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WASHINGTON-Premiums paid by a company's subsidiaries to its wholly owned captive insurer are deductible, the U.S. Tax Court has ruled.

The ruling marks the second high-profile defeat for Internal Revenue Service efforts to disallow deductions for captive premiums paid by subsidiaries.

The Tax Court held last month that Hospital Corp. of America, now part of Columbia/HCA Healthcare Corp., may deduct premiums its subsidiaries paid to its Tennessee-domiciled captive Parthenon Insurance Co.

The decision mirrors a landmark 6th U.S. Circuit Court of Appeals' ruling in 1989 allowing similar deductions to the Humana Inc. hospital chain.

"The facts of the instant case are strikingly similar to the facts presented in Humana," the Tax Court concluded. "Both Humana and HCA owned and operated hospitals that were facing difficulties in obtaining medical malpractice insurance at the time they formed their captive insurance companies. Both formed fully capitalized, domestic (captives) to provide on a direct basis general and professional liability insurance for themselves and their operating subsidiaries."

The Internal Revenue Service argued that the HCA case differed from Humana in several ways, however, including that HCA provided an indemnification letter to a fronting insurer for part of the coverage placed with Parthenon, undermining HCA's claim that the captive shifted risk.

The "comfort letter" led to a partial loss of HCA's deductions, but the court largely rejected the IRS's arguments and found that the captive coverage was true insurance and that HCA subsidiaries shifted risk to Parthenon.

"It's a highly fact-based decision" that doesn't necessarily create guiding legal principles for captive owners, observed Jon Harkavy, vp and general counsel of USA Risk Services Inc. in Arlington, Va. But "the good news is that it reaffirms Humana."

Like Humana, the HCA case arises within the 6th Circuit, and whether the precedent would be followed in other circuit courts is an open question, Mr. Harkavy said.

Meanwhile, the ruling underscores several elements important in arguing for captive premium deductibility, he added, including that the captive be formed for legitimate business purposes other than tax reasons; and that it be well-capitalized and based in a jurisdiction with strong regulation.

The court also indicated that "one land mine you really have to avoid at all costs is any kind of comfort letter," according to Mr. Harkavy.

In the 1989 Humana ruling, the 6th Circuit held that Humana subsidiaries are entitled to deduct premiums paid to a captive wholly owned by their parent, but that the parent company itself is not. It reached this conclusion partly by finding that losses suffered by the captive affect the parent company's net worth but not that of the subsidiaries; thus, only the subsidiaries have shifted their risk of loss.

Taking its cue from Humana, HCA did not try to argue that its own premiums should be deductible, but HCA did contend that its hospital units-numbering as high as 135 before a 1987 reorganization-should be able to deduct payments made to Parthenon.

The Tax Court, also following Humana, agreed: "HCA. . .operated Parthenon as a separate entity. It was separately staffed and managed. It maintained its own personnel files, accounting records, information management system, cash management system and banking arrangements. . .The transactions between Parthenon and. . . the sister subsidiaries constituted a bona fide insurance arrangement," the ruling noted.

The court also shot down several IRS attempts to distinguish the case from Humana.

Unlike Humana, for example, HCA provided a "comfort letter" agreeing to indemnify workers compensation fronting insurer Ideal Mutual Insurance Co. if Parthenon failed to pay reinsurance claims.

The court found that workers compensation was not a big enough part of Parthenon's business to affect the validity of the overall arrangement; however, it also found that the indemnification agreement meant there was no workers comp risk shifting for the few years the agreement was in force and denied deductions for the related workers comp premiums.

The IRS also argued that true insurance didn't exist because HCA units had no choice but to insure with Parthenon. "Choice," the court wrote, "plays no role in deciding whether the policies between Parthenon and its sister subsidiaries constituted insurance as commonly understood in the industry."

The court also rejected the Internal Revenue Service argument that HCA had agreed to provide financial help if Parthenon ran into trouble. While Tennessee regulators may have expected HCA to provide support, there was no "binding agreement that HCA or the sister subsidiaries do so," the court found.

Hospital Corp. of America and subsidiaries vs. Commissioner of Internal Revenue; U.S. Tax Court docket nos. 10663-91, 13074-91, 28588-91 and 6351-92.