On September 21, the United States Tax Court held in favor of the taxpayer inR.V.I. Guaranty Co., Ltd. and Subsidiaries v. Commissioner, 145 T.C. No. 9 (2015). The court concluded that the residual value insurance policies issued by RVI1 qualify as insurance policies for U.S. federal income tax purposes. In reaching its conclusion, the court held that the risks covered by RVI are insurance risks and that the policies otherwise meet the tax test for insurance treatment. Sutherland represented RVI in its administrative proceedings before the Internal Revenue Service (IRS) and in its litigation in the Tax Court.
- The case was the Tax Court’s first opportunity to address whether residual value insurance policies constitute insurance policies for tax purposes. In holding in favor of the taxpayer – consistent with the holdings of courts in non-tax cases and the views of state regulators – the court has clarified the tax treatment of these policies both for the insurance companies that issue them and for the insured parties that are protected by them.
- In determining that residual value policies cover insurance risk and that such policies constitute insurance in its commonly accepted sense, the court placed great weight on the state insurance regulators’ recognition of RVI’s policies as insurance.
- The IRS’s current priority guidance plan item on the issue of what is insurance could provide a vehicle for the IRS to incorporate into its guidance the court’s opinion in R.V.I. v. Commissioner and other recent Tax Court opinions that help define “insurance” for tax purposes.
Background of the Case
RVI. RVIA, a property and casualty insurance company domiciled in Connecticut, was engaged exclusively in the business of issuing residual value insurance policies in 2006. As a consequence, RVIA was required to be, and was, licensed to conduct the business of insurance in Connecticut and in all other states in which it issued residual value insurance policies, including New York, Pennsylvania, Ohio, Texas, Illinois and Georgia. RVIG was incorporated in Bermuda and since its incorporation has been registered and regulated as an insurance company under the laws of Bermuda. Almost all of RVIG’s business in effect in 2006 consisted of reinsuring risks under residual value insurance policies issued by RVIA. RVIG also reinsured residual value insurance policies issued by other insurance companies. RVIG elected under section 953(d) of the Internal Revenue Code (Code) to be treated as a domestic corporation and is the common parent of the consolidated group that includes RVIA.
Residual Value Insurance Policies. The residual value insurance policies were recognized as insurance contracts for non-tax purposes by Connecticut’s insurance regulators. The residual value insurance policies included standard insurance terminology and policy provisions typical of other insurance policies, including provisions for claims, payment of losses, exclusions, and conditions of coverage similar to other insurance policies. RVI issued the policies to insureds engaged in the business of leasing assets to others and in the financing business. Each policy indemnified the insured against loss the insured incurred in the event a leased asset or assets insured under the policy had a fair market value at lease termination (i.e., residual value) that was less than the insured value (which typically was less than the residual value projected at lease inception). Subject to the terms and conditions of the policy, if the value of the leased property decreased during the lease term below its estimated value at lease termination, RVI would pay the shortfall to the insured lessor. The assets RVI insured were passenger vehicles, aircraft, rail cars, and industrial equipment that the insured parties leased to third parties.
IRS Determination. The IRS determined that the taxpayer’s residual value insurance policies did not qualify as insurance contracts for tax purposes. The IRS’s arguments in the case were substantially the same as its position in TAM 201149021 (August 30, 2011). The IRS determined that the residual value insurance policies at issue in the TAM did not qualify as insurance contracts for tax purposes because they did not cover insurance risks, were not insurance in the commonly accepted sense, and failed to distribute risk. At trial, the IRS also argued that certain of RVI’s policies did not shift risk.
The IRS’s position was based chiefly on a determination that the residual value insurance policies offered protection against investment losses (i.e., investment risk or business risk) and not insurance risk. Consequently, the IRS determined that gross income and expenses under the policies could not be accounted for under rules specific to insurance contracts under section 832 of the Code and instead had to be accounted for under the general rules for recognizing income and claiming expenses in sections 451 and 461 of the Code. The IRS argued that the taxpayer had to recognize taxable income under section 451 in the amount of the premiums received when the policies were executed, but could not claim any deductions under section 461 for losses incurred until the end of a policy’s term. As a result of this mismatching of income and expenses, the IRS determined a deficiency of $55,197,620 for RVI’s 2006 taxable year.
The Tax Court’s Analysis
Both parties agreed that the Tax Court’s three-pronged test from AMERCO v. Commissioner, 96 T.C. 18 (1991), aff’d, 979 F.2d 162 (9th Cir. 1992), should apply to determine whether the policies at issue qualified as insurance contracts for tax purposes. The test requires an insurance policy to meet all of the following requirements in order to constitute insurance for federal income tax purposes: (1) an insurance risk, as opposed to an investment risk or other non-insurance risk, must be present; (2) the transaction must involve risk shifting and risk distribution; and (3) the arrangement must resemble insurance in its commonly accepted sense.
The Tax Court applied the three-pronged test for what is insurance and held that the residual value insurance policies at issue satisfied all three prongs of the test. In determining the central issue in the case – whether the policies insure against an insurance risk – the court focused on the fact that the states have regulated, as insurance, policies that provide coverage against a decline in the market values of particular assets, and the taxpayer’s regulators and external auditors have uniformly concluded that its policies involve insurance risk.
On the issue of risk shifting, the court held that the policies shifted a sufficient amount of risk for tax purposes, stating: “We have no difficulty concluding that the lessors and finance companies that purchased the RVI policies transferred to petitioner a meaningful risk of loss.” The IRS argued at trial that the policies shifted some but not enough risk, but the court found this argument “unpersuasive on both theoretical and evidentiary grounds.”
On the issue of risk distribution, the court noted the number of different insured parties covered by RVI’s policies in 2006, but it focused more on the fact that RVI had a “vast array of different risk exposures,” including 754,532 passenger vehicles, 2,097 individual real estate properties, and 1,387,281 commercial equipment assets. Cf. Rent-A-Center v. Commissioner, 142 T.C. 1 (January 14, 2014) (finding, inter alia, that there was risk distribution based on the number of risk units) and Securitas v. Commissioner, T.C. Memo. 2014-225 (October 29, 2014) (same).
With respect to the requirement that the arrangement at issue constitutes insurance in its commonly accepted sense, the court analyzed the following factors: (1) whether RVI was organized, operated and regulated as an insurance company by the states in which it did business, (2) whether RVI was adequately capitalized, (3) whether the residual value insurance policies were valid and binding, (4) whether the premiums were reasonable in relation to the risk of loss, and (5) whether the premiums were duly paid and the loss claims were duly satisfied. The court gave significant weight to the first factor, because the court recognized that, under the McCarran-Ferguson Act, Congress delegated to the states the exclusive authority (subject to specific statutory exceptions) to regulate the business of insurance.
The court’s emphasis on the importance of the treatment of a policy as insurance by its state regulators for purposes of determining whether there is an insurance risk and insurance in its commonly accepted sense confirms the long-held position of the insurance industry.