Rev. Rul. 77-316

Advice has been requested whether, under each of the three situations described below, amounts paid as insurance premiums by a domestic parent corporation and its domestic subsidiaries to a wholly owned foreign "insurance" subsidiary of the parent are deductible as ordinary and necessary business expenses under section 162 of the Internal Revenue Code of 1954. Advice has also been requested whether deductions for losses that are incurred by the domestic parent and its domestic subsidiaries and that are otherwise allowable under section 165(a), will be reduced by amounts received from the "insurance" subsidiary with respect to risks retained by the "insurance" subsidiary. In addition, advice has been requested whether the wholly owned foreign "insurance" subsidiary in each situation described below qualifies as an insurance company for Federal income tax purposes.

Situation 1

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 paid amounts as casualty insurance premiums directly to S1. Such amounts reflect commercial rates for the insurance involved. S1 has not accepted risks from parties other than X and its domestic subsidiaries.

Situation 2

The facts are the same as set forth in Situation 1 except that domestic corporation Y and its domestic subsidiaries paid amounts as casualty insurance premiums to M, an unrelated domestic insurance company. This insurance was placed with M under a contractual arrangement that provided that M would immediately transfer 95 percent of the risks under reinsurance agreements to S2, the wholly owned foreign "insurance" subsidiary of Y. However, the contractual arrangement for reinsurance did not relieve M of its liability as the primary insurer of Y and its domestic subsidiaries; nor was there any collateral agreement between M and Y, or any of Y's subsidiaries, to reimburse M in the event that S2 could not meet its reinsurance obligations.

Situation 3

The facts are the same as set forth in Situation 1 except that domestic corporation Z and its domestic subsidiaries paid amounts as casualty insurance premiums directly to Z's wholly-owned foreign "insurance" subsidiary, S3. Contemporaneous with the acceptance of this insurance risk, and pursuant to a contractual obligation to Z and its domestic subsidiaries, S3 transferred 90 percent of the risk through reinsurance agreements to an unrelated insurance company, W.

Section 162(a) of the Code provides, in part, that there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.

Section 1.162-1(a) of the Income Tax Regulations provides, in part, that among the items included in business expenses are insurance premiums against fire, storms, theft, accident, or other similar losses in the case of a business.

Historically, insurance involves risk-shifting and risk-distributing, and the sharing and distribution of the insurance risk by all the parties insured is essential to the concept of true insurance. See Helvering v. Le Gierse, 312 U.S. 531 (1941); Commissioner v. Treganowan, 183 F. 2d 188 (2d Cir. 1950); and Rev. Rul. 60-275, 1960-2 C.B. 43. Thus, when there is no economic shift or distribution of the risk "insured," the contract is not one of insurance, and the premiums therefor are not deductible under section 1.162-1(a) of the regulations.

Also, both the Internal Revenue Service and the courts have long held that amounts set aside by a taxpayer as a reserve for self-insurance, though equal to commercial insurance premiums, are not deductible for Federal income tax purposes as "ordinary and necessary expenses paid or incurred during the taxable year." See Rev. Rul. 60-275, Rev. Rul. 57-485, 1957-2 C.B. 117, and Pan American Hide Co. v. Commissioner, 1 B.T.A. 1249 (1925). Even where a self-insurance fund is administered by an independent agent, such fact does not make payments to such fund deductible. See Spring Canyon Coal Company v. Commissioners, 43 F. 2d 78 (10th Cir. 1930), cert. denied, 284 U.S. 654 (1930).

Under the three situations described, there is no economic shifting or distributing of risks of loss with respect to the risks carried or retained by the wholly owned foreign subsidiaries, S1, S2, and S3, respectively. In each situation described, the insuring parent corporation and its domestic subsidiaries, and the wholly owned "insurance" subsidiary, though separate corporate entities, represent one economic family with the result that those who bear the ultimate economic burden of loss are the same persons who suffer the loss. To the extent that the risks of loss are not retained in their entirety by (as in Situation 2) or reinsured with (as in Situation 3) insurance companies that are unrelated to the economic family of insureds, there is no risk-shifting or risk-distributing, and no insurance, the premiums for which are deductible under section 162 of the Code.

Thus, the amounts paid by X, Y, and Z, and their domestic subsidiaries, and retained by S1 (100 percent), S2 (95 percent), and S3 (10 percent), respectively, are not deductible under section 162 of the Code as "ordinary and necessary expenses paid or incurred during the taxable year." Because such amounts remain within the economic family and under the practical control of the respective parent in each situation, there has been no amount "paid or incurred." See Rev. Rul. 60-275, and Rev. Rul. 69-512, 1969-2 C.B. 24.

However, in Situation 2, to the extent the unrelated insurer, M, retains the risks (5 percent) that are not reinsured by S2, and in Situation 3, to the extent S3 transfers the risks (90 percent) through reinsurance agreements to W, the unrelated reinsurer, that portion of the premiums paid by Y and Z and their domestic subsidiaries to cover these risks are deductible under section 162 of the Code. Since these amounts are not withdrawable by either Y and its domestic subsidiaries or Z and its domestic subsidiaries, they have been "paid or incurred" within the meaning of section 162. Furthermore, the requisite shifting and distribution of the risks has occurred to the extent the unrelated insurers, M and W, respectively, bear the risks of loss.

