In Matter of Stewart's Shops Corp., No. 525841, 2019 NY Slip Op. 04062, (3d Dep't, May. 23, 2019), the Appellate Division, Third Department, affirmed the decision of the New York State Tax Appeals Tribunal that a corporate taxpayer could not deduct insurance payments made to its wholly owned captive insurance company, because the payments did not qualify as valid insurance premiums under federal income tax law.

Facts. Stewart's Shops Corp. ("Stewart's Shops") owns and operates convenience stores and gas stations in New York and Vermont. After legislation was enacted in 1997 amending the New York Insurance Law to permit the creation of captive insurance companies, Stewart's Shops created a captive insurance company, Black Ridge Insurance Corp. ("BRIC"), to insure some of its self-insured risks. Stewart's Shops met with representative of the Department of Insurance's Captive Insurance Group concerning the new captive insurance program before setting up BRIC and claimed that it had been assured that its premium payments would be deductible for New York State tax purposes under Article 9-A.

On its corporation franchise tax returns for 2006 through 2009, Stewart's Shops deducted the insurance payments. After an audit, the Department of Taxation and Finance disallowed the insurance expense deductions, claiming that because the payments made to BRIC did not qualify as deductible for federal income tax purposes, they were also not deductible for New York purposes. The Department assessed additional tax of nearly $2 million, plus interest and penalties.

The Law. For the tax years at issue, a corporation's entire net income ("ENI") was defined as being "presumably the same as" a corporation's federal taxable income. Tax Law 208(9). While the statute includes numerous modifications to federal taxable income, none of these were relevant to Stewart's Shops' insurance payments to BRIC.

Decisions Below. An Administrative Law Judge ("ALJ") had concluded that Stewart's Shops' insurance payments to BRIC were not deductible for corporate tax purposes, because they did not constitute insurance payments under federal tax law. The ALJ sustained the assessment of additional tax but canceled the penalties, finding that Stewart's Shops had acted reasonably and in good faith. The Tax Appeals Tribunal upheld the ALJ's decision, agreeing that the insurance payments at issue were not deductible for federal income tax purposes, and that federal law controls for purposes of defining ENI unless there is a specific statutory departure, relying heavily on Matter of Dreyfus Special Income Fund, Inc. v. N.Y.S. Tax Comm'n, 72 N.Y. 2d 874 (1988).

Appellate Division Decision. The Third Department agreed with the Tribunal that federal law governed and that Stewart’s Shops was not entitled to the deductions. The statute, Tax Law § 208(9), explicitly provides that ENI is “presumably” the same as federal taxable income, and the court found that federal law controls, since the statute specifically incorporated federal law for the purpose of determining ENI. As the Court of Appeals held in Dreyfus Special Income Fund, the word “presumably” does not provide the Department with the ability to depart from reliance on federal taxable income, but merely means that federal taxable income governs in the absence of a specific state adjustment. Stewart’s Shops did not dispute that its insurance payments to BRIC did not constitute insurance premiums for federal income tax purposes.

The court rejected Stewart’s Shops’ argument that, while there is no explicit deduction allowed for captive insurance premiums, the deduction should be inferred from the creation of captive insurance companies in 1997, because, Stewart’s Shops claimed, the legislature “expressly intended to establish a favorable tax regime” for such companies. The court found that it was Stewart’s Shops’ burden to establish its entitlement to a tax deduction, and that Stewart’s Shops failed to meet that burden. Although the 1997 legislation did set up competitive premium tax rates for captive insurance companies and established certain assessments to be paid by captives, it did not amend Tax Law § 208(9) to decouple from the applicability of federal law in determining the deductibility of premiums paid to captive insurers. The court held that Stewart’s Shops’ “conclusory assertion” that the “tax deductibility of premiums was a critical part” of the new insurance legislation was unsupported by any clear provision in the 1997 statute, and that the Legislature is presumed to be aware that federal law governed for tax purposes, but did not make any statutory amendment governing deductibility.

The court also found no support in the record for Stewart’s Shops’ allegation that it had been provided with an “affirmative representation” by the Insurance Department that its payments to BRIC would be tax deductible, noting that the head of the Captive Insurance Group testified that he did not recall making any representations regarding tax deductibility, and Stewart’s Shops never sought an informal or advisory opinion from the Insurance Department prior to creating BRIC.

Because the court found no ambiguity regarding the applicability of federal law, it concluded that it did not need to consider whether the 1997 Insurance Law and Tax Law § 208(9) must be read together, or whether subsequent amendments in 2009 and 2014 provide evidence of the Legislature’s intent, since those amendments did not modify the computation of ENI or otherwise permit deductions to a captive insurer.

ADDITIONAL INSIGHTS

The determination that the statute’s definition requiring ENI to “presumably” be the same as federal taxable income has been part of the tax law for generations, and at least since the Court of Appeals decision in Dreyfus Special Income Fund more than 30 years ago it has been found to bar variation from federal taxable income in the absence of specific New York statutory modifications. It has been employed both to protect taxpayers from adjustments sought to be imposed by the Department – as in Dreyfus Special Income Fund, where the court invalidated a regulation under which the Department purported to deny regulated investment companies a deduction for dividends paid to shareholders – and, as in Stewart’s Shops, to deny taxpayers deductions that are not permitted under federal law

Captive insurance companies have become a common corporate insurance vehicle. If certain requirements are met, deductions for payments paid to captive insurers are recognized for federal purposes, and under the Stewart’s Shops decision, these deductions should also be respected for New York State purposes for years governed by pre-2015 law. The court explicitly noted that Stewart’s Shops could have structured its arrangement with BRIC to achieve the risk shifting and risk distribution that are required under federal law to constitute bona fide insurance by, for example, having BRIC insure affiliated companies or reinsuring risk with a third-party insurer. 

Under current New York State and City law, effective for years beginning on or after January 1, 2015, a taxpayer is required by statute to include a captive insurance company in its combined reports where less than 50% of the captive insurance company’s premiums are from arrangements that constitute valid insurance for federal purposes. Tax Law §§ 2, 1500(a) and 1500-b(a). N.Y.C. Admin. Code § 11-651.