                              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. 8320-09, 6909-10,               Filed January 14, 2014.
              21627-10.


          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

Rent-A-Center, Inc. (RAC), and its subsidiaries’ 2003,1 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

deductible, pursuant to section 162,2 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 2003.
      2
      Unless otherwise indicated, all section references are to the Internal
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

provided coverage;3 and Specialty Risk Services, Inc. (SRS),4 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.
      4
       SRS was affiliated with the Hartford Insurance Co., a well-established
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

Legacy, a wholly owned Bermudian subsidiary.6 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.
      6
       Legacy elected, pursuant to sec. 953(d), to be treated as a domestic
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-

reference to the insurer’s net premiums, general business assets,7 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.




      7
       The Bermuda Insurance Act, the Insurance Accounts Regulations, and the
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

policy,8 estimated petitioner’s total insurance costs (i.e., Legacy policies, Discover

Re policies, third-party administrator fees, overhead, etc.), and established a

      8
        From December 31, 2002, through September 12, 2003, Legacy incurred a
$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

purposes and income recognized for financial accounting (book) purposes.9 For

      9
        Each premium was generally paid in September of the year following the
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...)
                                        - 10 -

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, 2002. 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

2003. 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 2004.




      9
       (...continued)
to revoke its use of the recurring item exception.
                                        - 11 -

             1. 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
                                         - 12 -

      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,

2003.10 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. 15-16.
                                       - 13 -

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

Parental Guarantee from Rent-A-Center, Inc. dated 17th 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,
                                          - 14 -

2003, 2004, 2005, and 2006. Legacy used the parental guaranty only to meet the

minimum solvency margin (i.e., to treat DTAs as general business assets).11 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 2006. 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. 15-16.
                                       - 15 -

DTAs,12 minimum solvency margin,13 premium-to-surplus ratio,14 and net

underwriting income.15 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 infra p. 16. Arthur Morris calculated Legacy’s statutory surplus by

adding statutory surplus at the beginning of the year and income for the year,

subtracting dividends paid and payable, and making other adjustments relating to

changes in assets.

      12
           See supra pp. 9-10.
      13
           See supra p. 11.
      14
        Premium-to-surplus ratio is one measure of an insurer’s economic
performance. On Legacy’s reports and statements, Arthur Morris referred to
Legacy’s premium-to-surplus ratio as the “premium to statutory capital & surplus
ratio”. For purposes of this Opinion, there is no significant difference between
these terms.
      15
      Net underwriting income equals gross premiums earned minus
underwriting expenses.
                                                          - 16 -

          The following table summarizes key details relating to Legacy’s policies:

                                                                                 Minimum                          Net
   Policy                                  Parental           Total statutory    solvency     Premium-to-     underwriting
   period      Premium        DTAs       guaranty asset      capital & surplus    margin      surplus ratio     income

   2003       $42,800,300   $5,840,613    $4,805,764           $5,898,192        $5,898,192     8.983:1       $1,587,542

   2004        50,639,000    6,275,326     4,243,823               7,036,573      7,036,572     7.695:1        (982,000)

   2005        54,148,912    7,659,009     3,987,916               8,379,436      8,379,435     6.369:1        8,411,912

   2006        53,365,926    8,742,425        -0-              10,014,206         9,284,601     6.326:1        8,810,926

   2007        63,345,022    9,689,714        -0-              12,428,663        10,888,698     5.221:1       10,933,022


   2008        64,884,392    9,607,661        -0-              23,712,022        11,278,359     2.538:1       18,391,392



IV. Procedural History

          Respondent sent petitioner, on January 7, 2008, a notice of deficiency

relating to 2003; on December 22, 2009, a notice of deficiency relating to 2004

and 2005; and on August 5, 2010, a notice of deficiency relating to 2006 and 2007

(collectively, notices). In these notices, respondent determined that petitioner’s

payments to Legacy were not deductible pursuant to section 162. On April 6,

2009, March 22, 2010, and September 29, 2010, respectively, petitioner, whose

principal place of business was Plano, Texas, timely filed petitions with the Court

seeking redeterminations of the deficiencies set forth in the notices. After

concessions, the remaining issue for decision is whether payments to Legacy were

deductible.
                                       - 17 -

                                     OPINION

      In determining whether payments to Legacy were deductible, our initial

inquiry is whether Legacy was a bona fide insurance company. See Harper Grp. v.