Amounts paid as so-called insurance premiums by X, Y, and Z, and their domestic subsidiaries, with respect to risks remaining with S1, S2, and S3, respectively, will not constitute taxable income to S1, S2, and S3 under section 61 of the Code as nothing has occurred other than a movement of an asset (cash) within each family of related corporations. Instead such amounts will be considered contributions of capital under section 118.

Because the parent through its control of the corporate family members (its domestic subsidiaries and its wholly owned foreign subsidiary) has control over the movement of assets within the family, the payments of so-called "insurance" premiums made by the domestic subsidiaries of X, Y, and Z to S1, S2, and S3, respectively, to the extent of available earnings and profits, are viewed first as a distribution of dividends under section 301 of the Code from such subsidiaries (equal to premiums paid that end up in the foreign "insurance" subsidiary) to their respective parents and then as a contribution of capital by the parents to the respective foreign subsidiaries. Compare Rev. Rul. 69-630, 1969-2 C.B. 112, discussing the treatment of a "bargain sale" between two corporate entities controlled by the same shareholders.

Furthermore, any proceeds paid by S1, S2, and S3 to their respective parents or the parents' domestic subsidiaries with respect to risks of loss retained by S1, S2, and S3 are viewed, to the extent of available earnings and profits, as distributions under section 301 of the Code to the respective parent. Specifically, proceeds paid by S1, S2, and S3 to domestic subsidiaries of their respective parents are viewed, to the extent of available earnings and profits, as distributions under section 301 to the respective parent followed by a contribution of capital from the respective parent to the domestic subsidiary.

The preceding analysis recognizes S1, S2, and S3 as independent corporate entities in view of their business activities (Moline Properties v. Commissioner, 319 U.S. 436 (1943), 1943 C.B. 1011), but also examines the economic reality of each situation described. It is concluded that the "insurance agreement" with respect to the risks retained by S1, S2, and S3 is designed to obtain a deduction by indirect means that would be denied if sought directly.

The second issue relates to whether any loss otherwise allowable to X, Y, and Z and their respective domestic subsidiaries under section 165 of the Code would be reduced by the proceeds received from S1, S2, and S3 to the extent such payments are with respect to risks retained by S1, S2, and S3. Section 165(a) provides as a general rule that there shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise.

Consistent with the reasons given above in denying the deduction of the amounts paid as insurance premiums by X, Y, and Z and their respective domestic subsidiaries, any benefits paid by S1, S2, and S3 to their respective parents and affiliates could not qualify as compensation by insurance or otherwise to the extent they result from the risks remaining with S1, S2, and S3. Accordingly, X and its domestic subsidiaries in Situation 1 are entitled to a deduction under section 165(a) of the Code for any losses sustained during the taxable year, since the losses are not compensated by insurance or otherwise. Y and its domestic subsidiaries in Situation 2 are entitled to a deduction for losses sustained during the taxable year to the extent not compensated for by insurance (that is, not compensated by insurance relating to risks assumed by M). Z and its domestic subsidiaries in Situation 3 are entitled to a deduction for losses sustained during the taxable year to the extent not compensated for by insurance (that is, not compensated by insurance relating to risks reinsured by W).

The final issue is whether S1, S2, or S3 qualifies as an insurance company for Federal income tax purposes. Section 1.831-3(a) of the regulations (applicable generally to stock casualty insurance companies) provides, in part, that the term "insurance companies" means only those companies that qualify as insurance companies under the definition provided by section 1.801-1(b), predecessor to section 1.801-3(a).

Section 1.801-3(a) of the regulations defines an insurance company for purposes of subchapter L as follows:

The term "insurance company" means a company whose primary and predominant business activity during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies. Thus, though its name, charter powers, and subjection to State insurance laws are significant in determining the business which a company is authorized and intends to carry on, it is the character of the business actually done in the taxable year which determines whether a company is taxable as an insurance company under the Internal Revenue Code.

The question, therefore, is whether S1, S2, and S3 are primarily and predominantly engaged in the insurance business, either by virtue of their assuming a portion of the risks of their respective parents and the parents' domestic subsidiaries, or on the basis of the business it transfers for reinsurance with unrelated insurance companies. Since the arrangement whereby S1, S2, and S3 assume a portion of the risks of their respective corporate families is not insurance under the standards set forth in Le Gierse, such an arrangement does not constitute the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies as stated in section 1.801-3(a)(1) of the regulations. Also, S3 is not engaged in the business of insurance by transferring the risks of its parent corporation and affiliates to an unrelated insurance company because, under a reinsurance agreement, there will be no shifting to or assumption by S3 of any risk constituting insurance. See Rev. Rul. 56-106, 1956-1 C.B. 313, for the proposition that an insurance company that disposes of its insurance business under a reinsurance agreement ceases to be an insurance company on the effective date of the agreement and thereafter becomes taxable as an ordinary corporation.

Accordingly, S1, S2, and S3, as described above, are not insurance companies within the definition of section 1.801-3(a)(1) of the regulations because their primary and predominant business activity is not the issuing of insurance and annuity contracts or the reinsuring of risks underwritten by other insurance companies.