The third prong of the Harper Test is “whether the arrangement was for “insurance” in its commonly accepted sense.” The case provides further guidance in this paragraph:

Rampart was both organized and operated as an insurance company. It was regulated by the Insurance Registry of Hong Kong. The adequacy of Rampart’s capitalization is not in dispute. The premiums charged by Rampart to its affiliates, as well as to its shippers, were the result of arm’s-length transactions. The policies issued by Rampart were valid and binding. In sum, such policies were insurance policies, and the arrangements between the Harper domestic subsidiaries and Rampart constituted insurance, in the commonly accepted sense. Read More

In looking at the cases, a few points immediately become apparent.

First, all the captives that were challenged by the Internal Revenue Service4 were formed because of business necessity. They are all great examples of the business purpose test outlined in the Frank Lyon case, where has the following factors:

1. there is a genuine multiple-party transaction

2. with economic substance that is

3. compelled or encouraged by business or regulatory realities,

4. that is imbued with tax-independent considerations, and Read More

Today, I want to turn to the Harper Test, which states that a captive must comply with the following three factors:

(1) whether the arrangement involves the existence of an “insurance risk”;

(2) whether there was both risk shifting and risk distribution; and

(3) whether the arrangement was for “insurance” in its commonly accepted sense.

I’ve already discussed the idea of risk shifting and risk distribution. For the next few posts, I want to focus on factors 1 and 3, starting with one, that the arrangement involves the existence of an “insurance risk.” Read More

Analyzing UPS’ situation before and after it established the captive, the tax court noted that UPS performed all the work related to the EVCs before and after the transaction:

Before January 1, 1984, petitioner performed all the functions and activities related to the EVC’s and was liable for the damage or loss of packages up to their declared value. After January 1, 1984, petitioner continued to perform all the functions and activities related to EVC’s, including billing for and receiving EVC’s, and remained liable to shippers whose shipments were damaged or lost while in petitioner’s possession. Petitioner continued to receive shippers’ claims for lost or damaged goods, investigate and adjust such claims, and pay such claims out of the EVC revenue that it had collected from shippers. The difference between petitioner’s EVC activity before and after January 1, 1984 was that after Read More

The UPS case is the last big captive case. However, there is a bit of history between UPS and Harper that we need to explain before moving forward.

In the 1990s, the IRS expanded the scope of their captive litigation, targeting bigger companies. Humana was one of the first truly large, fortune 500 style companies subject to captive litigation. It was not the last. Harper (which I discussed last week) was a large, international company. The service went so far as to argue Allstate — then a subsidiary of Sears — was a captive, even though Allstate wrote a a very small part of their business with Sears. UPS fits with this general case theory of the service generally targeting larger companies after establishing a legal foundation with smaller companies. However, this tactic did not work. The dam started to burst with the Humana (see here, here and here). Read More

Today’s posting will be a bit shorter than most. Although they lost the Humana case, the service continued to file challenges to various captive insurance arrangements. The Harper case — which was a 1991 decision — is important because it gives us a three prong test which a captive must comply with in order to be a “bona fide” captive. The following is from my book:

The court introduced a new three-prong test to determine “the propriety of claimed insurance deductions by a parent or affiliated company to a captive insurance company.” The three prongs are:

(1) whether the arrangement involves the existence of an “insurance risk”; Read More

For background, please see Humana Part I and Humana Part II:

By way of background, in Part I, we looked at the background facts of the case, and learned that Humana was a near-perfect set-up for a captive. The company was forced by business circumstances to form a captive, considered a variety of options (and obviously documented same) and then formed a stand-alone company that was adequately capitalized, independently managed and charged a fair price for its insurance. In Part II, we see a very well tried case for the plaintiff who take full advantage of the facts. In addition, we get the first real explanation (at lease in a case record) of the thinking behind the economic family doctrine. Finally, we see the first real cracks in the economic family doctrine, thanks to some of the insureds not being owners of captive stock. As such, the Read More

Below is an excerpt from my book on the Humana case. As an aside, if you get a bit confused by some of the terms used, you may want to go back and read some of the earlier posts on the captive cases.

Humana lost the trial case but filed a petition for reconsideration. The tax court withdrew its memorandum opinion and issued a full opinion after review by the 19-person court. The written opinion contains a 12-member majority opinion, an 8-person concurrence, a 2- member concurring and a 7-member dissent. The sole reason for Humana’s petition was to get a long opinion which the company could use for the basis of an appeal.

The court first notes the many captive cases heard before Humana that apply directly to Read More

Just to provide some context before moving forward, we’ve been looking at the captive cases in chronological order. We finished with the economic family doctrine. In the conclusion of my analysis to those cases I noted that, most importantly, the IRS was very prepared for captive litigation while the taxpayers weren’t. As a result, the IRS gained a strategic foothold in captive jurisprudence. With Humana, we see the first really good taxpayer push back against the IRS’ efforts. To that end,we’ll be spending some time delving into the decision’s details. The following is an excerpt from my book, U.S. Captive Insurance Law.

Humana was a groundbreaking case because it was the first major victory for a taxpayer in the captive insurance area. Humana was (and is) a publicly traded health care Read More

Next in the Captive Cases Series will be the Humana Cases.  The captive cases can be broken down into two segments: the economic family cases — where the IRS gained trial momentum for their theories, and the Humana cases, where taxpayers began scoring victories. As such, this is an appropriate place to stop and sum up the overall captive legal situation before moving onto Humana.

Here are the salient points moving forward.

1.) Business necessity drove the formation of early captives. In all economic family cases, some defining business need drove the formation of the captive. For example, the taxpayer in Ocean Drilling was engaged in a business which was new (offshore oil Read More

When looking at the economic family cases, it’s important to organize them in a comprehensible way. This installment looks at cases with fact patterns similar to Scenario 2 from Revenue Ruling 77-316. The following is taken directly from my book, U.S. Captive Insurance Law.

Situation 2 of Revenue Ruling 77-316 is the same as situation 1, except that the parent and subsidiaries pay premiums to a non-affiliated third party who reinsures 95% of the risk with a captive insurance company.[1] General Counsel Memorandum 35629 fleshes out the service’s thinking regarding situation 2.[2] The service argues the taxpayer should be allowed to deduct any payment not reinsured through the taxpayer’s captive.[3] In other words, risks that are outside the “economic family” and that follow proper insurance Read More

When looking at the economic family cases, it’s important to have some type of structure. Therefore, I’ll be using the fact patterns outlined in Revenue Ruling 77-316 and then looking at the cases which most resemble those fact patterns. What follows is an excerpt from my book U.S. Captive Insurance Law.

The first fact pattern outlined in Revenue Ruling 77-316 is entirely insular:

During the taxable year domestic corporation X and its domestic subsidiaries entered into a contract for fire and other casualty insurance with S1, a newly organized wholly owned foreign “insurance” subsidiary of X. S1 was organized to insure properties and other casualty risks of X and its domestic subsidiaries. X and its domestic subsidiaries Read More