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U.S. Tax Court decision on Rent-A-Center deductions buoys captive owners


SCOTTSDALE, Ariz. — A U.S. Tax Court decision that allows a federal income tax deduction for premium payments by subsidiaries of Rent-A-Center Inc. to the company's Bermuda captive was not a “game changer” for captive owners.

“But it is maybe the first inning of what could become a nine-inning game, and it came out favorably for the taxpayer,” said Thomas M. Jones, a partner at law firm McDermott Will & Emery L.L.P.

In Rent-A-Center Inc. v. Commissioner, the Internal Revenue Service argued that the company's captive was a sham entity established to generate federal income tax benefits. But the court found that Rent-A-Center's Bermuda-based Legacy Insurance Co. Ltd. captive is a genuine insurance company providing real risk transfer for the subsidiaries.

“It's a little bit frustrating for our clients, because they say 'tell us the new rules,'” Mr. Jones said. But despite the court's Jan. 14 ruling, the advice that he and P. Bruce Wright, a partner at the Sutherland Asbill & Brennan L.L.P., would give clients in similar situations is it all comes down to individual “facts and circumstances,” Mr. Jones said.

Their comments came during a session on complex tax issues during the Captive Insurance Cos. Association's 2014 International Conference, held March 9-11 in Scottsdale, Ariz.

Even so, it was significant that 15 of the 16 the Tax Court judges decided the case, Mr. Jones said. It also was the first full court review of a captive premium deductibility case involving the so-called “brother-sister theory” since the 1987 Humana Inc. & Subs. v. Commissioner case, Mr. Jones said.


In that case, the Tax Court did not allow Louisville, Ky.-based Humana to take a tax deduction for premiums paid to its captive, holding that risks that are either insured or reinsured by a related insurance company cannot be deducted from federal income taxes because the risk was not shifted from the policyholder. But the 6th U.S. Circuit Court of Appeals in Cincinnati overturned the decision in 1989.

Mr. Jones said part of the reason the full Tax Court decided to review Rent-A-Center was because the 5th U.S. Circuit Court of Appeals in New Orleans, not the 6th Circuit, would have decided any appeal.

“So the tax court got all the judges together in a room to decide whether they thought that they were actually wrong back in 1987 and that Rent-A-Center should take advantage of brother-sister, or should they stick to their guns and say they were still right, which they could have done and rejected brother-sister,” Mr. Jones said. “Or as one of the dissenting judges I think rather sarcastically said, they could have avoided the whole thing by saying the IRS issued a revenue rule that accepts brother-sister in certain circumstances.”

In 2001, the IRS issued Revenue Ruling 2001-31 that reversed its longstanding position that premiums paid to captives are not deductible under the “economic family” theory.

“In any case, they tackled the hard thing. They admitted they were wrong,” Mr. Jones said.

But because Rent-A-Center was not a unanimous decision and could easily have gone the other way.” he said. “In other words this is not money in the bank, it's just what we think might be the beginning of a trend. The brother-sister theory is now accepted in Tax Court.”


Also during the session, Mr. Wright addressed attempts by the IRS to tax reinsurance transactions multiple times, a process he called “cascading tax.”

Under a 2008 IRS revenue ruling, “every time a U.S. risk is transferred from one insurer to another, that is another taxable transaction” subject to federal excise tax, Mr. Wright said. “So for example, if an insurer reinsures with a Bermuda company, it's 4%; if the Bermuda company reinsures with another Bermuda company, it's 1% on the next transaction, and on and on.”

In response, Bermuda-based Validus Reinsurance Ltd. filed a refund suit in U.S. District Court for the District of Columbia in 2013 arguing that the excise tax did not apply to retrocessions. In February this year, the court ruled for Validus.

“The problem is, they may have won too much because the decision was based on retrocessions,” Mr. Wright said. “Let's assume a U.S. insured insures with an insurance company in the U.S. and that company reinsures with another company in the U.S. and that company reinsures with a Bermuda company. Now, based on the decision in this case, there is no excise tax on that transaction ... because it's a retrocession transaction.”

Mr. Wright said he expects the IRS to appeal, and recommended that captive owners pay the excise tax on reinsurance transactions to avoid an IRS audit.

The heavily attended session was part of the annual CICA conference that attracted more than 560 attendees and 49 exhibitors.