142 T.C. No. 1 UNITED STATES TAX COURT. RENT-A-CENTER, INC. AND AFFILIATED SUBSIDIARIES, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent

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142 T.C. No. 1 UNITED STATES TAX COURT RENT-A-CENTER, INC. AND AFFILIATED SUBSIDIARIES, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent Docket Nos , , Filed January 14, 2014.
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142 T.C. No. 1 UNITED STATES TAX COURT RENT-A-CENTER, INC. AND AFFILIATED SUBSIDIARIES, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent Docket Nos , , Filed January 14, P, a domestic corporation, is the parent of numerous wholly owned subsidiaries including L, a Bermudian corporation. P conducted its business through stores owned and operated by its subsidiaries. The other subsidiaries and L entered into contracts pursuant to which each subsidiary paid L an amount, determined by actuarial calculations and an allocation formula, relating to workers compensation, automobile, and general liability risks, and, in turn, L reimbursed a portion of each subsidiary s claims relating to these risks. P s subsidiaries deducted, as insurance expenses, the payments to L. In notices of deficiency issued to P, R determined that the payments were not deductible. Held: P s subsidiaries payments to L are deductible, pursuant to I.R.C. sec. 162, as insurance expenses. - 2 - Val J. Albright and Brent C. Gardner, Jr., for petitioners. R. Scott Shieldes and Daniel L. Timmons, for respondent. FOLEY, Judge: Respondent determined deficiencies of $14,931,159, $13,409,628, $7,461,039, $5,095,222, and $2,828,861 relating, respectively, to 1 Rent-A-Center, Inc. (RAC), and its subsidiaries 2003, 2004, 2005, 2006, and 2007 (years in issue) consolidated Federal income tax returns. The issue for decision is whether payments to Legacy Insurance Co., Ltd. (Legacy), were 2 deductible, pursuant to section 162, as insurance expenses. FINDINGS OF FACT RAC, a publicly traded Delaware corporation, is the parent of a group of approximately 15 affiliated subsidiaries (collectively, petitioner). During the years in issue, petitioner was the largest domestic rent-to-own company. Through stores owned and operated by RAC s subsidiaries, petitioner rented, sold, and delivered home electronics, furniture, and appliances. The stores were in all 50 States, the 1 Respondent, in his amended answer, asserted an additional $2,603,193 deficiency relating to Unless otherwise indicated, all section references are to the Internal 2 Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure. - 3 - District of Columbia, Puerto Rico, and Canada. From 1993 through 2002, petitioner s company-owned stores increased from 27 to 2,623. During the years in issue, RAC s subsidiaries owned between 2,623 and 3,081 stores; had between 14,300 and 19,740 employees; and operated between 7,143 and 8,027 insured vehicles. I. Petitioner s Insurance Program In 2001, American Insurance Group (AIG), in response to a claim against RAC s directors and officers (D&O), withdrew a previous offer to renew RAC s D&O insurance policy. To address this problem, RAC engaged Aon Risk Consultants, Inc. (Aon), which convinced AIG to renew the policy. Impressed with Aon s insurance expertise and concerned about its growing insurance costs, petitioner engaged Aon to analyze risk management practices and to broker workers compensation, automobile, and general liability insurance. With Aon s assistance, petitioner developed a risk management department and improved its loss prevention program. Prior to August 2002, Travelers Insurance Co. (Travelers) provided petitioner s workers compensation, automobile, and general liability coverage through bundled policies. Pursuant to a bundled policy, an insurer provides coverage and controls the claims administration process (i.e., investigating, - 4 - evaluating, and paying claims). Travelers paid claims as they arose and withdrew amounts from petitioner s bank account to reimburse itself for any claims less than or equal to petitioner s deductible (i.e., a portion of an insured claim for which the insured is responsible). Pursuant to a predetermined formula, each store was allocated, and was responsible for paying, a portion of Travelers premium costs. In 2001, after receiving a $3 million invoice from Travelers for claim handling fees, petitioner became dissatisfied with the cost and inefficiency associated with its bundled policies. On August 5, 2002, petitioner, with the assistance of Aon, obtained unbundled workers compensation, automobile, and general liability policies from Discover Re. Pursuant to an unbundled policy, an insurer provides coverage and a third-party administrator manages the claims administration process. Discover Re underwrote the policies; multiple insurers 3 4 provided coverage; and Specialty Risk Services, Inc. (SRS), a third-party administrator, evaluated and paid claims. Petitioner and its staff of licensed adjusters had access to SRS claims management system and monitored SRS to 3 The following insurers