Quinn Global Tax Law Issues Public Comment to Treasury Dept.

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WASHINGTON, June 13 -- Quinn Global Tax Law P.C., Las Vegas, Nevada, has issued a public comment to the U.S. Department of the Treasury. The comment was written and posted on June 9, 2023.

The comment, on Docket No. IRS-2023-0017-0001, was sent to the Internal Revenue Service.

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Proposed Regulation 109309-22, RIN 1545-BQ44 should be withdrawn because it fails to consider other regulations governing bona fide insurance companies; adds a new element to the definition of insurance, for tax purposes, not otherwise promulgated by the courts; blurs material differences amongst financial instruments and products as a means to pigeon-hole a desired result; and threatens taxpayers with the proverbial whipsaw in the form of double and, in some cases, triple taxation.

Consider the QIC test

Instead of issuing the proposed regulation, the Service should consider the Qualified Insurance Corporation Test under Subchapter P to determine whether a nontraditional insurance company/1 is a bona fide insurer. While Congress intended that this test apply only to foreign insurers, applying this test to domestic/2 nontraditional insurance companies would put the domestic insurer on the same level with foreign insurers in the context of federal tax regulation.

In determining whether an insurer otherwise is exempt from the PFIC anti-deferral regime, the insurer must (1) be a qualifying insurance corporation (QIC), (2) be engaged in an insurance business, and (3) derive its income from the active conduct of that insurance business./3 To be a QIC, the foreign insurer must (a) be predominantly engaged in the insurance business/4 and (b) have applicable insurance liabilities that exceed 25 percent of its total assets./5

1 By "nontraditional insurance" I mean captives, microcaptives, and any other insurance arrangement where the insured can, somehow and someway, participate in the underwriting profits of their own risks.

2 Including by way of a Code Secs. 953(d) election

3 See TD 9936, RIN 1545-BO59 (January 15, 2021).

4 See Code Secs. 816(a)

5 The 25 percent test is reduced to 10 percent if the foreign corporation fails the 25 percent test solely due to runoff-related or rating-related circumstances involving its insurance business.

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The purpose of these tests is to ascertain whether the foreign insurer was truly engaged in the insurance business./6 By meeting the QIC test, the foreign insurer's income is deemed to be derived from the active conduct of an insurance business.

QIC status creates a rebuttable presumption that the insurer is a bona fide insurance company. And so applying the same QIC test to domestic nontraditional insurers should create a similar rebuttable presumption that the insurer is a bona fide insurance company. Because the Service has already finalized regulations defining and regulating a QIC,/7 bridging its terms to nontraditional insurance regulation would impose no additional burden on Service. Congress has already legislated around the concept and limits of a QIC,/8 and so the Service would not be in a position to draft regulations that may run afoul the Chevron doctrine.

Adhere to the courts' three-prong test for insurance

The proposed regulation caustically reminds taxpayers of the Service's victory in each of the Avrahami, Reserve Mechanical, Syzygy, and Caylor Land cases./9 In each case, the court applied the three-prong test of (1) insurable risks, (2) risk transfer and risk distribution,/10 and (3) common notions of insurance to conclude, correctly, that the transactions at issue did not resemble insurance for federal tax purposes.

The proposed regulation adds a fourth prong in the form of the 65% loss ratio test./11 The rationale underlying the 65% threshold is rooted in Section 833, which applies a ratio specific only to health insurers, and a publication by the NAIC, an unelected, tax-exempt nonprofit. I am not aware of...

6 See H.R. Rep. No. 115-466, at 671 (2017) (Conf. Rep.)

7 See Treas. Reg. Secs. 1.1297-4

8 See Code Secs. 1297(f)

9 Notably, the proposed regulation fails to mention the recent cases of Puglisi; Series Protected Cell 76, a Series of Oxford Insurance Co. TN LLC; and Series Protected Cell 102, a Series of Oxford Ins. Co TN LLC whereby the Service essentially dropped their microcaptive challenges with stipulated decisions, thus avoiding actual judicial rulings. Note, also, that the facts in each of the four microcaptive victory cases were poor, leaving little doubt to the government's victory in each. But no taxpayer, insured, or practitioner needs those facts. We need good facts that can help create good law. Unfortunately, the Service precluded good facts and good law in the Puglisi and Oxford cases out of fear that doing so would impact their 4-0 winning streak (thanks).

10 Risk transfer and risk distribution are two sides of the same coin. While each should be analyzed separately, the failure to achieve one precludes application of the other. That is, if the risk doesn't transfer away from the insured then it can't be distributed and if the risk isn't distributed then it doesn't transfer away from the insured.

