n-02-70.pdf

Preserve advance releases and the authoritative Internal Revenue Bulletin rendition; directory timestamps are file-publication metadata, not legal effective dates. HTML bulletins begin June 2003; earlier available issues require full PDF parsing.

This collection currently includes the publisher’s available advance-release directory. Historical bulletin renditions are discovered separately; an advance-release record alone does not certify the collection archive complete.

Part III - Administrative, Procedural, and Miscellaneous

Certain Reinsurance Arrangements

Notice 2002-70

The Internal Revenue Service and Treasury Department have become aware of
a type of transaction, described below, that is being used by taxpayers to shift income
from taxpayers to related companies purported to be insurance companies that are
subject to little or no U.S. federal income tax. This notice alerts taxpayers and their
representatives that these transactions often do not generate the federal tax benefits
that taxpayers claim are allowable for federal income tax purposes. This notice also
alerts taxpayers, their representatives, and promoters of these transactions, to certain
reporting and record keeping obligations and penalties that they may be subject to with
respect to these transactions.
The transaction generally involves a taxpayer (ATaxpayer@) (typically a service
provider, automobile dealer, lender, or retailer) that offers its customers the opportunity
to purchase an insurance contract through Taxpayer in connection with the products or
services being sold. The insurance provides coverage for repair or replacement costs if
the product breaks down or is lost, stolen, or damaged, or coverage for the customer=s
payment obligations in case the customer dies, or becomes disabled or unemployed.
Taxpayer offers the insurance to its customers by acting as an insurance agent
for an unrelated insurance company (ACompany X@). Taxpayer receives a sales

2

commission from Company X equal to a percentage of the premiums paid by
Taxpayer=s customers. Taxpayer forms a wholly-owned corporation (ACompany Y@),
typically in a foreign country, to reinsure the policies sold by Taxpayer. Promoters
sometimes refer to these companies as producer owned reinsurance companies or
APORCs@. If Company Y is a foreign corporation, it typically elects to be treated as a
domestic insurance company under ' 953(d) of the Internal Revenue Code. Company
Y takes the position that it is entitled to the benefits of ' 501(c)(15) (providing that non-
life insurance companies are tax exempt if premiums written for the taxable year do not
exceed $350,000), ' 806 (providing a deduction for certain life insurance companies
with life insurance company taxable income not in excess of $15,000,000), or ' 831(b)
(allowing qualifying non-life insurance companies whose net written premiums are
between $350,000 and $1,200,000 to elect to be taxed solely on investment income).
Taxpayer receives premiums from its customers and remits those premiums
(typically net of its sales commission) to Company X. Company X pays any claims and
state premium taxes due and retains an amount from the premiums received from
Taxpayer. Under Company Y=s reinsurance agreement with Company X, Company Y
reinsures all insurance policies that Taxpayer sells to its customers. Company X
transfers the remainder of the premiums to Company Y as reinsurance premiums.
ANALYSIS
Many of the transactions described in this Notice have been designed to use a
reinsurance arrangement to divert income properly attributable to Taxpayer to Company
Y, Taxpayer=s wholly-owned reinsurance company that is subject to little or no federal
income tax. The Service intends to challenge the purported tax benefits from these

3

transactions on a number of grounds.
First, depending upon the facts and circumstances, the Service may assert that
Company Y is not an insurance company for federal income tax purposes. For federal
income tax purposes, an insurance company is 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.
' 1.801-3(a) of the Income Tax Regulations; ' 816(a) (which provides that a company
will be treated as an insurance company for federal income tax purposes only if Amore
than half of the business@ of that company is the issuing of insurance or annuity
contracts or the reinsuring of risks underwritten by insurance companies). While a
taxpayer=s name, charter powers, and state regulation help to indicate the activities in
which it may properly engage, whether the taxpayer qualifies as an insurance company
for tax purposes depends on its actual activities during the year.
Inter-American Life
Ins. Co. v. Commissioner, 56 T.C. 497, 506-08 (1971), aff=d per curiam, 469 F.2d 697
(9
th
Cir. 1972) (taxpayer whose predominant source of income was from investments
did not qualify as an insurance company); see also
Bowers v. Lawyers Mortgage Co.,
285 U.S. 182, 188 (1932). To qualify as an insurance company, a taxpayer Amust use
its capital and efforts primarily in earning income from the issuance of contracts of
insurance.@
Indus. Life Ins. Co. v. United States, 344 F. Supp. 870, 877 (D. S.C. 1972),
aff=d per curiam
, 481 F.2d 609 (4
th
Cir. 1973). To determine whether Company Y
qualifies as an insurance company, all of the relevant facts will be considered, including
but not limited to, the size and activities of any staff, whether Company Y engages in
other trades or businesses, and its sources of income.
See generally Lawyers

4

Mortgage Co.
at 188-90; Indus. Life Ins. Co., at 875-77; Cardinal Life Ins. Co. v. United
States, 300 F. Supp. 387, 391-92 (N.D. Tex. 1969), rev=d on other grounds, 425 F. 2d
1328 (5
th
Cir. 1970); Serv. Life Ins. Co. v. United States, 189 F. Supp. 282, 285-86 (D.
Neb. 1960), aff=d on other grounds, 293 F.2d 72 (8
th
Cir. 1961); Inter-Am. Life Ins. Co.,
at 506-08 ; Nat=l. Capital Ins. Co. of the Dist. of Columbia v. Commissioner, 28 B.T.A.
1079, 1085-86 (1933).
If Company Y is not an insurance company, it is not entitled to the benefits of ''
501(c)(15), 806, or 831(b). Further, if Company Y is a foreign corporation and is not an
insurance company, any election Company Y made under ' 953(d) is not valid and
Company Y will be treated as a controlled foreign corporation as defined in ' 957. In
such a case, Taxpayer will be treated as a U.S. shareholder of Company Y and
generally will include in its gross income on a current basis any subpart F income of
Company Y.
See ' 951(a) and (b). In addition, Company Y will not qualify for the
exceptions from subpart F income under '' 953(a)(2) and 954(i) for certain insurance
income because those exceptions are only available to a foreign corporation that,
among other requirements, is engaged in the insurance business and would be subject
to tax under subchapter L if such corporation were a domestic corporation.
See

