Special Industries
Cash Settlement and Note from Investment Adviser Are Qualifying RIC Income
In Letter Ruling 200739010, the Service ruled that a regulated investment company’s (RIC’s) receipt of cash and a note from its investment adviser (IA) are qualifying income under Sec. 851(b)(2). Further, although the note caused a Sec. 851(b)(3) asset-test failure, the IRS ruled that satisfaction of the note within 30 days of the close of the quarter cured the failure.
Facts
A RIC invested in a passive foreign investment company (PFIC), which invested in segregated portfolio companies (SPCs) taxable as partnerships. The SPCs held deposits as collateral for the PFIC’s trading activities with a company that operated as a private bank. At a certain point, the IA to the PFIC and the SPCs requested a return of its invested money from this private bank. After the money was transferred, the bank’s parent company froze all customer accounts, preventing any persons from receiving invested money; the bank and its parent corporation filed voluntary bankruptcy petitions.
The RIC made two tenders to the PFIC for redemption of its PFIC shares. Subsequently, the RIC determined that, as a result of the bankruptcy, its PFIC shares had depreciated between 8% and 30% of the tender fair market value; in addition, the PFIC’s adviser indicated that the shares were not transferable.
Ultimately, to maintain goodwill and its reputation, the IA paid the RIC an amount equal to the amount that would have been paid on the two earlier tenders. The IA transferred cash and a note to the RIC as settlement of its interests in the PFIC and the RIC agreed to give the IA any amounts it received from the PFIC.
The IA satisfied the note and the RIC liquidated the next day by distributing its PFIC shares to a liquidating trust. The RIC represented that the transactions were not entered into to artificially inflate its qualifying income and that, at the close of its quarter, the RIC otherwise satisfied the diversification test of Sec. 851(b)(3) if the value of the note was treated as cash held by the RIC.
Analysis
Generally, to qualify as a RIC, at least 90% of its gross income must be from certain sources, including dividends; interest; gain from the sale or other disposition of stock, securities, or foreign currencies; or other income derived from its business of investing in such stock, securities, or currencies.
Rev. Rul. 92-56 examined the issue of qualifying income of a RIC. It held that if, in the normal course of its business, a RIC received a reimbursement from its investment adviser and the reimbursement was includible in the RIC’s gross income, the reimbursement was qualifying income under Sec. 851(b)(2).
The Service found that in this case, the receipt was income to the RIC. Because the RIC received the cash payment and note from its investment adviser under a settlement agreement in the normal course of its business of investing in stock, securities, or foreign currencies, the receipt of the note and the cash payment by the RIC were qualifying income under Sec. 851(b)(2).
The Sec. 851(b)(3) diversification requirements prevent RICs from concentrating their investment assets in a small number of companies or in certain types of assets. Under Sec. 851(d), a corporation that meets these diversification requirements at the close of any quarter will not lose its status as a RIC because of a discrepancy in a subsequent quarter between the value of its various investments and such requirements, unless the discrepancy exists immediately after the acquisition of any security (or other property) and is wholly or partly the result of this acquisition. A corporation that does not meet such requirements at the close of any quarter, by reason of a discrepancy existing immediately after the acquisition of any security (or other property), shall not lose its RIC status during such quarter if the discrepancy is eliminated within 30 days after the close of that quarter.
In this case, the RIC’s assets did not meet the diversification requirement test of Sec. 851(b)(3) at the close of the quarter. However, by disposing of the note for cash within 30 days of the close of the quarter, the RIC eliminated any discrepancy. Therefore, if the RIC otherwise satisfied the requirements of Sec. 851(b)(3), it will be considered to have met these requirements at the close of the quarter.
Implications
Rev. Rul. 92-56 left some doubt about whether this type of reimbursement was gross income. This letter ruling clearly states the Service’s position that it is income. Given that conclusion, it is not surprising that the Service ruled that the income qualified under the “other income” provision of Sec. 851(b)(2). It is worth noting that the Service treated the payoff of the note within the 30-day cure period as a disposition and that the RIC carefully liquidated the day after that payoff to avoid raising the diversification issue a second time (because the liquidation date is a testing date as well).
