Extras on Excise: In Insurance Tax Case, New York Follows Where the Federal Government Leads

As discussed in a previous Bloomberg BNA SALT Talk post, the IRS has concerns over particular captive insurance companies’ potential for tax evasion. But the federal government isn’t the only jurisdiction scrutinizing captive insurance company activity with this inquiry, however. For example, New York’s tax appeals tribunal recently examined a case dealing with a captive insurance company and upheld the Administrative Law Judge (ALJ)’s determination that the federal government’s determination about premium deductibility for income tax purposes must govern the state’s determination, as well.

At the federal level, there is no statutory definition of “insurance” in the Internal Revenue Code; instead, it is necessary to look at the facts in each case and decide whether the activities are consistent with commonly accepted notions of insurance. Risk shifting and risk distribution are key factors to consider when determining whether a transaction is insurance.

On July 27, 2017, the New York Tax Appeals Tribunal discussed some of these issues in New York Tax Appeals Tribunal Decision No. 825745. The petitioner in question owned several convenience stores and gas stations. The petitioner also had a direct subsidiary, a pure captive insurance company, and deducted premiums paid to the captive on its franchise tax returns.

The ALJ for the case had determined that the arrangement between the taxpayer and its captive didn’t constitute insurance because the captive received premium payments only from the taxpayer, there wasn’t sufficient risk shifting or risk distribution. Thus, because the arrangement wasn’t “insurance” and the payments weren’t deductible for federal tax purposes (a point the taxpayer conceded during its audit), the ALJ determined that the payments could not be deducted from state franchise tax either.

On appeal, the petitioner argued that New York captive laws permitted treating captive payments as deductible and that was the legislative intent behind those laws. The petitioner also claimed that the state captive law, not federal law, should govern how insurance was defined. The tribunal, however, disagreed.

Under New York franchise tax law at the time, the tax was based on the highest of four bases, including entire net income (ENI). N.Y. Tax Law § 208(9)’s definition of ENI includes ENI for federal tax purposes; relevant regulations and case law also indicate, as the ALJ and court held, that federal taxable income is the starting point for calculating state ENI. Because the premium payments weren’t deductible under federal law and were included in federal taxable income, the payments similarly had to be included in state ENI as well.

The petitioner’s argument stemmed from its treatment under state captive laws. The payments that the petitioner made to the captive were legally considered premiums. The captive paid the captive premiums tax on its direct gross premiums and paid other state insurance administrative assessments. However, the court ruled that because state law did not specifically allow a deduction for captive premiums when calculating ENI, the petitioner’s argument was incorrect.

The tax division agreed to refund the captive premiums taxes the petitioner paid for the time period at issue. The division decided after audit that the governing statutes treated the petitioner inconsistently because the premiums paid to the captive could not be considered premiums for captive premiums tax purposes while not being considered premiums for franchise tax purposes. The department thus determined that the payments would not be considered premiums for either the franchise tax or the captive premiums tax.

Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: Do you think there should be a federal definition for “insurance” in the Internal Revenue Code, or is case law enough guidance for taxpayers?

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