State & Local Tax Alert Breaking state and local tax developments from Grant Thornton LLP Tax Appeals Tribunal Holds That Insurance Premiums Paid to a Captive Insurance Company Are Not Deductible The State Tax Appeals Tribunal recently held that a taxpayer parent corporation could not reduce its entire net income by amounts it paid as premiums to its wholly-owned, captive insurance subsidiary. 1 In its decision, the Tribunal concluded that the lack of risk-shifting and risk distribution between the parent and subsidiary resulted in intercompany payments that were not deductible for federal income tax purposes, and hence, not deductible for purposes of determining entire net income. Background Stewart s Shops Corporation (SSC), headquartered in Saratoga Springs,, is a family- and employee-owned business operating over 300 convenience stores in and Vermont. After experiencing a dramatic increase in its insurance costs, SSC started self-insuring certain risks related to its operations. At the end of 2003, SSC formed Black Ridge Insurance Corp. (BRIC), a captive insurance company, to insure some of its self-insured risks. BRIC was licensed as a captive insurance company by the State Insurance Department (Insurance Department). 2 BRIC provided coverage related to excess follow form insurance, deductible buy-back insurance and other insurance. BRIC filed annual statements with the Insurance Department and, during this time, was never contacted by the Insurance Department regarding any issues related to these statements. BRIC paid insurance company franchise taxes on the insurance payments received from SSC. For the 2006-2009 tax years under audit, SSC filed a consolidated federal income tax return that included BRIC. For corporation franchise tax purposes during the audit period, BRIC was not included on SSC s CT-3-A combined franchise tax returns. Furthermore, SSC modified its federal taxable income in computing entire net income by deducting premiums paid to BRIC, less losses paid out by BRIC. On audit, the Department of Taxation and Finance (Department) disallowed SSC s insurance expense deduction for the periods under audit, concluding Release date October 20, 2017 States Issue/Topic Corporation Franchise Tax Contact details Matthew DiDonato T 212.542.9960 E matthew.didonato@us.gt.com John Forni T 212.542.9865 E john.forni@us.gt.com Spiro Dorizas T 631.577.1844 E spiro.dorizas@us.gt.com Jason Clarke T 212.624.5532 E jason.clarke@us.gt.com Michael Callari T 631.577.1842 E michael.callari@us.gt.com www.grantthornton.com/salt 1 Matter of Stewart s Shops Corp., DTA No. 825745 (N.Y.S. Tax App. Trib., July 27, 2017). 2 The State Insurance Department is now the State Department of Financial Services..
Grant Thornton LLP - 2 that the expenses were not allowable deductions for federal income tax purposes when computing federal taxable income. Specifically, the Department determined that the payments were not premiums paid for bona fide insurance, because there was no riskshifting or risk-distribution between SSC and BRIC. 3 ALJ Decision Finds Payments Not Deductible From FTI On appeal to the Division of Tax Appeals, the Administrative Law Judge (ALJ) explained that s Article 9-A franchise tax is based on entire net income which, in turn, is federal taxable income as modified by adjustments under N.Y. Tax Law Sec. 208(9). Because federal taxable income serves as the starting point for entire net income, the ALJ looked to federal case law to determine whether the payments to BRIC were deductible in calculating federal taxable income. Based on federal case law, the ALJ concluded that the arrangement between SSC and BRIC lacked certain essential elements of insurance required under federal case law. As a result, the ALJ concluded that SSC s payments were not deductible from its federal taxable income and must be included in its entire net income. This appeal followed. Definition of ENI Controlled by Federal Law Affirming the decision of the ALJ, the Tax Appeals Tribunal held that, because the arrangement between SSC and BRIC lacked the character of insurance under federal case law and because tax law does not provide for a deduction from entire net income, the nondeductibility of the payments in the calculation of SSC s federal taxable income results in their nondeductibility in the calculation of its entire net income. The Tribunal began its analysis by determining whether the ALJ properly concluded that the premium payments at issue were not deductible for federal income tax purposes, and that the definition of entire net income was controlled solely by federal law. Summarizing the analysis by the ALJ, the Tribunal explained that premium payments for insurance may be deducted from gross income in the calculation of federal taxable income as an ordinary and necessary business expense if certain conditions are met. Two of these conditions require that an insurance arrangement contain the attributes of risk shifting and risk distribution. The Tribunal explained that these two attributes, while ever-present under traditional insurance arrangements, are noticeably absent under a parent-subsidiary captive insurance arrangement. Under a traditional insurance arrangement, the risk of loss shifts from the insured to the insurer who then distributes the risk among its policy holders. However, under a parentsubsidiary captive insurance arrangement, the risk of loss remains with the parent and there is no ability to distribute the risk because a two-party parent-subsidiary captive insurance arrangement means that the parties cannot distribute risk to any other 3 During the audit, SSC conceded that, for federal income tax purposes, the insurance contracts between it and BRIC did not qualify as insurance contracts, and that payments made on such contracts did not constitute insurance premiums. Additionally, SSC did not provide the Department with either an opinion predating the filing of its tax returns in which the tax advisor opined that the payments to BRIC were deductible for federal income tax purposes or a letter from the Insurance Department opining that the payments to BRIC were deductible for purposes of computation of its combined entire net income.