Commissioner, 96 T.C. 45, 59 (1991), aff’d, 979 F.2d 1341 (9th Cir. 1992);

AMERCO v. Commissioner, 96 T.C. 18, 40-41 (1991), aff’d, 979 F.2d 162 (9th

Cir. 1992). We respect the separate taxable treatment of a captive unless there is a

finding of sham or lack of business purpose. See Moline Props., Inc. v.

Commissioner, 319 U.S. 436, 439 (1943); Harper Grp. v. Commissioner, 96 T.C.

at 57-59. Respondent contends that Legacy was a sham entity created primarily to

generate Federal income tax savings.

I. Legacy Was Not a Sham

      A. Legacy Was Created for Significant and Legitimate Nontax Reasons

      After successfully resolving petitioner’s D&O insurance problem, Aon

evaluated petitioner’s risk management department. Petitioner, with Aon’s

assistance, improved risk management practices, switched from bundled to

unbundled policies, and hired SRS as a third-party administrator. Aon proposed

that petitioner form a captive, and petitioner determined that a captive would allow

it to reduce its insurance costs, obtain otherwise unavailable insurance coverage,

formalize and more efficiently manage its insurance program, and provide
                                        - 18 -

accountability and transparency relating to insurance costs. Petitioner engaged

KPMG to prepare financial projections and evaluate tax considerations referenced

in the feasibility study. Federal income tax consequences were considered, but the

formation of Legacy was not a tax-driven transaction. See Moline Props., Inc. v.

Commissioner, 319 U.S. at 439; Britt v. United States, 431 F.2d 227, 235-236 (5th

Cir. 1970); Bass v. Commissioner, 50 T.C. 595, 600 (1968). To the contrary, in

forming Legacy, petitioner made a business decision premised on a myriad of

significant and legitimate nontax considerations. See Jones v. Commissioner, 64

T.C. 1066, 1076 (1975) (“A corporation is not a ‘sham’ if it was organized for

legitimate business purposes or if it engages in a substantial business activity.”);

Bass v. Commissioner, 50 T.C. at 600.

      B. There Was No Impermissible Circular Flow of Funds

      Respondent further contends that Legacy was “not an independent fund, but

an accounting device”. In support of this contention, respondent cites a purported

“circular flow of funds” through Legacy, RAC, and RAC’s subsidiaries.

Respondent’s expert, however, readily acknowledged that he found no evidence of

a circular flow of funds, nor have we. Legacy, with the approval of the BMA,

purchased RAC treasury shares but did not resell them. Furthermore, petitioner

established that there was nothing unusual about the manner in which premiums
                                       - 19 -

and claims were paid. Finally, respondent contends that the netting of premiums

owed to Legacy during 2003 is evidence that Legacy was a sham. We disagree.

This netting was simply a bookkeeping measure performed as an administrative

convenience.

      C. The Premium-to-Surplus Ratios Do Not Indicate That Legacy Was a
         Sham

      Respondent emphasizes that, during the years in issue, Legacy’s premium-

to-surplus ratios were above the ratios of U.S. property and casualty insurance

companies and Bermuda class 4 insurers16 (collectively, commercial insurance

companies). On cross-examination, however, respondent’s expert admitted that

his analysis of commercial insurance companies contained erroneous numbers.

Furthermore, he failed to properly explain the profitability data he cited and did

not include relevant data relating to Legacy. Moreover, his comparison, of

Legacy’s premium-to-surplus ratios with the ratios of commercial insurance

companies, was not instructive. Commercial insurance companies have lower

premium-to-surplus ratios because they face competition and, as a result, typically

price their premiums to have significant underwriting losses. They compensate for


      16
        A class 4 insurance company may carry on insurance business, including
excess liability business or property catastrophe reinsurance business. See
Insurance Act, 1978, sec. 4E.
                                        - 20 -

underwriting losses by retaining sufficient assets (i.e., more assets per dollar of

premium resulting in lower premium-to-surplus ratios) to earn ample amounts of

investment income. Captives in Bermuda, however, have fewer assets per dollar

of premium (i.e., higher premium-to-surplus ratios) but generate significant

underwriting profits because their premiums reflect the full dollar value, rather

than the present value, of expected losses. Simply put, the premium-to-surplus

ratios do not indicate that Legacy was a sham.