From Alan Munro, CPA, Washington, DC
Prop. Regs. Will Eliminate Federal Tax Benefit for Many Captive Insurance Companies
The Service has issued proposed regulations (REG-107592-00 and REG-105964-98) that, if adopted, will eliminate the federal tax benefit associated with most captive insurance companies that are included in a consolidated federal return and insure other members of the consolidated group. The proposed regulations put intercompany insurance transactions between members of a consolidated group on the self-insurance method of accounting. The proposed regulations, if adopted, will apply to intercompany insurance transactions in consolidated return years beginning on or after the date the rules are published as final in the Federal Register.
Background—Deferred Intercompany Transactions
Regs. Sec. 1.1502-13 provides rules for taking into account items of income, gain, deduction, and loss of members resulting from intercompany transactions. The purpose of these regulations is to provide rules to clearly reflect the taxable income and tax liability of the group as a whole, by preventing intercompany transactions from creating, accelerating, avoiding, or deferring consolidated taxable income or consolidated tax liability.
The matching rule is the principal source of single-entity treatment for intercompany transactions (see Regs. Sec. 1.1502-13(c) and Notice 94-49). For each consolidated return year, the matching rule requires the seller and buyer to take into account their intercompany items and corresponding items to reflect the treatment of the seller and buyer as divisions of a single corporation. Single-entity treatment under the matching rule might entail redetermining the attributes of intercompany and corresponding items, including exclusion from gross income or treatment as a noncapital, nondeductible amount. As for timing, the seller’s intercompany items are generally taken into account in each consolidated return year based on the difference between the corresponding items the buyer takes into account and recomputed corresponding items the buyer would take into account if the seller and buyer were divisions of a single corporation. Single-entity treatment is not possible for all intercompany items and corresponding items. The acceleration rule requires the seller and buyer to take into account their items from an intercompany transaction, to the extent the items cannot be taken into account to produce the effect of treating the seller and buyer as divisions of a single corporation.
The regulations adopt a simplifying rule for direct insurance. Under Regs. Sec. 1.1502-13(e)(2)(ii)(A), direct insurance provided by one member to another member is taken into account by both members on a separate-entity basis. Premiums, reserve increases and decreases, and other similar items are determined and taken into account under the members’ separate-entity method of accounting rather than under the matching rule of Regs. Sec. 1.1502-13(c) and the acceleration rule of Regs. Sec. 1.1502-13(d). This exception was intended to avoid the complexity that would result from adjustments needed to produce single-entity results and thus simplify intercompany accounting (see proposed regulation CO-11-91, 1994-1 CB 724).
The exception to the matching rules allows for a federal tax benefit for many captive insurance companies that provide insurance to other members of a consolidated group. For example, a member of a group is allowed a deduction under the all-events and economic performance rules for workers’ compensation liabilities when the loss is paid to the injured employee. However, an insurance company that provides workers’ compensation insurance coverage is allowed a deduction for a reasonable estimate of incurred losses. If the insurance company provides the insurance to other members of a consolidated group, the simplifying exception to the matching rule allows the insurance company its reserve deduction.
The consolidated return regulations do not require the insurance company to match the other member’s method of accounting. As a result, the intercompany insurance can accelerate a deduction. However, under Sec. 846, the insurance company is required to discount its reserve for unpaid losses. While the discounting under Sec. 846 is mechanical and based on insurance industry data, the discounted loss reserve does reflect to some extent the present value of the loss that will be paid in the future.
Proposed Regulations
The Service and Treasury believe that separate-entity treatment for direct insurance transactions is inappropriate when a significant amount of the insuring member’s business arises from transactions with other group members. The proposed regulations provide that, when a significant portion of the captive insurance company’s business is insuring other members of the consolidated group, it is appropriate to take into account the items from the intercompany insurance transactions on a single-entity basis. The members’ items from the insurance transactions are subject to the matching and acceleration rules of Regs. Sec. 1.1502-13.
The proposed regulations call off the simplifying exception to the matching and acceleration rule for direct insurance between members of a consolidated group if a “significant insurance member” insures the risk of another member (the insured member) in an intercompany transaction. The intercompany transaction is taken into account by both members on a single-entity basis. The timing and attributes of items from a premium payment from an insured member to a significant insurance member will be taken into account under the matching and acceleration rules, and the premiums earned from the intercompany payment will not be accounted for by the significant insurance member under the rules of Secs. 832(b)(4) or 807(c). The significant insurance member’s deduction for losses incurred with respect to the intercompany insurance will be taken into account under the rules of Secs. 162 and 461 (the all-events and economic performance rules) rather than Secs. 832(b)(5) or 807(c) (the insurance reserve method of accounting).