' 953(e)(3)(C).
Second, the Service may apply '' 482 or 845 to allocate income from Company
Y to Taxpayer if necessary clearly to reflect the income of Taxpayer and Company Y.
Section 482 provides the Secretary with authority to allocate gross income, deductions,
credits or allowances among persons owned or controlled directly or indirectly by the
same interests, if such allocation is necessary to prevent evasion of taxes or clearly to

5

reflect income. The ' 482 regulations provide that in determining the taxable income of
a controlled person, the standard to be applied is that of a person dealing at arm=s
length with an uncontrolled person. ' 1.482-1(b)(1). Section 482 may apply to a
transaction between two or more controlled persons notwithstanding that an
uncontrolled person participates in the transaction as an intermediary. See
GAC
Produce Co. v. Commissioner, T.C.M. 1999-134. If, as a result of the reinsurance
transaction, Taxpayer=s income is not consistent with the arm=s length standard, then
' 482 authorizes the Secretary to allocate income from Company Y to Taxpayer.
Section 845(a) allows the Service to reallocate income, deductions, assets, reserves,
credits, and other items between two or more related parties who are parties to a
reinsurance agreement. Thus, such items may be reallocated from Company Y to
Taxpayer under the authority of ' 845(a).
Third, in appropriate cases, the Service may disregard the insurance and
reinsurance arrangements, and thereby require Taxpayer to recognize an additional
portion of premiums received from its customers as its income, if the arrangements are
shams in fact or shams in substance.
See
Kirchman v. Commissioner, 862 F.2d 1486,
1492 (11
th
Cir. 1989). Courts have distinguished between Ashams in fact@ where the
reported transactions never occurred and Ashams in substance@ which actually occurred
but lack the substance their form represents.
ACM Partnership v. Commissioner
, 157
F.3d 231, 247 n. 30 (3
d
Cir. 1998), cert. denied, 526 U.S. 1017 (2002) (citations
omitted). In determining whether a transaction constitutes a sham in substance, both a
majority of the Courts of Appeals and the Tax Court consider two related factors,
economic substance apart from tax consequences, and business purpose.
See
ACM

6

Partnership
; Karr v. Commissioner, 924 F.2d 1018, 1023 (11
th
Cir. 1991), cert. denied,
502 U.S. 1082 (1992);
James v. Commissioner
, 899 F.2d 905, 908-09 (10
th
Cir. 1990);
Shriver v. Commissioner
, 899 F.2d 724, 727 (8
th
Cir. 1990); Rose v. Commissioner, 868
F.2d 851, 853 (6
th
Cir. 1989); Kirchman. Although a taxpayer has the right to arrange
its affairs to reduce its tax liability, the substance of a transaction must govern its tax
consequences regardless of the form in which the transaction is cast.
See
Gregory v.
Helvering, 293 U.S. 465, 469 (1935). If the transactions involving Taxpayer, Company
X, and Company Y are disregarded, the income of Company Y is income of Taxpayer.
See
Wright v. Commissioner, T.C.M. 1993-328.
Transactions that are the same as, or substantially similar to, the transaction
described in this Notice that involve taxpayers claiming entitlement to the benefits of
'' 501(c)(15), 806, or 831(b) are identified as Alisted transactions@ for purposes of
' 1.6011-4T(b)(2) of the temporary Income Tax Regulations and ' 301.6111-2T(b)(2) of
the temporary Procedure and Administration Regulations. See also ' 301.6112-1T, A-
4. Independent of their classification as Alisted transactions@ for purposes of '' 1.6011-
4T(b)(2) and 301.6111-2T(b)(2), transactions that are the same as, or substantially
similar to, the transaction described in this notice may already be subject to the
disclosure requirements of ' 6011, the tax shelter registration requirements of ' 6111,
or the list maintenance requirements of ' 6112 ('' 1.6011-4T, 301.6111-1T, 301.6111-
2T and 301.6112-1T, A-3 and A-4).
Persons who are required to satisfy the registration requirement of ' 6111 with
respect to the transactions described in this Notice and who fail to do so may be subject
to the penalty under ' 6707(a). Persons who are required to satisfy the list-keeping

7

requirement of ' 6112 with respect to the transactions described in this notice and who
fail to do so may be subject to the penalty under ' 6708(a). In addition, the Service
may impose penalties on participants in these transactions or substantially similar
transactions involving taxpayers claiming entitlement to the benefits of '' 501(c)(15),
806, or 831(b) or, as applicable, on persons who participate in the promotion or
reporting of such transactions, including the accuracy-related penalty under ' 6662, the
return preparer penalty under ' 6694, the promoter penalty under ' 6700, and the
aiding and abetting penalty under ' 6701.
The principal authors of this Notice are John Glover of the Office of Associate
Chief Counsel (Financial Institutions and Products) and Theodore Setzer and Sheila
Ramaswamy of the Office of Associate Chief Counsel (International). For further
information regarding this notice contact Mr. Glover at (202) 622 -3970 or Mr. Setzer or
Ms. Ramaswamy (202) 622-3870 (not a toll-free call).