      D. Legacy Was a Bona Fide Insurance Company

      Petitioner presented convincing, and essentially uncontradicted, evidence

that Legacy was a bona fide insurance company. As respondent concedes,

petitioner faced actual and insurable risk. Comparable coverage with other

insurance companies would have been more expensive, and some insurance

companies (e.g., Discover Re) would not underwrite the coverage provided by

Legacy. In addition, RAC established Legacy for legitimate business reasons,

including: increasing the accountability and transparency of its insurance

operations, accessing new insurance markets, and reducing risk management costs.

Furthermore, Legacy entered into bona fide arm’s-length contracts with petitioner;

charged actuarially determined premiums; was subject to the BMA’s regulatory

control; met Bermuda’s minimum statutory requirements; paid claims from its
                                       - 21 -

separately maintained account; and, as respondent’s expert readily admitted, was

adequately capitalized. See Humana Inc. & Subs. v. Commissioner, 881 F.2d 247,

253 (6th Cir. 1989), aff’g in part, rev’g in part and remanding 88 T.C. 197, 206

(1987); Harper Grp. v. Commissioner, 96 T.C. at 59. Moreover, the validity of

claims Legacy paid was established by SRS, an independent third-party

administrator, which also determined the validity of claims pursuant to the

Discover Re policies. See Harper Grp. v. Commissioner, 96 T.C. at 59. Finally,

RAC’s subsidiaries did not own stock in, or contribute capital to, Legacy.

II. The Payments to Legacy Were Deductible Insurance Expenses

      The Code does not define insurance. The Supreme Court, however, has

established two necessary criteria: risk shifting and risk distribution. See

Helvering v. Le Gierse, 312 U.S. 531, 539 (1941). In addition, the arrangement

must involve insurance risk and meet commonly accepted notions of insurance.

See Harper Grp. v. Commissioner, 96 T.C. at 58; AMERCO v. Commissioner, 96

T.C. at 38. These four criteria are not independent or exclusive, but establish a

framework for determining “the existence of insurance for Federal tax purposes.”

See AMERCO v. Commissioner, 96 T.C. at 38. Insurance premiums may be

deductible. A taxpayer may not, however, deduct amounts set aside in its own

possession to compensate itself for perils which are generally the subject of
                                        - 22 -

insurance. See Clougherty Packing Co. v. Commissioner, 84 T.C. 948, 958

(1985), aff’d, 811 F.2d 1297 (9th Cir. 1987). We consider all of the facts and

circumstances to determine whether an arrangement qualifies as insurance. See

Harper Grp. v. Commissioner, 96 T.C. at 57. Respondent contends that payments

to Legacy represent amounts petitioner set aside to self-insure its risks.

      A. The Policies at Issue Involved Insurance Risk

      Respondent concedes that petitioner faced insurable risk relating to all three

types of risk: workers’ compensation, automobile, and general liability. Petitioner

entered into contracts with Legacy and Discover Re to address these three types of

risk. Thus, insurance risk was present in the arrangement between petitioner and

Legacy.

      B. Risk Shifting

      We must now determine whether the policies at issue shifted risk between

RAC’s subsidiaries and Legacy. This requires a review of our cases relating to

captive insurance arrangements.

             1. Precedent Relating to Parent-Subsidiary Arrangements

      In 1978, we analyzed parent-subsidiary captive arrangements for the first

time. See Carnation Co. v. Commissioner, 71 T.C. 400 (1978), aff’d, 640 F.2d

1010 (9th Cir. 1981). In Carnation, the parties entered into two insurance
                                         - 23 -

contracts: an agreement between Carnation and an unrelated insurer, and a

reinsurance agreement between the captive and the unrelated insurer. Id. at 402-

404. The unrelated insurer expressed concern to Carnation about the captive’s

financial stability and requested a letter of credit or other guaranty. Id. at 404.

Carnation refused to issue a letter of credit or other guaranty but did execute an

agreement to provide, upon demand, $2,880,000 of additional capital to the

captive. Id. at 402-404. We held, relying on Le Gierse, that the parent-subsidiary

arrangement was not insurance because the three agreements (i.e., the two

insurance contracts and the agreement to further capitalize the captive), when

considered together, were void of insurance risk. Id. at 409. The Court of

Appeals for the Ninth Circuit affirmed and concluded that our application of Le

Gierse was appropriate given the interdependence of the three agreements. See

Carnation Co. v. Commissioner, 640 F.2d at 1013. Furthermore, the Court of

Appeals held that “[t]he key was that * * * [the unrelated insurer] refused to enter

into the reinsurance contract with * * * [the captive] unless Carnation” executed

the capitalization agreement. See id.