provided coverage: U.S. Fidelity & Guarantee Co., Fidelity & Guaranty Insurance Co., Discover Property and Casualty Insurance Co., St. Paul Fire & Marine Co. of Canada, and Fidelity Guaranty Insurance Underwriters Inc. SRS was affiliated with the Hartford Insurance Co., a well-established 4 insurer, and did not have a contract with Discover Re. - 5 - ensure the proper handling of claims. This arrangement gave petitioner greater control over the claims administration process. Petitioner, pursuant to the Discover Re policies deductibles, was liable for a specific amount of each claim against its workers compensation, automobile, and general liability policies (e.g., pursuant to its 2002 workers compensation policy, petitioner was liable for the first $350,000 of each claim). Petitioner s retention of a portion of the risk resulted in lower premiums. II. Legacy s Inception Between 1993 and 2002, petitioner rapidly expanded and became increasingly concerned about its growing risk management costs. In 2002, after analyzing petitioner s insurance program, Aon suggested that petitioner form a wholly owned insurance company (i.e., a captive). Aon representatives informed David Glasgow, petitioner s director of risk management, about the financial and nonfinancial benefits of forming a captive. Aon convincingly explained that a captive could help petitioner reduce its costs, improve efficiency, obtain otherwise unavailable coverage, and provide accountability and transparency. Mr. Glasgow presented the proposal to petitioner s senior management, who concurred with Mr. Glasgow s recommendation to further explore the formation of a captive. Petitioner s senior management directed Aon to conduct a feasibility study (i.e., - 6 - relying on petitioner s workers compensation, automobile, and general liability loss data) and to prepare loss forecasts and actuarial studies. Petitioner engaged KPMG to analyze the feasibility study, review tax considerations, and prepare financial projections. Aon, in the feasibility study, recommended that the captive be capitalized with no less than $8.8 million. Before deciding where to incorporate the captive, RAC analyzed projected financial data and reviewed multiple locations. On December 11, 2002, RAC incorporated, and capitalized with $9.9 million, 5 6 Legacy, a wholly owned Bermudian subsidiary. Legacy opened an account with Bank of N.T. Butterfield and Son, Ltd., and, on December 20, 2002, filed a class 1 insurance company registration application with the Bermuda Monetary Authority (BMA), which regulated Bermuda s financial services sector. A class 1 insurer may insure only the risk of its shareholders and affiliates; must be capitalized with at least $120,000; and must meet a minimum solvency margin calculated by 5 RAC contributed $9.9 million of cash and received 120,000 shares of Legacy capital stock with a par value of $1. Legacy elected, pursuant to sec. 953(d), to be treated as a domestic 6 corporation for Federal income tax purposes. In addition, Legacy engaged Aon Insurance Managers (Bermuda), Ltd., to monitor Legacy s compliance with Bermudian regulations and to provide management, financial, and administrative services. - 7-7 reference to the insurer s net premiums, general business assets, and general business liabilities. See Insurance Act, 1978, secs. 4B, 6, Appleby (2008) (Berm.); Insurance Returns and Solvency Regulations, 1980, Appleby, Reg. 10(1), Schedule I, Figure B (Berm.). During the years in issue, the BMA had the authority to modify prescribed requirements through both prospective and retroactive directives for special allowances. See Insurance Act, 1978, sec. 56. Legacy planned to insure petitioner s liabilities for the period beginning in 2002 and ending December 31, 2003 (proposed period). Aon informed petitioner that coverage provided by unrelated insurers would be more costly than Aon s estimate of Legacy s premiums and that some insurers would not be willing to offer coverage. In response to a quote request, Discover Re stated that it was not in the market to provide the coverage Legacy contemplated. Discover Re estimated, however, that its premium (i.e., if it were to write one relating to the proposed period) would be approximately $3 million more than Legacy s. The Bermuda Insurance Act, the Insurance Accounts Regulations, and the 7 Insurance Returns and Solvency Regulations reference general business, admitted, and relevant assets. See Insurance Act, 1978, sec. 1, Appleby (2008) (Berm.); Insurance Accounts Regulations, 1980, Appleby, Schedule III, Pt. 1, 13 (Berm.); Insurance Returns and Solvency Regulations, 1980, Appleby, Reg. 10(3), 11(4) (Berm.). For purposes of this Opinion, there is no significant difference among these terms. - 8 - III. Petitioner s Policies During the years in issue, petitioner obtained unbundled workers compensation, automobile, and general liability policies from Discover Re. Pursuant to these policies, Discover Re provided petitioner with coverage above a predetermined threshold relating to each line of coverage. In