State Tax Return. Finance and Service Charges: Premium for Premium Tax Purposes Or Not? Josie Lowman Atlanta (404)

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1 May 2007 Volume 14 Number 5 State Tax Return Finance and Service Charges: Premium for Premium Tax Purposes Or Not? Josie Lowman Atlanta (404) In the last couple of months there have been three cases, in three different states, addressing whether finance and service charges are included in the premium tax base. It may be somewhat surprising to some that this issue was litigated in several states in the late 1950s, early 1960s. In those cases, the insurance companies generally lost. See Allstate Ins. Co. v. State Bd. of Equalization, 336 P.2d 961 (Cal. Ct. App. 1959); State Insurance Commissioner v. Allstate Ins. Co., 351 P.2d 433 (Or. 1960) Since then, insurance companies have generally included finance and services charges in the premium tax base in all states except those states which statutorily exclude the charges. The decisions are starting to change. Two recent cases discussed below, Dairyland Insurance Co. v. State Tax Assessor, Maine Superior Court Docket No. AP (Jan. 26, 2007) and In the Matter of the Petition of New York State Insurance Fund Workers Compensation Fund, DTA No (NY Div. of Tax App. Mar. 15, 2007) dealt directly with the question of whether finance and service charges should be included in the premium tax base. The third case, Wilson v. Farmers Insurance Exchange, No. B (Cal. Ct. App. 2nd App Div. April 16, 2007), deals with whether the California Fair Claims Act is applicable to premium taxes. The underlying issue in the Farmers Insurance Exchange case is whether Farmers Insurance Exchange should have paid premium tax on the finance and service charges collected from the policyholders. Finance and Service Charges What are they? When determining the price that an insurance company should charge for an insurance policy, the company considers, in small part, the administrative costs in providing the policy to a policyholder. These costs are generally referred to as the loading factor and mainly consist of operating, management and administrative expenses. The loading factor is generally included in the calculation of the rates and is reviewed by the state insurance regulators when approving the insurance product. When a policyholder purchases an insurance policy, the policyholder is required to pay the premium at the time the policy is purchased. In several types of insurance sold mainly to individuals such as personal auto, home owners, and individual umbrella polices, insurance companies may allow the policyholders to pay the premium over time

2 in installments. Companies charge service charges to policyholders that choose to pay their premium in installments. The insurance company also charges finance/interest charges on the installment payments. In summary, insureds can choose to pay the premium in one lump sum or in installments at the cost of incurring the finance and service charges. Generally it is a choice made by the insured and not something that the insurer requires. For statutory accounting purposes, the finance and service charges are not included in direct written premium, unlike administrative fees which make up the loading factor that are included in direct gross written premium as they are part of the premium price. Finance and service charges are listed in a separate column on a company s schedule T to the annual statement that is required to be filed with every insurance department where the insurance company is licensed to sell insurance. Thus for regulatory purposes, finance and service charges are not considered to be included in gross direct written premium. Dairyland Insurance Co. v. State Tax Assessor 1 During all relevant times, Dairyland Insurance Company ( Dairyland ) allowed its insureds to pay their premium in installments and charged finance and service charges to the insureds. Dairyland had originally paid tax in Maine on the finance and service charges. After filing its 2001 through 2003 premium tax returns, Dairyland determined that the finance and service charges were not premium and thus should not have been included in the premium tax base. Dairyland submitted amended returns excluding the finance and service charges from the tax base. The Maine Tax Assessor denied the refunds and Dairyland brought the instant suit. Dairyland continued to pay the tax on the administrative fees contained in the loading factor. The Maine Assessor took the position that the finance and service charges were consideration for an insurance contract; thus the premium was subject to the tax. Maine imposes the premium tax on all gross direct premiums. Me. Rev. Stat. Ann. tit. 36, Premium is defined as consideration for insurance, by whatever name called. Any assessment, membership, policy, survey, inspection, service or similar fee or other charge in consideration for an insurance contract is deemed to be part of the premium. Me. Rev. Stat. Ann. tit. 24-A, Dairyland argued that the finance and service charges were not part of the consideration as the charges were merely payments for the ability to pay in installments. Dairyland Insurance Co. v. State Tax Assessor, Maine Superior Court Docket No. AP (Jan. 26, 2007). The Maine Superior Court agreed with the Assessor and held that the finance and service charges were premium and thus should be included in the premium tax base. The Court found that the fact that Dairyland would cancel a policy for non payment of the finance and service charges proved that the finance and service charges were consideration for the policy. The Court also held that Dairyland had not shown any case (Jan. 26, 2007). 1 Dairyland Insurance Co. v. State Tax Assessor, Maine Superior Court Docket No. AP-05-20