      In Clougherty, our next opportunity to analyze a parent-subsidiary captive

arrangement, the parties entered into two insurance contracts: an agreement

between Clougherty and an unrelated insurer, and a reinsurance agreement
                                        - 24 -

between the captive and the unrelated insurer. Clougherty Packing Co. v.

Commissioner, 84 T.C. at 952. We concluded that “the operative facts[17] in the

instant case * * * [were] indistinguishable from the facts in Carnation”, analyzed

Clougherty’s balance sheet, and held that risk did not shift to the captive:

            We found in Carnation, as we find here, that to the extent the
      risk was not shifted, insurance does not exist and the payments to that
      extent are not insurance premiums. The measure of the risk shifted is
      the percentage of the premium not ceded. This is nothing more than a
      recharacterization of the payments which petitioner seeks to deduct as
      insurance premiums.

Id. at 956, 958-959. The Commissioner urged us to adopt his economic family

theory, which posits that

      the insuring parent corporation and its domestic subsidiaries, and the
      wholly owned “insurance” subsidiary, though separate corporate
      entities, represent one economic family with the result that those who
      bear the ultimate economic burden of loss are the same persons who
      suffer the loss. To the extent that the risks of loss are not retained in
      their entirety by * * * or reinsured with * * * insurance companies
      that are unrelated to the economic family of insureds, there is no risk-
      shifting or risk-distributing, and no insurance, the premiums for
      which are deductible under section 162 of the Code.

Rev. Rul. 77-316, 1977-2 C.B. 53, 54. In rejecting the Commissioner’s economic

family theory, we emphasized that “[w]e have done nothing more in Carnation and

      17
        Our Opinion emphasized that the “operative” facts related to the
“interdependence of all of the agreements” as confirmed by the “execution dates”.
See Clougherty Packing Co. v. Commissioner, 84 T.C. 948, 957 (1985), aff’d, 811
F.2d 1297 (9th Cir. 1987).
                                         - 25 -

here but to reclassify, as nondeductible, portions of the payments which the

taxpayers deducted as insurance premiums but which were received by the

taxpayer’s captive insurance subsidiaries.” See Clougherty Packing Co. v.

Commissioner, 84 T.C. at 960.

      The Court of Appeals for the Ninth Circuit affirmed our decision in

Clougherty and applied a balance sheet and net worth analysis, pursuant to which

a determination of whether risk has shifted depends on whether a covered loss

affects the balance sheet and net worth of the insured. See Clougherty Packing

Co. v. Commissioner, 811 F.2d at 1305. In defining insurance, the Court of

Appeals stated that “a true insurance agreement must remove the risk of loss from

the insured party.” Id. at 1306. The Court of Appeals elaborated:

      [W]e examine the economic consequences of the captive insurance
      arrangement to the “insured” party to see if that party has, in fact,
      shifted the risk. In doing so, we look only to the insured’s assets, i.e.,
      those of Clougherty, to determine whether it has divested itself of the
      adverse economic consequences of a covered workers’ compensation
      claim. Viewing only Clougherty’s assets and considering only the
      effect of a claim on those assets, it is clear that the risk of loss has not
      been shifted from Clougherty.

Id. at 1305. Furthermore, the Court of Appeals explained that the balance sheet

and net worth analysis does not ignore separate corporate existence:

      Moline Properties requires that related corporate entities be afforded
      separate tax status and treatment. It does not require that the
                                       - 26 -

      Commissioner, in determining whether a corporation has shifted its
      risk of loss, ignore the effect of a loss upon one of the corporation’s
      assets merely because that asset happens to be stock in a subsidiary.
      Because we only consider the effect of a covered claim on
      Clougherty’s assets, our analysis in no way contravenes Moline
      Properties.

Id. at 1307. Finally, the Court of Appeals concluded that “[t]he parent of a captive

insurer retains an economic stake in whether a covered loss occurs. Accordingly,

an insurance agreement between parent and captive does not shift the parent’s risk

of loss and is not an agreement for ‘insurance.’” Id.