addition, Legacy wrote policies that covered petitioner s workers compensation, automobile, and general liability claims below the Discover Re threshold. Petitioner, depending on the amount of a covered loss, could seek payment from Legacy, Discover Re, or both companies. The annual premium Legacy charged petitioner was actuarially determined using Aon loss forecasts and was allocated to each RAC subsidiary that owned covered stores. RAC was a listed policyholder pursuant to the Legacy policies. No premium was attributable to RAC, however, because it did not own stores, have employees, or operate vehicles. RAC paid the premiums relating to each 8 policy, estimated petitioner s total insurance costs (i.e., Legacy policies, Discover Re policies, third-party administrator fees, overhead, etc.), and established a From December 31, 2002, through September 12, 2003, Legacy incurred a 8 $4,861,828 liability relating to claim reimbursements due petitioner. This amount was netted against petitioner s September 12, 2003, premium payment (i.e., petitioner paid a net premium of $37,938,472 rather than the $42,800,300 gross premium). - 9 - monthly rate relating to each store s portion of these costs. The monthly rate was based on three factors: each store s payroll, each store s number of vehicles, and the total number of stores. At the end of each year, RAC adjusted the allocations to ensure that its subsidiaries recognized their actual insurance costs. SRS administered all claims relating to petitioner s workers compensation, automobile, and general liability coverage. During the years in issue, the terms of Legacy s coverage varied, Legacy progressively covered greater amounts of petitioner s risk, and Legacy did not receive premiums from any unrelated entity. From December 31, 2002, through December 30, 2007, Legacy earned net underwriting income of $28,761,402. See infra p. 16. A. Legacy s Deferred Tax Assets Pursuant to the Legacy policies, coverage began on December 31 of each year. Because petitioner was a calendar year accrual method taxpayer, these policies created temporary timing differences between income recognized for tax 9 purposes and income recognized for financial accounting (book) purposes. For Each premium was generally paid in September of the year following the 9 year in which the policy became effective. Use of the recurring item exception allowed petitioner to claim a premium deduction relating to the year in which the policy became effective, rather than the following year when the premium was actually paid. See sec. 461(h)(3)(A)(iii). On August 28, 2007, petitioner filed Form 3115, Application for Change in Accounting Method, requesting permission (continued...) example, on December 31, 2002, when Legacy s second policy became effective, Legacy recognized, for tax purposes, the full amount of the premium (i.e., $42,800,300) relating to the taxable year ending December 31, See sec. 832(b)(4). For book purposes, however, Legacy in 2002 recognized only 1/365 of the premium (i.e., $117,261), and the remaining $42,683,039 constituted a reserve. This timing difference created a deferred tax asset (DTA) because in 2002 Legacy prepaid its tax liability relating to income it recognized, for book purposes, in Each day Legacy recognized a portion of its premium income (i.e., $117,261) for book purposes and reduced its reserve by the same amount. On December 30, 2003, the reserve was fully depleted. Upon the issuance of a new policy on December 31, 2003, a new DTA was created because Legacy recognized, for tax purposes, in 2003 the full amount of the premium; a corresponding tax liability was incurred; the premium reserve increased; and most of the premium income attributable to the 2003 policy was recognizable, for book purposes, in (...continued) 9 to revoke its use of the recurring item exception. Bermuda s Minimum Solvency Margin Requirement Pursuant to the Bermuda Insurance Act, an insurance company must maintain a minimum solvency margin. See Insurance Act, 1978, sec. 6. More specifically, a class 1 insurer s general business assets must exceed its general business liabilities by the greatest of: $120,000; 10% of the insurer s loss and loss expense provisions plus other insurance reserves; or 20% of the first $6 million of net premiums plus 10% of the net premiums which exceed $6 million. See Insurance Returns and Solvency Regulations, 1980, Appleby, Reg. 10(1), Schedule I, Figure B. DTAs generally may be treated as general business assets only with the BMA s permission. 