3 law that contradicted the Assessor s position and had not presented any justifiable reason for excluding installment fees from all of the other administrative expenses in the loading factor. Id. In the Matter of the Petition of New York State Insurance Fund Workers Compensation Fund 2 The New York State Insurance Fund Workers Compensation Fund ( SIF ) allowed its policyholders to pay the premium over the policy period in 10 installments. SIF charged its policyholders finance and service charges if the policyholders chose to pay the premium over time. The policyholder was not required to pay the premium in installments and could pay the amount due in one lump sum and not incurred the finance and service charges. SIF did not include the finance and service charges in the premium tax base for purposes of the New York Insurance Corporate Franchise Tax. On audit the New York Division of Taxation determined that the finance and service charges should be included in the tax base and so assessed SIF. SIF appealed the Division s determination to the New York Division of Tax Appeals. New York imposes its Insurance Franchise Tax on all gross direct premiums, less return premiums thereon, written on risks located or resident in this state. N.Y. Tax Law 1510(a). Premium is defined as all amounts received as consideration for insurance contracts or reinsurance contracts... and shall include premium deposits, assessments, policy fees, membership fees, any separate costs by carriers assessed upon their policyholders and every other compensation for such contract. N.Y. Tax Law 1501(c)(1). The Division of Taxation had published a Technical Service Bulletin ( TSB ) in 1980 and a Circular Letter in 1967 addressed to all property and casualty companies stating that finance and service charges are to be included in the premium tax base. 3 The Division of Tax Appeals Administrative Law Judge ( ALJ ) held that the finance and service charges were not consideration for the insurance contracts and thus should not be included in the premium tax base. The ALJ found that a key fact was that a policyholder was not required to pay the finance and service charges in order to purchase a policy. The policyholder could pay the premium in one lump sum. Therefore the finance and service charges were not consideration for the policy. The ALJ discussed and found that the fact that the policy could be canceled due to non payment of the finance and service charges did not alter the fact that the finance and service charges were not consideration for the policy. The ALJ found that neither the Circular Letter No. 6 nor the TSB had any basis in the law. The ALJ further held that even though both the Letter and the TSB had been the department s policy for over 20 years, neither publication could be accorded any weight 2 In the Matter of the Petition of New York State Insurance Fund Workers Compensation Fund, DTA No (NY Div. of Tax App. Mar. 15, 2007). 3 TSB-M-80(8)C; Circular Letter No. 6 (NY Dept. of Taxation Aug. 15, 1967).

4 as neither were based on a correct interpretation of the law. The ALJ found that he was required to accord weight to Department publications only if the publications were based on a well-reasoned application of the law. Wilson v. Farmers Insurance Exchange 4 As mentioned above, the Farmers Insurance Exchange case did not directly address whether finance and service charges are subject to the premium tax. The case dealt with an allegedly false claim made by the insurance company as to whether the finance and service charges should be included in the premium tax base. Farmers Insurance Exchange, like Dairyland and the SIF, provided payment options to its policyholders so that the policyholder could pay the premium over a period of time. In exchange for allowing the policyholder to extend the payment, the policyholder was required to pay a finance and service charge in addition to the premium payment. 5 Floyd Wilson brought the suit as a qui tam plaintiff alleging that Farmers Insurance Exchange had made false statements on its premium tax return by not including the finance and service charges in the premium tax base. Mr. Wilson alleged that the making of such false statements was subject to the California False Claims Act 6 ( CFCA ). The California Court of Appeals held that the CFCA did not apply to tax cases and the instant case was a tax case. Mr. Wilson had argued that the exemption under the CFCA for tax matters did not apply to premium taxes as premium taxes are imposed under the California Constitution as well as under the tax code. The CFCA specifically provides that it does not apply to taxes imposed under the tax code. The Court of Appeals found that while the premium tax is imposed under the Constitution, the actual requirement that (and how) the insurance company must file a return is provided in the tax code. Because the inclusion/exclusion of the finance and service charges dealt with the amount included in the actual return, which was governed by the tax code not the Constitution, the Court held that the CFCA did not apply. The Court specifically held that it was not ruling on whether the finance and service charges should be included in the premium tax base in California. So Is There Hope? Like nearly every other area in state tax, the answer to the question as to whether there is hope in the finance and service charge arena is that it depends. There are ways of distinguishing the holdings in the Dairyland and SIF cases but its more likely that further court cases will come down to how well the insurance companies are able to argue that the finance and service charges are not part of the consideration for the insurance 4 Wilson v. Farmers Insurance Exchange, No. B (Cal. Ct. App. 2 nd App Div. April 16, 2007) 5 Note that unlike in the SIF and Dairyland cases, the finance and service charges were actually collected by a non insurance affiliate of Farmers Insurance Exchange. 6 Cal. Gov. Code

5 policy. To the extent that the tax is imposed on gross premium and gross premium is defined as consideration for a policy, there is a strong argument that finance and service charges are not consideration for the actual policy but rather are consideration for the ability to pay such premium over time. While the New York and Maine decisions come to opposite conclusions based on nearly the same set of facts, the New York ALJ understood the difference between the administrative costs that are built into the premium price and subject to the premium tax and finance and service charges that are not related to the policy, but rather related to how the policy is paid. What makes the California case interesting is that the case was brought by a whistleblower and not by the California Department of Insurance. 7 One might question why the Department of Insurance had not audited and assessed Farmers Insurance Exchange if the Department thought that finance and service charges were subject to the premium tax. What is clear is that the finance and service charge debate is far from over. There will be refund claims filed in New York and in other states where the premium tax imposition statute and the definition of premium are similar to the New York statutes. In addition, it would not be surprising to see refund suits filed in California given the nature of the Farmers Insurance Exchange case brought in California. 7 The premium tax is administered by the Department of Insurance in California.

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