Service Identifies “Listed Transaction” Insurance Arrangement

In Notice 2002-70 the Service added to its “listed transactions” an insurance arrangement involving an insurance company subject to beneficial Federal income tax treatment.

The transaction generally concerns a U.S. service provider, automobile dealer, lender or retailer that offers its customers the opportunity to insure its purchased services or products. The insurance would cover repair or replacement of products broken, lost, stolen or damaged, or a customer's payment obligations if he or she dies, or becomes disabled or unemployed.

The taxpayer offers the insurance by acting as an insurance agent for an unrelated insurance company, and receives a sales commission equal to a percentage of the premiums paid. The taxpayer forms a wholly owned corporation, typically in a foreign country, to reinsure the policies and sends the premiums it receives to the unrelated insurance company, which reinsures a portion of the premiums to the taxpayer's insurance company.

The taxpayer’s insurance company is entitled to certain tax benefits allowed to small insurance companies under (1) Sec. 501(c)(15) (nonlife insurance companies are tax exempt if premiums written for the year do not exceed $350,000), (2) Sec. 806 (providing a deduction for certain life insurance companies whose incomes do not exceed $15 million) or (3) Sec. 831(b) (allowing qualifying nonlife insurance companies, with net written premiums between $350,000 and $1.2 million, to be taxed solely on investment income).

IRS Challenges

The IRS will challenge these insurance arrangements on several grounds. First, it may assert that a taxpayer's insurance company is not an insurance company for Federal income tax purposes. In making that determination, the Service will consider, among other things, (1) the size and activities of any staff, (2) whether the company engages in other trades or businesses and (3) the company's income sources. If the Service determines that a company is not qualified, it will deny it benefits under Sec. 501(c)(15), 806 or 831(b).

If the taxpayer’s insurance company is a foreign corporation that elected to be treated as a domestic corporation under Sec. 953(d), the election will not be valid, and the IRS will treat the company as a controlled foreign corporation under Sec. 957. The company will thus be treated as a U.S. shareholder of the taxpayer and will have to include in its gross income any of the taxpayer's subpart F income.

Second, the Service may determine that, as a result of the insurance transaction, the taxpayer’s income is inconsistent with Sec. 482’s arm’s-length standard, and apply Sec. 482 or 845 to allocate income from the foreign company to the taxpayer.

Third, if the Service concludes that the arrangements are shams in fact or in substance, it may disregard the insurance and reinsurance arrangements and require the company to recognize income on an additional portion of the premiums it receives from its customers. If these arrangements are disregarded, the Service will treat the taxpayer's foreign insurance company's income as part of the taxpayer's income.

Scope

The term “listed transaction” includes transactions that are the same as, or “substantially similar to,” the transaction described in Notice 2002-70. A transaction is substantially similar to a listed transaction if it would result in the same or similar types of tax benefits and is either factually similar to or based on the same or a similar tax strategy; see Temp. Regs. Sec. 1.6011-4T(b)(1)(i). The regulations require that the term substantially similar be broadly construed.

The transactions described in the notice appear to have two significant elements:

1. The insurance is sold to customers in connection with the taxpayer’s products or services; and

2. The taxpayer’s insurance company claims a benefit as a small company under Sec. 501(c)(15), 806 or 831(b).

Notice 2002-70 may apply to business structures put in place many years ago.

From Marc D. Levy, Washington, DC