2. Legacy Receives Permission To Treat DTAs as General Business Assets Through 2003 In the minimum solvency margin calculation set forth in its insurance company registration application, Legacy treated DTAs as general business assets. On March 11, 2003, Legacy petitioned the BMA for the requisite permission to do so. The following letter from RAC accompanied the request: We write to confirm to you that Rent-A-Center, Inc., * * * will guarantee the payment to Legacy Insurance Company, Ltd. (the Company ), * * * of all amounts reflected on the projected balance sheets of the Company previously delivered to you as deferred tax assets arising from timing differences in the amounts of taxes payable for tax and financial accounting purposes. This guaranty of payment will take effect in the event of any change in tax laws that would require recognition of an impairment of the deferred tax asset, and will be effective to the extent of the amount of the impairment. On March 13, 2003, the BMA granted Legacy permission to treat DTAs as general business assets on its statutory balance sheet through December 31, The BMA also informed Legacy that from December 31, 2002, through March 13, 2003, it wrote insurance business without being in receipt of its Certificate of Registration and was therefore in violation of the [Bermuda Insurance] Act as it engaged in insurance business without a license. Despite this violation, the BMA registered Legacy as a class 1 insurer effective December 20, 2002 (i.e., the date Legacy filed its insurance registration request and before it issued policies relating to the years in issue). 3. The Parental Guaranty: Facilitating the Treatment of DTAs as General Business Assets Through 2006 In response to the recurring DTA issue, Legacy requested that RAC guarantee DTAs relating to subsequent years. On September 17, 2003, RAC s board of directors authorized the execution of a guaranty of the obligations of Legacy to comply with the laws of Bermuda. On the same day, RAC s chairman 10 See infra pp and chief executive officer executed a parental guaranty and sent it to Legacy s board of directors. The parental guaranty provided: The undersigned, Rent-A-Center, Inc. a Delaware corporation ( Rent- A-Center ) is sole owner of 100% of the issued and outstanding shares in your share capital and as such DOES HEREBY GUARANTEE financial support for you, Legacy Insurance Co., Ltd., * * * and for your business, as more particularly set out below, which is to say: Under the [Bermuda] Insurance Act * * * and related Regulations (the Act ), Legacy Insurance Co., Ltd., must maintain certain solvency and liquidity margins and, in order to ensure continued compliance with the Act, it is necessary to support Legacy Insurance Co., Ltd. with a guarantee of its liabilities under the Act (the Liabilities ) not to exceed Twenty-Five Million US dollars (US $25,000,000). Accordingly, Rent-A-Center DOES HEREBY GUARANTEE to you the payment in full of the Liabilities of Legacy Insurance Co., Ltd. and further to indemnify and hold harmless Legacy Insurance Co., Ltd. from the Liabilities up to the maximum dollar amount [$25,000,000] indicated in the foregoing paragraph. Seeking regulatory approval to treat DTAs as general business assets in subsequent years, Legacy, on October 30, 2003, petitioned the BMA and attached the parental guaranty. On November 12, 2003, the BMA issued a directive which approved the th Parental Guarantee from Rent-A-Center, Inc. dated 17 September, 2003 up to an aggregate amount of $25,000,000 for utilization as part of * * * [Legacy] s capitalization. This approval was granted for the years ending December 31, , 2004, 2005, and Legacy used the parental guaranty only to meet the 11 minimum solvency margin (i.e., to treat DTAs as general business assets). On December 30, 2006, RAC unilaterally canceled the parental guaranty because Legacy met the minimum solvency margin without it. B. Legacy s Ownership of RAC Treasury Shares Legacy purchased RAC treasury shares during 2004, 2005, and The BMA approved the purchases and allowed Legacy to treat the shares as general business assets for purposes of calculating its liquidity ratio (i.e., its ratio of general business assets to liabilities). Pursuant to Bermuda solvency regulations, an insurer fails to meet the liquidity ratio if the value of its general business assets is less than 75% of its liabilities. See Insurance Returns and Solvency Regulations, 1980, Appleby, Reg. 11(2). During the years in issue, Legacy met its liquidity ratio and did not resell the shares. C. Legacy s Financial Reports For each policy period, Legacy s auditor, Arthur Morris & Co. (Arthur Morris), prepared, and provided to RAC and the BMA, reports and financial statements. In these reports and statements, Arthur Morris calculated Legacy s 11 See infra pp DTAs, minimum solvency margin, premium-to-surplus ratio, and net 15 underwriting income. During each of the years in issue, Legacy s total statutory capital and surplus equaled or exceeded the BMA minimum solvency margin. In calculating total statutory capital and surplus, Arthur Morris took into account the following four components: contributed surplus, statutory surplus, capital stock, and other fixed capital (i.e., assets deemed to be general business assets). During 2003, 2004, and 2005, Legacy included portions of the parental guaranty as general business assets. During the years in issue, the amounts of Legacy s DTAs exceeded the portions of Legacy s parental guaranty treated as general business assets. See infr
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