in a foreign country. The foreign captive elected to be taxed as a domestic corporation under I.R.C. § 953(d) and is included in the consolidated annual tax return of the retailer.
While premiums for insurance policies are deductible expenses for federal tax purposes, reserves for estimated liability of warranty repair costs are not.
The IRS relied on the Black’s Law Dictionary definition of a “warranty” and noted that neither the Internal Revenue Code nor its accompanying regulations define the term “insurance” or “insurance contract.” In order to distinguish the meaning of the term “warranty” from the term “insurance” for federal tax purposes, the IRS relied on the long history of case law defining the term “insurance” including: (i) Helvering v. LeGierse, 312 U.S. 531, 539 to 542 (1941) (In order for an arrangement to constitute insurance for federal tax purposes, both risk shifting and risk distribution must be present; and the risk must not be merely an investment or business risk); (ii) Allied Fidelity Corp. v. Commissioner, 572 F. 2d 1190, 1193 (7th Cir. 1978) (The risk transferred must be risk of economic loss); and (iii) Commissioner v. Treganowan, 183 F.2d 288, 290-291 (2d Cir. 1950) (The risk must contemplate the fortuitous occurrence of a stated contingency).
According to the IRS, the distinguishing feature that sets a warranty apart from an insurance policy is the fact that the a manufacturer’s warranty guarantees the integrity of a manufactured item for a period of time, while an insurance contact reimburses a loss caused by an outside force at work, such as a fire or other accident. The warranty is with respect to the work of the manufacturer on the product. It guarantees that the product will work as designed. Thus, the manufacturer’s warranty is imbedded in the product being sold. The IRS distinguished a manufacturer’s warranty from a separately priced extended warranty, which qualifies as insurance for federal tax purposes, by noting that an extended warranty indemnifies the consumer for losses that the consumer may incur beyond those covered by the manufacturer’s warranty and which represent a fortuitous event.
In addition, the IRS determined that any risk that the retailer will pay out more in repairs costs than the amount factored into the price paid to the manufacturer for the product is a business risk rather than a fortuitous one. The IRS concluded that the mere insertion of a third party insurance captive does not create insurance for federal tax purposes where the underlying risk, the manufacturer’s warranty, cannot be the subject of insurance in the first instance. Therefore, the product warranty risks covered by reimbursement policies purchased by retailer do not constitute insurable risks for federal tax purposes, and therefore are not treated as deductible expenses.