CAPTIVE INSURANCE arrangements may be harder to make work after an IRS ruling in December.

US companies sometimes self insure.  A company might set up an affiliate in a lower-tax jurisdiction, pay it premiums, and deduct the premiums.  The parent company has a deduction.  The income used to pay the premiums is shifted in this manner to the affiliate.

US courts have refused to recognize such arrangements as insurance unless there is truly a shifting of risks to someone else.  Thus, no deduction could be claimed for a payment to a wholly-owned subsidiary that insures no one other than its parent company.  There is no risk shifting in such cases.

The IRS drew a line of sorts in a ruling in December.  The ruling addresses two cases.  A US parent company forms a wholly-owned subsidiary to provide insurance.  In one case, 90% of the premiums collected by the subsidiary and risks borne by it are from its parent company.  In the other case, only 50% are.  The rest of the premiums and risks are from unrelated parties.  In both cases, the subsidiary is regulated as an insurance company in the states where it does business.

The IRS said the premiums could be deducted in the case where they accounted for only 50% of premium income and risks, but not so where they accounted for 90%.  The ruling is Revenue Ruling 2002-90.

The IRS said separately that it will resume issuing private rulings to companies that want to know in advance whether their captive insurance arrangements work.  However, it warned that some cases may be too factual on which to rule and suggested that companies should ask first whether a ruling is available.  The announcement is in Revenue Procedure 2002-75.

Keith Martin