On March 30, 2010, Sec. 7701(o), which codified the economic-substance doctrine, became law as part of the Health Care and Education Reconciliation Act of 2010, P.L. 111-152. This provision provides that for any transaction to which the economic-substance doctrine is relevant, the transaction is treated as having economic substance only if:
- It changes in a meaningful way (without considering federal or state income tax effects) the taxpayer’s economic position, and
- The taxpayer has a substantial purpose (not including federal and state income tax effects) for undertaking the transaction.
The new provisions also added a special rule for testing the profit potential of a transaction. Sec. 7701(o)(2) provides that where a taxpayer asserts that the transaction’s profit potential satisfies the economic-substance requirement, the taxpayer must establish that the present value of the reasonably expected pretax profit from the transaction is substantial in relation to the present value of the net tax benefits (pretax profit less fees and transaction expenses).
Guidance on the economic-substance doctrine’s codification was provided in Notice 2010-62 and applies to transactions entered into on or after March 31, 2010. The notice clarifies that the IRS will still rely on prior case law in determining whether the two-prong conjunctive test of Sec. 7701(o)(1) has been met, but will challenge taxpayers that rely on prior case law that determined the economic-substance test had been met merely because it satisfied one prong of the test.
The notice also states that the IRS will apply prior case law in determining whether the present value of the reasonably expected pretax profit is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected for federal income tax purposes. The notice does not provide specific guidance on how to compute the present value, such as what interest rates to use in computing the present value or a specific percentage to use in determining whether the profit was substantial compared to the net tax benefits. The notice also states that the IRS will not issue private letter rulings on whether the economic-substance doctrine is relevant to any transaction or whether a specific transaction meets the economic-substance test of Sec. 7701(o).
Captive Insurance Companies
Because Sec. 7701(o) was only recently enacted and certain sections of the new law are ambiguous, it is not clear that the new law applies to captive insurance companies. The new law applies only to transactions where the economic-substance test is relevant. The Joint Committee on Taxation’s report states:
The provision is not intended to alter the tax treatment of certain basic business transactions that, under longstanding judicial and administrative practice are respected, merely because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages. [Joint Committee on Taxation, Technical Explanation of the Revenue Provisions of the “Reconciliation Act of 2010,” as Amended, in Combination With the “Patient Protection and Affordable Care Act” (JCX-18-10), p. 152 (March 21, 2010)]
One example cited by the report to which the economic-substance doctrine was not intended to apply was the choice to use a related-party entity in an arm’s-length transaction. The Joint Committee stated:
If the realization of the tax benefits of a transaction is consistent with the Congressional purpose or plan the tax benefits were designed by Congress to effectuate, it is not intended that such tax benefits be disallowed. [Id., at 152, n. 344]
In light of the Joint Committee comments, there appears to be an argument that the economic-substance doctrine should not apply to the choice of whether to do business as a regular corporation or as an insurance company. One could argue that Congress clearly intended for an insurance company to have specific tax benefits and that, if one carries on the business of insurance, it is consistent with congressional purpose to segregate this business in a separate entity to achieve those tax benefits.
However, the business-purpose and economic-substance analyses have been applied to captive insurance companies before Sec. 7701(o) was enacted. For example, in United Parcel Service of America, Inc., 254 F.3d. 1014 (11th Cir. 2001), rev’g T.C. Memo. 1999-268, the IRS argued that United Parcel Service (UPS) premium payments to National Union Fire Insurance Co. (National Union) for insurance on excess-value packages, which were reinsured by Overseas Partners Ltd. (OPL), originally a UPS foreign subsidiary, should be gross income to UPS because there was no business purpose to the transaction with OPL, the charges were above the norm, and the main motivation of the transaction was tax avoidance.
In its discussion of the case, the Eleventh Circuit determined that the kind of economic effect required for this type of transaction was whether the arrangement resulted in “genuine obligations enforceable by an unrelated party.” The court found that the contract between UPS and National Union gave National Union the right to receive the excess-value charges and that National Union had assumed the risk for losses on the excess-value shipments. The court stated that “[e]ven if the transaction has economic effects, it must be disregarded if it has no business purpose and its motive is tax avoidance.” It noted that the Tax Court did not find that there was any business purpose in the transaction because the excess-value business operated effectively the same before and after the restructuring. The court concluded that the business-purpose test was met if the transaction was part of a “bona fide, profit-seeking business” and that it did not require the transaction to be “free of tax considerations.” Since this case addressed both economic effect and business purpose, based upon Notice 2010-62, it would appear to still have relevance under the new law.
Additionally, a Sixth Circuit case, Humana Inc., 881 F.2d 247 (6th Cir. 1989), also discussed business purpose with respect to captive insurance companies. This case involved a hospital group that formed a captive to provide insurance for the parent and brother-sister subsidiaries. Although the court addressed business purpose, it did not explain what it was. The court held that “Health Care Indemnity was formed for legitimate business purposes. Health Care Indemnity and the hospital subsidiaries conduct legitimate businesses and are devoid of sham. No suggestion has been made that the premiums were overstated or understated.” Thus, it appears that at least some form of business-purpose test has historically been applied to captives.
Economic-Substance Test and Captive Insurance Companies
In light of the lack of guidance on whether the new codified economic-substance rules apply to captive insurance companies, it is prudent to assume that the law does apply. Based on the UPS decision, the economic-effect test for captive insurance companies should be manageable. Arm’s-length premiums documented by independent actuarial reports, capital surplus in excess of reserves, the absence of loans from the captive to related parties, and no guarantees from related parties for the captive’s obligations would support the proposition that the economic-effect test was met.
Because the cost of operating as a regulated entity is higher than self-insuring risks and there is no guidance on how to apply the present-value test, it may be difficult to ascertain whether the profit-motive test can be established for a captive that only insures related entities. Therefore, it will be important to document the business purposes for establishing the captive other than state and federal income tax benefits. For example, captive insurance companies are often used in estate and succession planning. It is extremely important to not just document the initial reasons for forming a captive but also to follow up with supporting evidence. For example, if one of the reasons for forming a captive is to improve cost control and enhance risk management, document the new controls and program and provide evidence of additional safety training.
In summary, the ambiguities of the new economic-substance provisions give the IRS some discretion in applying the rules to a particular transaction. Therefore, it is imperative to have a clear evidentiary trail establishing that the captive was formed and operated for business purposes other than just tax savings. The better the evidence, the less likely it is that the doctrine will be invoked, avoiding what could be a very costly defense.
Frank J. O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, Ill.
For additional information about these items, contact Mr. O’Connell at 630-574-1619 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.