On February 4, 2008, the Internal Revenue Service will publish Revenue Ruling 2008-8 and Notice 2008-19, addressing tax issues arising in the context of insurance provided by “protected cell companies” i.e., generally, companies that consist of an array of separate cells, each of which is economically and legally insulated from the others.
Rev. Rul. 2008-8 and Notice 2008-19 build on the proposition, which is vigorously advocated by the IRS and supported by case law, that risk pooling and risk distribution are essential elements of insurance and must be present in any arrangement that is treated as insurance for tax purposes -- for example, in determining whether payments characterized as insurance premiums are deductible. The thrust of Rev. Rul. 2008-8 and Notice 2008-19 is that, in assessing whether risk pooling and risk distribution are present in purported insurance arrangements involving protected cell companies, the IRS will treat each cell as a separate entity and will not amalgamate the individual cells into a single entity. In other words, risk transfer and risk pooling may occur within the individual cells of a protected cell company, but not across the cells.
Protected cell companies have typically been used in captive insurance arrangements. In that context, some have argued that risk shifting and risk distribution should be determined by looking at the protected cell company as a whole and not confining the analysis to each separate cell. According to this argument, if a corporation establishes an individual cell in a protected cell company and that cell insures only risks of the corporation, the arrangement could nevertheless qualify as insurance if there is a sufficient number of other parties insured by other cells within the same protected cell company.
Rev. Rul. 2008-8 and Notice 2008-19 reject this argument. As discussed below, Rev. Rul. 2008-8 considers whether premiums paid to a cell of a protected cell company are deductible as “insurance” premiums. Click here for a copy of Rev. Rul. 2008-8. Notice 2008-19 announces, and requests commentary on, proposed guidance on the status of a cell as an “insurance company” for tax purposes and consequences of that status. Click here for a copy of Notice 2008-19
Revenue Ruling 2008-8
Rev. Rul. 2008-8 addresses a protected cell company which is a legal entity that has established multiple accounts or “cells,” where each cell has its own name and is identified with one or more specific participants, but is not a legal entity distinct from the protected cell company. Each cell is required to pay out claims with respect to insurance contracts to which it is a party. The cell is funded by its participants’ capital contribution and by premiums collected from contracts to which the cell is a party. The income, assets, liabilities, and capital of the cell and the protected cell company are accounted for separately. The assets of each cell are statutorily protected from the creditors of any other cell and from creditors of the protected cell company. In the event that a participant ceases its participation in the protected cell company, the participant is entitled to a return of the assets of the cell in which it participated.
Revenue Ruling 2008-8 considers whether certain arrangements between a participant and a cell of a protected cell company in a captive insurance setting constitute “insurance” for Federal income tax purposes. In particular, insurance premiums against fire, storm, theft, accident, or other similar losses that are ordinary and necessary business expenses may be deducted under Internal Revenue Code section 162. The ruling notes that neither the Code nor the regulations define “insurance” for this purpose, but court decisions and IRS rulings generally conclude that “insurance” entails both risk shifting and risk distribution:
- Risk shifting occurs where the possibility of an economic loss is transferred, at least in part, from the insured to the insurer.
- Risk distribution occurs when the party assuming the risk distributes its potential liability among others, at least in part.
- The ruling addresses two scenarios involving the protected cell company and its cells.
- In the first scenario, a cell has a single participant that owns all the preferred stock issued in respect of that cell. (The common stock is owned by the sponsor of the protected cell company.) The cell annually insures the professional liability risks of the participant, either directly or as a reinsurer, and does not enter into arrangements with any other entities. The capital of the cell consists entirely of the participant’s capital contributions and premium payments. The Service ruled that although the cell and the participant consistently conducted themselves in a manner consistent with insurance arrangements between unrelated entities, this structure does not constitute “insurance” for tax purposes. The Service reasoned that the arrangement is akin to an arrangement between a parent and its wholly owned subsidiary where there is no unrelated risk; in the event of a claim, payment would be made to the participant out of its own premiums and contributions to the cell without the pooling deemed necessary for risk shifting and distribution and thus tax treatment as “insurance.”
- The second scenario varies the facts in one respect: a parent company owns the preferred stock of the cell, which insures the professional liability risks of twelve domestic subsidiaries of that parent. Each subsidiary operates on a decentralized basis and each enters into a separate arrangement with the cell. Together, the subsidiaries have a significant volume of independent, homogeneous risks. The cell again does not enter into arrangements with any other entity. In this case, the Service found that, consistent with case law and its previous rulings with regard to risk shifting and risk distribution in captive insurance contexts, the arrangements between the cell and each subsidiary do constitute insurance for federal income tax purposes and that amounts paid pursuant to those arrangements are deductible as insurance premiums under section 162. The Service emphasized that the premiums of each subsidiary are pooled such that a loss by one subsidiary is not, in substantial part, paid from its own premiums. The Service stated that an identical relationship between the parent and a sibling corporation regulated as an insurance company would constitute insurance, and that the protected cell company structure does not change that result.
In Notice 2008-19, the IRS and the Treasury announced their intention to publish guidance on the status of a cell as an “insurance company” within the meaning of Code sections 816(a) and 831(c). The proposed guidance would provide that a cell is treated as an insurance company separate from any other entity if:
- the assets and liabilities of the cell are segregated from the assets and liabilities of any other cell and from the assets and liabilities of the Protected Cell Company, and thus protected from the creditors of any other cell or creditors of the Protected Cell Company; and
- based on all the facts and circumstances, the arrangements and activities of the cell, if conducted as a corporation, would result in classification as an insurance company for federal income tax purposes.
The proposed guidance would also include certain rules governing the effect of treatment of a cell as an insurance company:
a) Tax elections available to any cell company treated as an insurance company must be made by the cell itself and not the protected cell company of which it is a part
b) A cell subject to U.S. tax jurisdiction would be required to apply for and receive an Employer Identification Number.
c) The activities of the cell would be disregarded for purposes of determining the status of the protected cell company as an insurance company for federal income tax purposes.
d) The cell (or, in certain circumstances, its parent would be required to complete all applicable federal income tax returns and pay all required taxes with respect to its income.
e) The protected cell company may not take into account any items of income, deduction, reserve or credit with respect to any cell that is treated as an insurance company under the provisions of this rule.
The proposed guidance would be effective for the taxable year beginning 12 months after the publication of final guidance, with no inference regarding the treatment of a cell that does not meet the requirements to be treated as an insurance company or regarding the treatment of the protected cell company of which it is a part.
The Service invited comments primarily on: (a) necessary transition rules for protected cell companies and cells that are not currently following the rules under the proposed guidance, or for cells that may qualify as an insurance company for some years but not others; (b) any necessary reporting requirements; (c) whether different rules should apply with respect to foreign entities; (d) treatment of protected cell companies and their cells under the rules regarding consolidated returns; and (e) appropriate guidance concerning similarly segregated arrangements that do not involve insurance. Comments are due 90 days after publication of the Notice.