Complying With The Economic Substance Doctrine

Within the last few months, the Tax Court has issued three decisions (Patel, Royalty Management, and Kadau) holding the economic substance doctrine (“ESD”) applies to captive insurance transactions. This adds a new and complex compliance layer for all captives, requiring them to affirmatively demonstrate they are not tax shelters.

The ESD is one of five anti-avoidance law doctrines, which are legal theories used by the Treasury or Tax Court to determine if a transaction is a tax shelter. All essentially analyze two factors: the taxpayer’s reason for forming the captive and the transaction’s objective substance.

The ESD, which was codified in 2010, describes the two-part inquiry this way:

(A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and

(B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.[1]

Note first that tax benefits cannot be used as substantiation, removing a significant formation enticement from justifying the transaction. Next, the resulting changes brought about by the captive must be “meaningful” or “substantial;” both words imply significant justification.

The first factor is called the objective test; it analyzes the transaction’s substance. For a captive, that would mean demonstrating compliance with the Harper factors: the captive covered an “insurance risk;” the captive operated like insurance “in its commonly accepted sense”; there is risk shifting and risk distribution.

While it must still be documented, this is a minor issue if the captive is underwriting common policies such as commercial auto or worker’s compensation. But less common policies need extensive documentation.  As for other common insurance factors the micro-captive cases provide a plethora of bad facts to avoid, including life insurance and land in the investment portfolio and poorly handled and documented claims processes. Risk shifting is uncontroversial, but risk distribution remains the preverbal “elephant in the room.” Ideally, all captives should have actuarial justification for this factor.

The second factor is the subjective test; it analyzes the taxpayer’s motivation in forming the captive. Here, it’s imperative to demonstrate a strong, non-tax reason such as providing cheaper or better coverage, giving the insured more control over the claims process (preferably due to a poor and well-documented negative claim experience), or providing a more efficient method of purchasing insurance (see below).

Documentation is key. While it does not need to rise to the level of a formal tax opinion, it should be legally weighty, with ample explanation of the law along with accompanying transactional documentation showing compliance with the same. Expressed differently, the document should be sufficient to provide the foundation for an audit defense if needed.

In many ways, this new requirement harkens back to an earlier time for captives, when feasibility studies were less perfunctory in their methodology and presentation and more in-depth and probing in their research and analysis. This is best explained in the Mobil Oil case:

Mr. Adams gathered data concerning the insurance needs and practices of the Mobil Overseas affiliates which accounted for the largest outside premium amounts, some 80 percent of those paid in 1956. These affiliates were MOAG, Mobil Oil Francaise, Mobil Oil Italiana, and Mobil Oil U.K. The data included: (a) the estimated amount of insurable risks; (b) the nature of the insurance purchased to cover such risks; (c) the administrative methods for handling the affiliates' current insurance or self-insurance programs; (d) the insurance or self-insurance practices of other oil companies; and (e) insurance, currency and tax regulations in the United Kingdom, France, Germany and Italy, including a review of the extent to which commercial insurance was required by law, regulation, business custom, leases, etc. and the tax treatment of self-insurance and commercial insurance premiums and losses. Mr. Adams consulted with insurance brokers and agents in New York, London and Europe; he travelled to Europe to visit the major affiliates of Mobil Overseas; he discussed the insurance practices of these affiliates with those responsible for the affiliate's insurance affairs.

I outline this kind of methodology in my second book, which is available from Amazon.