A company is a significant insurance member if it is an insurance company subject to tax under subchapter L and 5% or more of the member’s insurance premiums written during the tax year are attributable to insuring risks of other group members. Insurance premiums written during the tax year mean gross premiums written, as defined in Regs. Sec. 1.832-4(a)(4) and as reported by the insuring member under the method prescribed by Regs. Sec. 1.832-4(a)(5), on insurance contracts during the tax year, less return premiums and premiums paid for reinsurance.
Reinsurance transactions engaged in by group members that attempt to circumvent the single-entity rules of Regs. Sec. 1.1502-13(e) may be subject to the anti-avoidance rules of Regs. Sec. 1.1502-13(h). The anti-avoidance rules provide that if a transaction is engaged in or structured with a principal purpose of avoiding the intercompany transaction rules, adjustments must be made to carry out the intercompany transaction rules. For example, if a member enters into an insurance contract with a third-party insurer and the contract is then reinsured with a group member in order to avoid treatment as an intercompany transaction, appropriate adjustments will be made to carry out the intercompany transaction regulations. In addition, Sec. 845 allows the Secretary to allocate, recharacterize, or make other adjustments with respect to two or more related persons who are parties to a reinsurance agreement in order to reflect the proper amount, source, or character of taxable income related to such an agreement.
Request for Comments
The IRS and Treasury have requested comments on several aspects of the proposed regulations, including:
- Whether the status of an insuring member as a “significant insurance member” should be an annual determination;
- Whether the amounts determined under Sec. 832(b)(4)(A) (gross premiums written during the tax year less return premiums and premiums paid for reinsurance) are appropriate measures of an insuring member’s business, as well as suggestions for alternatives;
- Whether additional rules are needed when an insuring member’s status changes; and
- Whether any additional special rules are needed to accomplish single-entity treatment for intercompany insurance transactions.
Implications
The proposed regulations, if adopted, will have a significant negative effect on captive insurance companies that insure other members of a consolidated group. In Rev. Rul. 2001-31, the Service announced it will no longer invoke the “economic family” theory set out in Rev. Rul. 77-316 when analyzing captive insurance transactions. Rather, the IRS adopted a “facts and circumstance” approach to the evaluation of captive insurance companies. In Rev. Ruls. 2002-90 and 2005-40, the Service identified those arrangements that it would consider to be valid insurance arrangements for federal tax purposes. While the facts of the rulings do not state that a consolidated return was being filed by the captive insurance company and the insureds, the fact pattern is typical for a consolidated return (i.e., a domestic holding company owning all of the stock of 12 domestic subsidiaries).
Relying on these rulings, numerous consolidated groups have established captive insurance companies. Under existing regulations, captive insurance companies have been able to use the insurance accounting methods allowable to insurance companies in general, which provide the ability to deduct a reserve for a reasonable estimate of incurred losses. The proposed regulations effectively overrule Rev. Ruls. 2002-90 and 2005-40 for captive insurance companies that insure other members of a consolidated group and put the captive insurance company back on a self-insurance method of accounting.
The IRS and Treasury may be relying on a questionable premise to support the proposed changes to the regulations. They have expressed a concern that captive insurance companies may have a greater effect on consolidated taxable income than was anticipated when the current regulations were issued. As discussed, the effect on consolidated income is brought about by the captive insurance company’s ability to deduct a reserve for a reasonable estimate of incurred losses. However, the reserve must be discounted under Sec. 846 to reflect the present value of the payment of the incurred loss. Accordingly, the effect of the captive insurance company on consolidated taxable income may not be as great as thought by the Service and Treasury.
The proposed regulations affect only the accounting methods to be used by the captive insurance company, not the classification of the contracts issued by the captive as insurance contracts or the classification of the captive as an insurance company. Accordingly, items based on the qualification of the captive as an insurance company—for example, an election under Sec. 953(d) to treat a foreign insurance company as a domestic company—do not appear to be affected by the proposed regulations.
The proposed regulations are not limited to captive insurance companies. They will also affect commercial insurance companies (i.e., companies licensed as commercial insurance companies to sell insurance to unrelated parties) if more than 5% of their net written premiums are derived from other members of the consolidated group.
From Kevin Owens, CPA, Washington, DC