11 Proposed Reg. 1.6011-1(c)(2). Note that I am not objecting to the introduction of the financing test proposed in 1.6011-10(c)(1), which fits squarely within the third prong, common notions of insurance, and does not otherwise expand the definition of insurance for tax purposes.

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...any caselaw holding a failed loss ratio test as determinative in deciding whether a transaction constitutes insurance for tax purposes./12

Likewise, the loss ratio test should not be considered for the third prong (common notions of insurance). The loss ratio test is a mix of health care ratios and NAIC industry standards to conclude, erroneously, that nontraditional insurance metrics should resemble the same. The loss ratio ignores material differences between insurance markets and demonstrates the Service's lack of understanding of basic insurance economics. As a matter of tax policy, uniformly applying loss ratios across completely unrelated insurance markets is arbitrary, capricious, and unreasonable. And using such bad tax policy to impose draconian reporting penalties and threatened examinations on small businesses who depend on nontraditional insurance transactions is hardly what Congress intended when it enacted the reportable transaction disclosure regime.

The courts have published numerous factors that the Service should consider when determining whether an insurance transaction meets the third prong./13 I urge you to review those factors, adhere to them, and avoid relying on ratios published by non-legislative thinktanks.

Respect the material differences between the tax treatment of stock and derivatives

In defining a "captive," the proposed regulation adopts the 20-perecent vote-or-value ownership of the insurer requirement from Notice 2016-66 but goes further to state that ownership via a derivative instrument is treated as indirectly owning the referenced assets./14 Under the proposed regulation, derivatives are treated no differently than stock ownership.

But derivatives are not stock. Stock represents the legal and economic ownership of a business. Its value rises and falls in proportion to the value of the business. Dividends paid on stock are contingent,15 and stock generally carries the right to vote for directors. Stock always shares in assets at liquidation (unless preferred) and usually lasts forever unless the business is liquidated.

On the other hand, derivatives are bilateral executory contracts with a limited term. The value of a derivative is determined by reference to the price of one or more fungible securities, commodities, rates, or currencies. They represent wagers on the change in the price or yield of an underlier for which ownership is not required. Derivatives are risk management vehicles and typically afford a party much higher leverage than would be commercially possible when compared to direct ownership of the underlier.

12 But see RVI Guar. Co v. Commissioner, 145 T.C. 209, 227-228 (2015), where the court rejected the position that a loss ratio of zero meant that the insurer didn't pay insurance claims and the insured did not incur losses.

13 See Harper Group & Subs. v. Commissioner, 96 T.C. 45, 60 (1991) and Securitas Holdings, Inc. v. Commissioner, T.C. Memo. 2014-225, 108 T.C.M. (CCH) 490, 494 (2014) for some examples.

14 Proposed Regulation 1.6011-10(b)(1)(iii)

15 Contingent in that they may be distributed only if there are legally available funds under state law; may not be paid unless the board of directors elects, and not all shares of stock are eligible to participate in dividends.

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The proposed regulations attempt to pigeon-hole derivatives to resemble stock ownership, which ignores the realities and distinctions between the two financial instruments. While there exists different sets of rules under the Code for stock/16 and derivatives,/17 the proposed regulations materially blur the lines between these rules to automatically impute ownership of the underlying in any derivative contract to the contract holder.

But which party to the derivative contract is to be imputed ownership of the captive's underlying assets: the long or the short? What effect does cash-settling, physical-settling, transferring, terminating, or remarking the derivative instrument have on this deemed ownership? Is there a situation where both the long and the short party can be deemed the owner of the captive? Must the underlier in the derivative contract be the stock or assets (or both) of the captive?

Under the proposed loss ratio test, a taxpayer can take a dividend from the captive to assist it in meeting the 65% threshold.18 By paying a dividend, the captive causes otherwise tax-deferred earnings to be taxed currently, which rationally supports and preserves the federal fisc.

But how can a derivative pay a dividend? Does closing the position resemble a dividend? Unlike a dividend, which results in gross income to the taxpayer, closing a derivative position could result in a loss. How does incurring such a loss impact the taxpayer's ability to meet the 65% threshold? What if the derivative contract doesn't permit the taxpayer to close or otherwise liquidate the position so as to help the party meet the 65% test?

The proposed regulation's disregard for the material differences between derivatives and full-flavor stock creates more problems than it solves and should be abandoned. The Service's cavalier use of derivatives in the proposed regulations will negatively impact the tax policy underlying tax treatment of both derivatives and insurance.

Preclude the Proverbial Whipsaw

The Service's attacks on nontraditional insurance transactions often result in a double-tax whipsaw whereby the taxpayer is being denied a deduction for the premium while the captive is nevertheless being taxed on its receipt. In some cases the Service is denying the deduction, recognizing the...

