McDermott Will & Emery LLP REVENUE RULING June, 2005

McDermott Will & Emery LLP S UMMARY  The IRS analyzed 4 hypothetical captive arrangements and concluded that 3 of the 4 lacked risk distribution, a hallmark of “insurance” status.  Prior to Rev. Rul , the IRS’s position regarding risk distribution was unclear, primarily because published IRS (and judicial) guidance focused on risk shifting, the other hallmark for insurance status.  Rev. Rul is a clear articulation of the IRS’s current position that risk distribution entails two elements.  First, a significant number of independent, homogeneous risk exposures must be transferred to the captive, such that the law of large numbers takes effect.  And second, the risk exposures transferred to the captive must derive from at least several “independent” entities from a Federal income tax perspective.

McDermott Will & Emery LLP Corp. X (U.S.) Corp. X (U.S.) S ITUATION 1  X owns and operates a large fleet of vehicles.  Vehicles represent a significant volume of independent, “homogeneous” risk.  X enters into an arrangement with unrelated Y where, in exchange for “premiums,” Y agrees to “insure” X against risk of loss with respect to X’s vehicle fleet.  Y does not “insure” any entity other than X. S ITUATION 2  Same as Situation 2, except that Y also “insures” unrelated Z in exchange for “premiums” against risk of loss with respect to Z’s vehicle fleet in the conduct of a business substantially similar to that of X.  Y’s earnings from its arrangement with Z constitute 10% of Y’s total amount earned (both gross and net) during the year and the risk exposures attributable to Z comprise 10% of the total risk borne by Y. Corp. Y (U.S.) Corp. Y (U.S.) Risk Funding Contract Premiums Corp. X (U.S.) Corp. X (U.S.) Corp. Y (U.S.) Corp. Y (U.S.) Risk Funding Contract 90% Premiums (and Risk) Corp. Z (U.S.) Corp. Z (U.S.) Risk Funding Contract 10% Premiums (and Risk)

McDermott Will & Emery LLP Corp. X (U.S.) Corp. X (U.S.) S ITUATION 3  X conducts a courier business through 12 LLCs that are disregarded entities for Federal income tax purposes.  The LLCs own a fleet of vehicles that represent a significant volume of independent, homogeneous risk.  Each of the LLCs enters into an arrangement with Y where unrelated Y agrees to “insure” the LLC against risk of loss with respect to its vehicle fleet.  Y does not “insure” any entity other than the LLCs.  None of the LLCs account for less than 5%, or more than 15%, of the total risk assumed by Y. S ITUATION 4  Same as Situation 2, except that the 12 LLCs elect to be treated as corporations for Federal income tax purposes. Corp. Y (U.S.) Corp. Y (U.S.) Risk Funding Contracts 12 Corp. X (U.S.) Corp. X (U.S.) Corp. Y (U.S.) Corp. Y (U.S.) Risk Funding Contracts Key:= Corporation for Federal income tax purposes = Disregarded entity for Federal income tax purposes

McDermott Will & Emery LLP H OLDING  The IRS concluded that, although each of the arrangements satisfied the risk shifting requirement for insurance status, risk distribution was lacking in Situations 1, 2 and 3. Accordingly, only Situation 4 constituted “insurance” from a Federal income tax perspective.  The IRS did not, however, provide a clear indication of the manner in which Situations 1, 2 and 3 should be treated for Federal income tax purposes.  Rather, the IRS stated that a range of “non-insurance” characterizations could apply, i.e., a deposit arrangement, a loan, a contribution to capital (to the extent of the net value, if any), an indemnity arrangement that is not an insurance contract, or otherwise.  The potential non-insurance characterizations can have dramatically different consequences from a Federal income tax perspective.

McDermott Will & Emery LLP R ISK S HIFTING  Risk shifting, which looks to whether the insureds transferred the financial consequences of a potential loss to the insurer, was found to exist in all four Situations.  The rationale, although unstated, was that the purported insurer, Y, was unrelated to the insureds.  This conclusion is consistent with existing authority.  See Humana v. Com’r, 881 F.2d 247 (6th Cir. 1989); Kidde Industries v. U.S., 40 Fed. Cl. 42, 54 (Fed. Cl. 1997); Rev. Rul ; Rev. Rul ; Rev. Rul

McDermott Will & Emery LLP R ISK D ISTRIBUTION Risk distribution, on the other hand, was found to be lacking. In reaching that conclusion, the IRS ruled that risk distribution has two elements. First, the insurer must assume a significant number of independent, homogenous risk exposures for the law of large numbers to apply. This allows the insurer to smooth out losses to match more closely its receipt of premiums. And second, the insurer must pool the premiums (and risk) from a particular insured with the premiums (and risk) of other insureds, such that the insured is not “in significant part paying for its own risks.”

McDermott Will & Emery LLP R ISK D ISTRIBUTION (C ONTINUED ) The first requirement for risk distribution was satisfied because a significant number of independent, homogenous risk exposures were transferred to Y, the purported insurer. The second requirement was not satisfied in Situations 1, 2 and 3. Situation 1 involved a single insured, so there was no pooling of premiums by Y. 90% of the risk (and premiums) transferred to Y in Situation 2 derived from a single insured, X. Thus, there was not a sufficient pooling of X’s premiums. It is possible, however, that there was a sufficient pooling of Z’s (the 10% insured’s) premiums to create risk distribution for Z (potentially resulting in characterization of Z’s payments as deductible “insurance premiums”). Situation 3 involved multiple insureds for state law purposes, but the insureds were treated as a single entity for Federal income tax purposes. The IRS concluded that, as a result, Situation 3 should be treated the same as Situation 1. In contrast, Situation 4 created risk distribution because numerous (albeit related) entities that were “regarded” for Federal income tax purposes transferred risk and premiums to Y.

McDermott Will & Emery LLP C OMMENTS  No attempt was made to reconcile Rev. Rul with prior judicial and IRS guidance indicating that a single insured can create sufficient risk distribution.  Gulf Oil v. Com’r, 89 T.C. 1010, (1987) (“a single insured can have sufficient unrelated risks to achieve adequate risk distribution”).  1998 FSA Lexis 167 (“a single taxpayer may transfer an amount of homogenous and statistically independent risks which would be sufficient to satisfy the risk distribution requirement”).  Other authority interpreting the risk distribution requirement is arguably ambigous.  Accordingly, some taxpayers may continue to take the position that multiple insureds are not needed to satisfy the risk distribution requirement.  Given the lack of authority and the IRS’s contrary position, there is a material possibility that in those situations, risk distribution (and, therefore, insurance status) will ultimately be found to be lacking.