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BURLINGTON, Vt. — A cease-and-desist order issued to Microsoft Corp.’s Arizona-based captive insurer earlier this year caught the attention of industry participants but should not have broader implications for the captive sector, tax experts say.
While the issue may affect similar captives with parents in Washington state, it may not extend beyond the software giant, they say.
However, court wins by tax authorities elsewhere in the United States, could have wider implications for some captive owners, they said.
In May, Washington’s insurance commissioner issued a cease-and-desist order and a notice that it intends to collect unpaid premium taxes from Cypress Insurance Co., which was admitted as a captive in the state on July 1, 2008.
Cypress operates as a pure captive and its sole policyholder is Redmond, Washington-based Microsoft’s group of companies, according to the order issued by Commissioner Mike Kreidler. The captive does not hold a certificate of authority to transact insurance or a surplus line broker's license to place unauthorized insurance in the state nor is insurance coverage provided by Cypress placed through a surplus line broker licensed in Washington state, according to the order.
Cypress has collected more than $71 million in premium from Microsoft between 2013 and 2018, but the captive has not paid premium tax to the state of Washington while insuring Microsoft during those years, representing more than S1.4 million in unpaid premium tax, according to the order. In addition to the alleged unpaid taxes, about $611,540 in interest and penalties would accrue, according to the notice.
“That obviously raised the attention of the captive community across the country,” Tom Jones, Chicago-based counsel with McDermott Will & Emery L.L.P., told attendees of the Vermont Captive Insurance Association conference in Burlington, Vermont, on Tuesday.
There likely will not be public comments about the dispute, he said. “From what I understand Microsoft has a very capable inhouse legal department that is handling this, and I think they’re going to settle it without any pronouncements and it will ‘go away’,” he said. “But the issue is: is it recurring elsewhere? First, the state of Washington has never had a captive statute and doesn’t particularly appreciate captives. That’s a part of it.”
Microsoft declined to comment on the issue.
Washington also does not have a direct placement tax “so there’s no mechanism to tax placements with nonadmitted companies,” said Bruce Wright, a New York-based partner with Eversheds Sutherland (US) L.L.P. In the 46 states that do have such a mechanism, they would just try to impose the tax, he said.
“I think the long and short of it is this is not likely contagious, (not likely) going to start popping up in other states or even in Washington once Microsoft gets this whole dispute finally settled,” Mr. Jones said. “But the cease-and-desist order is troublesome.”
“I think that was done to get somebody’s attention,” Mr. Wright said.
The panelists also discussed the implications of recent tax court cases on 831(b) microcaptives and the broader captive sector.
In June, Judge Kathleen Kerrigan of the U.S. Tax Court in Washington issued a decision in Reserve Mechanical Corp. v. Commissioner of Internal Revenue that the captive “was not operated as a bona fide insurance company, and there was no legitimate business purpose for the policies that Reserve issued for the insured.”
This marked the second unfavorable ruling against a microcaptive by a tax court following the 2017 decision in in Benyamin Avrahami and Orna Avrahami v. Commissioner of Internal Revenue and there are three other cases in the pipeline involving microcaptives – two of them being heard by the same judge who issued the Avrahami opinion.
“Make no mistake about it: if the IRS gets favorable sentences in the 831(b) opinions, they’re going to come back after the large captives because the IRS has always hated all captives,” said Charles J. Lavelle, senior partner and a member of the tax and employee benefits department of Bingham Greenebaum Doll L.L.P. in Louisville, Kentucky.
The rulings in Avrahami and Reserve Mechanical made references to the pooling arrangements that the captives used to distribute risk, including comments about the pools’ lack of effectiveness, but those comments were fact specific, Mr. Wright said.
“If you looked at other pools, a lot of the facts that the court relied on just are not there,” he said. “Some people have said ‘Oh, you can’t have pools anymore.’ I don’t think that’s necessarily an accurate comment. I think you have to look at the facts of the situation.”
“I think you can have pools,” Mr. Lavelle agreed.
The IRS is expending substantial resources on auditing these microcaptives because “they’ve had some success” in scrutinizing this group, Mr. Wright said. “They think the campaign is going to result in a lot of settlements and basically revenue.”
A U.S. Tax Court judge handed a victory to the Internal Revenue Service on Monday in a closely watched case involving an 831(b) captive insurer.