The IRS released a Chief Counsel advice memorandum* concluding that contracts issued by a captive insurance company that offered protection from the loss of earnings arising from foreign exchange fluctuations are not insurance contracts. CCA 201511021 (release date March 13, 2015 and dated December 1, 2014).
Read CCA 201511021 [PDF 87 KB]
*Chief Counsel advice documents are legal advice, signed by executives in the National Office of the IRS Office of Chief Counsel and issued to IRS personnel who are national program executives and managers. The documents are issued to assist IRS personnel in administering their programs by providing authoritative legal opinions on certain matters, such as industry-wide issues. However, they are not to be used or cited as precedent.
A global group of corporations involved in the design, manufacture, and marketing of medical, industrial, and commercial products in the environmental and life sciences industries (Taxpayer Group) includes a U.S. captive insurance company (Captive).
Captive provides coverage to the Taxpayer Group for automobile liability, products and general liability workers' compensation, product warranty, credit guarantee insurance, earthquake damage coverage, retiree medical cost coverage, and guaranteed renewable accident and health insurance.
Due to the global nature of Taxpayer Group’s business, fluctuations in foreign currencies relative to the U.S. dollar may adversely affect Taxpayer Group's financial results. Prior to the transactions at issue, Taxpayer Group did not use derivative instruments to hedge its risk of loss from such fluctuations.
Taxpayer Group’s parent company (Parent) entered into contracts with Captive on behalf of some members of the Taxpayer Group to guard against the risk arising from fluctuations in the rate of exchange between the U.S. dollar and certain foreign currencies. One type of contract protects the member against a decrease in the value of the specified foreign currencies and the other protects against an increase in value of the specified foreign currencies.
Under the contracts, Captive agrees to indemnify the participating members for the "loss of earnings" connected to either a decrease or increase in the value of each specified foreign currency relative to the U.S. dollar up to a stated coverage limit for the one-year term of the contract.* The coverage limit is the lesser of: (1) an undefined "specified loss limit" (according to the CCA, this limit may be based on the prior year's export sales), or (2) the sales revenue during the contract period (for contracts covering decreases in value). Contracts covered multiple foreign currencies.
*The CCA notes that a new one-year contract was entered into each month through endorsement.
For each contract, "loss of earnings" is defined as the percentage increase or decrease in the rate of exchange of the U.S. dollar against the specified foreign currency between the effective and expiration dates, multiplied by the coverage limit.
The CCA notes that in the tax opinion obtained by Taxpayer Group regarding the contracts, the Taxpayer Group represents that this loss of earnings does not measure the actual loss suffered by the change in foreign exchange rates, but rather "provides a reasonable approximation" of the actual loss.
For each contract, the premium is determined by multiplying the "rate of premium" by the coverage limit. Initially, the rate of premium per dollar of coverage is defined as twice the amount of premium as quoted by Bloomberg on the effective date, as a percentage of “notional” for a 12-month call option contract for the purchase of U.S. dollars against the specified foreign currency. The premium listed in each contract was a deposit premium only, and was the maximum that each participant would be required to pay. The actual premium was determined after the expiration date of each contract, based on the actual loss experience. The final premium was the lesser of the “retrospective adjusted premium” and the deposit premium. The retrospective adjusted premium equals the deposit premium less the “retrospective premium adjustment,” which is: (1) a specified percentage of the deposit premium, minus (2) paid losses in excess of a different specified percentage of the deposit premium. If the retrospective adjusted premium is less than the deposit premium, Captive will refund the difference to the participant. If the retrospective adjusted premium is greater than the deposit premium, the participant does not pay additional premium. The premium reconciliation is computed at the expiration of each contract.
Contracts were vetted (and presumably priced) by an outside actuary.
No single participant accounts for more than 15% of the premiums paid to Captive with respect to Contracts 1 and 2. The CCA also notes there is no mention of any parental guarantee, premium loan back, or other aspect of the arrangement that would be inconsistent with a bona fide insurance arrangement.
The issue addressed in the CCA was whether the arrangement between members of Taxpayer Group and the Captive involving foreign currency fluctuations constitutes “insurance” for federal tax purposes.
The CCA memo begins by acknowledging there is no income tax definition of “insurance.”
The CCA next avers that the predicate for insurance is “insurance risk”—as distinguished from investment risk. The CCA states “[n]ot all contracts that transfer risk are insurance policies even where the principal purpose of the contract is to transfer risk” and opines that “[i]nsurance risk requires a fortuitous event or hazard and not a mere timing or investment risk.”
After reviewing the facts and circumstances of the contracts, the CCA concludes that the risk involved is an investment-type risk as it is “solely the manifestation of fiat currency valuation.” The CCA notes as support for its position that although SSAP No. 60, Financial Guaranty Insurance, references protection against the fluctuation in currency exchange rates, "insurance" for this risk does not appear to be commonly available from the major carriers.
The CCA points to the lack of a casualty event as further evidence the contracts do not provide insurance and contrasts this coverage with property coverage and business interruption coverage, i.e., “known” insurance products.
The CCA also notes that the pricing of the contracts does not appear to leave sufficient risk of loss to qualify as insurance for federal tax purposes.
The CCA categorizes the Captive’s obligations under the contracts “other” payment liabilities under Reg. section 1.461-4(g)(7), which means loss payments made by the Captive under the contracts are not incurred (and deductible) until they are paid. The CCA asserts the recurring item exception is not available for these liabilities.
The CCA perpetuates and expands upon the IRS’s historic position that an insurance contract must involve insurance risk, as juxtaposed against investment or business risk. It also reiterates that insurance for tax purposes must involve a casualty event (or “fortuity”), and that contract termination does not define a casualty event. The fortuity issue is currently in litigation before the U.S. Tax Court in RVI v. Commissioner.
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