An issue on many people's lips at the ICAP captive conference last week was the new IRS (Internal Revenue Service in the US) ruling covering captive insurance companies. While practitioners consider it too early yet to predict how application of this ruling will evolve, it is generally regarded as being beneficial to the industry.

On June 4, the IRS officially abandoned its 24 year old `economic family ` basis for denying insurance status for single parent captives. By denying this status the IRS also denied premium/loss reserve deductions. The issuance of Revenue Ruling 2001-31 has serious implications both for planning future captive structures and for defending ongoing captive tax audits.

The IRS had refused to acknowledge the independence of a company's or group's captive, saying it was part of the same economic family.

Tom Jones, a partner with McDermott Will & Emery and one of the world's most revered captive experts, said, "A single parent captive covering only risks of its parent will continue to be subject to IRS challenge due to the lack of risk shifting and risk distribution. A captive also will remain in tax jeopardy if its parent directly or indirectly guarantees its policy issuing carrier's obligations, or if the captive is undercapitalised and/or it operates in an `under regulated' jurisdiction.

"But it appears that pure captives writing a significant level of brother-sister risk, i.e. other affiliates of the parent, will no longer be pursued by the IRS. That is, the IRS may accept brother-sister risk because it will substitute the balance sheet test for the now defunct economic family theory."

Mr. Jones said that because this ruling does not address how much unrelated risk is necessary to create true insurance, existing case law on the matter will continue to control it. This means the at least 30 percent unrelated risk, measured by net premiums, is rule of thumb.

"The 1988 `Sears-Allstate ruling, among others, was declared obsolete which means that it no longer is considered determinative with respect to future transactions. Thus the IRS has abandoned its former extreme position that, no matter how much unrelated risk a pure captive covers, there never can be premium deductibility by its single parent.

"The existing parameters of what constitutes unrelated risk exposures have not been changed. For example the surprise 1992 ruling declaring employee long-term group life coverage to constitute unrelated risk remains intact."

He said the ruling does not appear to change the existing tax situation of group captives, rent-a-captives and cell captives. "The 1978 ruling indicating that a captive with 31 unrelated owners, no one of which accounts for more than five percent of premiums, constitutes true insurance remains unchanged. However to the extent that classification of activities of a rent-a-captive's or segregated account captive's cell as insurance is in question, presumably the liberalised brother-sister rules should facilitate a favourable outcome."

Mr. Jones feels the likely long-term impact of this ruling will be that intelligently structured captives will achieve tax success, but that it will not permit tax-dodge captives to act with impunity.

"Past experience in non-captive areas indicates that it generally will discourage zealous IRS agents from pursuing captives unless the payoff ( taxpayer misbehaviour) is obvious. On the other hand one could read this ruling as merely a housekeeping pronouncement finally recognising the judicial reality that the economic family theory is inconsistent with the long-standing tax maxim that every legal entity has a separate and independent existence."