16 See, for example, Code Secs. 243-246 (concerning the dividends received deduction); Secs. 861(a)(2) and 862(a)(2) (concerning the source of dividend income); Secs. 316(a) (stating that dividends may only be paid on earnings and profits); Secs. 1032 (stating that issuers never recognize gain or loss on the sale of their own stock)

17 See, for example, Code Secs. 1256 (concerning mandatory mark-to-market elections on foreign currency forward contracts); Secs. 1092 (preventing the use of hedged positions to recognize losses in one tax year and offsetting gains in the following year); Treas. Reg. Secs. 1.446-4 (requiring income and loss on a derivative that is part of a hedge to be recognized when the income or loss from the hedged item is recognized); Secs. 1234A (treating any gain or loss on cash settlement of a derivative as capital gain arising on a sale or exchange if the asset is capital in the hands of the taxpayer and therefore repealing the extinguishment doctrine); Secs. 1258 (recharacterizing gain as ordinary if substantially all of the taxpayer's gain is attributable to the time value of money, thus implicating short forward or futures contracts); and Secs. 1259 (concerning constructive sales of derivative instruments).

18 Proposed Regulation 1.6011-10(c)(2)

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...income, and imposing the Chapter 3 withholding tax on the outbound premium payments made to non-953(d) electing foreign insurers. If Chapter 3 doesn't apply, then the Service typically imposes the Chapter 34 excise tax on the outbound payment.

Practitioners, insurers, and insureds all understand and take very seriously the Service's disdain for nontraditional insurance transactions, abusive and non-abusive alike. However, there is no need for the Service to threaten double and triple taxation against those participants who are merely following Congress's intent. I therefore recommend that you expand the proposed regulation to specifically preclude potential whipsaws that may arise as a result of your challenge to those listed transactions and transactions of interest.

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In addition to the aforementioned, I also recommend

1. that the Service reconcile the proposed regulation, in whatever final form, with other published guidance that describes what constitutes a bona fide insurance transaction, such as Rev. Rul. 2008-8, 2008-5 I.R.B. 340;

2. that the Service follow through on its proposal in Notice 2008-9 to deliver guidance on what constitutes insurance in a protected cell company structure;

3. that the Service revisit the proposed REG-119921-09 (September 14,2010) to provide meaningful guidance to insurers conducting their insurance activities in a protected cell company structure;

4. that, given the different variations of nontraditional insurance transactions that exist in the marketplace, the proposed regulations expand on what constitutes "substantially similar" for purposes of each disclosure regime, especially considering the reference to dividends, specific tax elections under 953(d) and 831(b), and derivatives; and

5. that the Service provide more concisely define the thresholds for those activities considered to be exempt from the proposed regulation. For example, how much Consumer Coverages must an insurer underwrite so as to be exempt?

I applaud and support the Service's efforts to weed-out the illegitimate and abusive insurance transactions that comport with neither economic reality nor the common notions of insurance. But the proposed regulation, in its current form, will do no such thing. It will exacerbate the Service's position that all nontraditional insurance isn't insurance for tax purposes, and it will chill an otherwise lawful, necessary market.

The nontraditional insurance market is real. It serves a real purpose, and small businesses really do depend on it. Tax policy concerning this market should not be rooted in the facts of a few bad cases and arbitrarily crafted ratios formulated by an agency who has, on multiple occasions, made its disdain for the market well known.

Nowhere in the Service's understanding of insurance is there a scenario where an insured can participate in the underwriting profits of their own risks. But that's expressly what the nontraditional insurance market permits, and both Congress and the courts allow it.19 The Service doesn't understand this market. Given the public hostility towards this market and its participants, it is clear that the Service hates what it can't understand.

As arguably the most powerful investigatory agency in the world, I respectfully urge the Service to change its attitude towards this market and provide meaningful guidance rooted in good facts that practitioners and participants can use as guideposts to clearly delineate between abusive and non-abusive transactions, thus helping steer market participants in this rapidly growing market towards legitimate transactions with economic substance.

Unfortunately, the proposed regulation do no such thing and, therefore, should be withdrawn.

Very Truly Yours,

Aran Quinn CPA, Esq., LL.M

Managing Attorney

Cc: Madison Insurance Group

#405 Esmeralda Avenue

Suite 2, PMB 338

Guaynabo, PR 00969

19 See Amerco and Subsidiaries v. Commissioner, 96 T.C. 18 (1991) where the court rejected the government's expert testimony from Dr. Plotkin that because the insured's economic family participates in the underwriting profits of the insurable risks that the risk never transfers away from the insured and thus cannot constitute insurance.

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Original text here: https://downloads.regulations.gov/IRS-2023-0017-0054/attachment_1.pdf