The “insurance” subsidiary of the foreign parent of a domestic holding company covered pollution liabilities with respect to (1) manufacturing by five operating subsidiaries of the holding company and (2) certain real estate owned by the holding company and used by two of the holding company’s operating subsidiaries in Technical Advice Memorandum 200323026. The foreign parent, incorporated in Country R, created the insurance subsidiary under the laws of another foreign country, Country S.
The insurance subsidiary was capitalized with $500x, although an independent consultant performed a feasibility study and recommended that the initial capitalization should be $10,000x. Premiums for the first year totaled $1000x, including $620x from one of the subsidiaries. By June 30 of “Year 4 ” the shareholder’s equity grew to $2,822x. The insurance subsidiary issued six policies, each of which covered liability of up to $10,000x per pollution incident and an aggregate of up to $10,000x. The amount of premiums varied considerably among the insureds. For the period July 1 of Year 3 to June 3 0 of Year 4 , more than two thirds of the premiums were paid by Operating Subsidiary 3.
The Service concluded that insurance was not present because the captive was not adequately capitalized. The capitalization was only onetwentieth of the amount recommended in a feasibility study and liability on a single incident that equaled the $10,000x per incident limit would far exceed the captive’s equity, premium and investment income combined.
That the capitalization was sufficient to obtain a charter in Country S and to satisfy a “specific tax rule” of Country R were not sufficient to demonstrate that it was adequately capitalized for United States Federal income tax purposes. In contrast, the Service noted that although one potential insurance loss could substantially exceed the capitalization, many states “limit the amount of loss to which an insurer may be exposed on any one risk to ten percent of the insurer’s surplus.” The Service also concluded that sufficient risk distribution was lacking.
In addition, the Service concluded that the insurance arrangement among the parties was too informal. The policies for “Year 2” and “Year 3,” for example, were not formally executed until “Year 4 .” The taxpayers “assert[ed] that there were oral contracts in the meantime.”
