The US Court of Appeals for the Tenth Circuit has affirmed the Reserve Mechanical decision in all respects, rejecting the petitioner’s appeal.
Reserve previously appealed the court’s decision that it did not qualify for an exemption from income tax as a small insurance company in 2020.
The long-running case met its conclusion on 13 May when the Tenth Circuit affirmed its original decision, indicating two grounds for deciding that Reserve was “not engaged in the business of insurance”.
First, the court argued that Reserve had not adequately distributed risk among a large number of independent insureds. Virtually all the insured risk was that of one insured, a company that had the same ownership as Reserve itself, the court found.
To appear to distribute risk, the court added, Reserve entered into an insurance pool with other purported insurance companies, each owned by an affiliate of its insured. The arrangement lacked substance and the pool itself did not distribute risk, the court argued.
Although recognising that no part of the Tax Code clearly defines the term “insurance” owing to the subjectivity of context, the court uses four general criteria: the arrangement involves insurable risks; shifts the risk of loss to the insurer; distributes the risk among policyholders; and constitutes insurance “in the commonly accepted sense”.
The Tax Court determined that the policies issued by Reserve failed to meet these criteria.
However, the Court of Appeals also stated: “Contrary to what is suggested in some briefs filed in this court, the Tax Court did not criticise risk pools as a general matter. Instead, its findings were specific to the PoolRe risk pool.”
How the court’s decision to uphold the actions and injunctions of the IRS will pan out for the captive industry remains to be seen. Certainly, this ruling affirms the need for risk distribution and risk transfer among captive insurance companies, for which the many consultants and brokers in the industry can provide invaluable knowledge.