Grant Thornton LLP - 3 insureds. As a result, the ALJ found that the payments from SSC to BRIC did not qualify as deductible insurance premiums. The Tribunal also noted that, during the periods at issue, state law did not allow for a deduction for insurance premiums from federal taxable income when calculating entire net income. Having established these two points, both of which were undisputed by the parties, the Tribunal turned to the main arguments raised by SSC in support of its position that premium payments from a corporate parent to a captive insurance subsidiary should nevertheless be deductible in calculating entire net income. Deduction May Be Inferred From Captive Insurance Laws SSC first argued that authorization for the deduction can be inferred from the structure of the captive insurance laws and the legislature s intent to provide favorable tax treatment for captive insurance companies. The Tribunal rejected these arguments, noting that s captive insurance laws do not allow a deduction from entire net income for captive premium payments. Case law clearly establishes that a taxpayer seeking a deduction must be able to identify the statute that authorizes the deduction and establish its entitlement to it. Furthermore, a taxpayer must also show that the Division s interpretation is irrational and that its interpretation of the statute is the only reasonable construction. The Tribunal held that SSC failed to meet this burden. The Tribunal explained that state law provides no explicit deduction for the deduction of captive premium payments from entire net income and SSC s reliance on an inference to establish such a deduction is evidence of its failure to meet the requirement firmly established by case law that a deduction must clearly appear in a taxing statute. The Tribunal also rejected SSC s efforts to rely on legislative history to support its positon, explaining that the core of statutory construction rests on the notion that the legislature is aware of the existing legal landscape when it drafts legislation. Accordingly, the legislature was aware that an express provision would be required to permit the deduction of captive premiums from entire net income and the noticeable absence of such a provision in either Article 9-A and Article 33 reflected the legislature s intent to not allow this deduction. SSC also argued that upholding the ALJ s interpretation of law would lead to an absurd result whereby the payments would be treated as insurance premiums under s insurance company tax regime, but not under its general corporate tax regime. Specifically, SSC argued that Article 9-A and the Captive Insurance Act should be read together to allow a deduction from entire net income for the captive insurance premiums paid. The Tribunal rejected this argument explaining that reading these provisions together requires that there be ambiguity in the underlying statute. The Tribunal noted that N.Y. Tax Law Sec. 208(9) contains no ambiguity on the deductibility of insurance premiums in the calculation of entire net income and the captive insurance laws are devoid of any intent to amend Article 9-A to permit the deduction of captive insurance premiums in determining entire net income. Turning to SSC s claim that the inconsistent treatment of captive premium payments between the two tax systems leads to an absurd result, the Tribunal pointing out that
Grant Thornton LLP - 4 whatever inconsistency that might occur was eliminated when the Department changed its position at audit to hold that the payments are not premiums under either Article 9-A or Article 33. Based on this analysis, the Tribunal concluded that, because the arrangement between SSC and BRIC lacked the character of insurance under federal case law and because tax law did not provide for a deduction from entire net income, the nondeductibility of the payments in the calculation of SSC s federal taxable income results in their nondeductibility in the calculation of its entire net income. Finally, the Tribunal rejected SSC s claim that taxing authority was equitably estopped from denying the claimed deductions since the Department had previously treated BRIC as an insurance company, and treated its payments to BRIC as taxable premiums. The Tribunal rejected this assertion, finding that SSC did not provide sufficient evidence to meet the requisite test in support of the equitable estoppel contention. Specifically, SSC failed to show that the Department changed its position as to the deductibility of the insurance payments in calculating federal taxable income or s entire net income under the corporate tax regime. The Tribunal also rejected SSC s allegation that the Insurance Department represented that the insurance payments would be deductible from entire net income, noting that SSC failed to produce any evidence supporting its claim. Commentary Although subject to appeal, this decision is noteworthy because it is the first precedential decision by the Tribunal examining the deductibility of insurance payments to a captive insurance company. As a result, the decision establishes that insurance payments to a captive insurance company are not deductible in determining entire net income unless they qualify as such under federal tax law and thus are deductible in arriving at federal taxable income. Additionally, it is important to note that, by relying on federal case law to establish the essential elements of insurance (specifically the requirements of risk-shifting and risk distribution), the Tribunal s decision signals that other captive insurance structures with qualifying deductible premiums for federal tax purposes could constitute valid insurance structures for tax purposes. 4 To determine the applicability, if at all, to their facts and circumstances, taxpayers with captive insurance companies must carefully review the Tribunal s decision understanding that SSC conceded that the insurance payments to its captive insurer did not constitute insurance premiums for federal income tax purposes 5 and that the captive was only insuring risks of its parent company. Interestingly, one of the arguments that SSC raised was that the 2009 and 2014 amendments to the captive insurance regime provides support for the argument that the Tax Law authorized a deduction from entire net income. Specifically, a 2014 amendment to the Tax Law expressly ties the taxability of a captive insurance 4 Citing Humana Inc. v Commr., 881 F2d 247 (6 th Cir. 1989), the Tribunal noted that brother-sister captive insurance structures have been found to constitute valid insurance for federal income tax purposes. 5 See Findings of Fact 33 and 34.
Grant Thornton LLP - 5 company to the status of its insurance arrangements for federal income tax purposes. 6 The Tribunal s decision, however, does not give any consideration as to the implications or significance of the change in tax law provided under the 2014 New York Tax Reform legislation. The information contained herein is general in nature and based on authorities that are subject to change. It is not intended and should not be construed as legal, accounting or tax advice or opinion provided by Grant Thornton LLP to the reader. This material may not be applicable to or suitable for specific circumstances or needs and may require consideration of nontax and other tax factors. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Grant Thornton LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. No part of this document may be reproduced, retransmitted or otherwise redistributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, re-keying or using any information storage and retrieval system without written permission from Grant Thornton LLP. This document supports the marketing of professional services by Grant Thornton LLP. It is not written tax advice directed at the particular facts and circumstances of any person. Persons interested in the subject of this document should contact Grant Thornton or their tax advisor to discuss the potential application of this subject matter to their particular facts and circumstances. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed. 6 Matter of Stewart s Shops Corp. at 37.