             2. Precedent Relating to Brother-Sister Arrangements

      In Humana Inc. & Subs. v. Commissioner, 88 T.C. at 206, we were faced

with two distinct issues: the deductibility of premiums paid by a parent to a

captive (parent-subsidiary arrangement) and the deductibility of premiums paid by

affiliated subsidiaries to a captive (brother-sister arrangement). Humana, Inc.

(Humana), operated a hospital network and, in 1976, was unable to renew its

existing policies relating to workers’ compensation, malpractice, and general

liability. Id. at 200. Humana’s insurance broker could not obtain comparable

coverage and recommended that Humana establish a captive insurance company.

Id. Humana subsequently incorporated, and capitalized with $1 million, a

Colorado captive. Id. at 201-202. The captive provided coverage relating to
                                         - 27 -

Humana and its subsidiaries’ workers’ compensation, malpractice, and general

liability. Id. at 202-204. Humana paid the captive a monthly premium which was

allocated among itself and each operating subsidiary. Id. at 203.

      We held that the parent-subsidiary premiums were not deductible because

Humana did not shift risk to the captive. See id. at 206-207. The brother-sister

arrangement, however, presented an issue of first impression. See id. at 208. We

rejected the Commissioner’s economic family theory and held “that it is more

appropriate to examine all of the facts to decide whether or to what extent there

has been a shifting of the risk from one entity to the captive insurance company.”

See id. at 214. We extended our rationale from Carnation and Clougherty (i.e.,

recharacterizing a captive insurance arrangement as self-insurance) to brother-

sister arrangements and stated that declining to do so “would exalt form over

substance and permit a taxpayer to circumvent our holdings by simple corporate

structural changes.” See id. at 213. The report on which we relied, prepared by

Irving Plotkin, stated: “‘A firm placing its risks in a captive insurance company in

which it holds a sole or predominant ownership position, is not relieving itself of

financial uncertainty.’” Id. at 210 (fn. ref. omitted). In addition, the report stated:

            “True insurance relieves the firm’s balance sheet of any
      potential impact of the financial consequences of the insured peril.
      For the price of the premiums, the insured rids itself of any economic
                                       - 28 -

      stake in whether or not the loss occurs. * * * [However] as long as the
      firm deals with its captive, its balance sheet cannot be protected from
      the financial vicissitudes of the insured peril.”

Humana Inc. & Subs. v. Commissioner, 88 T.C. at 211-212 (alteration in original)

(fn. ref. omitted). After quoting extensively from the report and analyzing the

facts, “[w]e conclude[d] that there was not the necessary shifting of risk from the

operating subsidiaries of Humana Inc. to * * * [the captive] and, therefore, the

amounts charged by Humana Inc. to its subsidiaries did not constitute insurance.”

See id. at 214.

      Seven Judges concurred with the opinion of the Court’s parent-subsidiary

holding but disagreed with the brother-sister holding. See id. at 219 (Korner, J.,

concurring and dissenting). They found the opinion of the Court’s rationale

“disingenuous and entirely unconvincing” and asserted that the opinion of the

Court had implicitly adopted the Commissioner’s “economic family” theory. Id. at

223. After emphasizing that the subsidiaries had no ownership interest in the

captive, paid premiums for their own insurance, and would not be affected (i.e.,

their balance sheets and net worth) by the payment of an insured claim, the dissent

further stated:

      The theory of Helvering v. Le Gierse, 312 U.S. 531 (1941), may have
      been adequate to sustain the holdings in Carnation and Clougherty,
      where only a parent and its insurance subsidiary were involved. It
                                         - 29 -

       cannot be stretched to cover the instant brother-sister situation, where
       there was nothing--equity ownership or otherwise--to offset the
       shifting of risk from the hospital subsidiaries to * * * [the captive]. If
       the majority is to accomplish the fell deed here, “a decent respect to
       the opinions of mankind requires that they should declare the causes
       which impel them” to such a result.

Id. at 224 (fn. ref. omitted).

       The Court of Appeals for the Sixth Circuit affirmed our decision relating to

the parent-subsidiary arrangement, but reversed our decision relating to the

brother-sister arrangement.18 See Humana Inc. & Subs. v. Commissioner, 881

F.2d at 251-252. The Court of Appeals for the Sixth Circuit adopted the Court of

Appeals for the Ninth Circuit’s balance sheet and net worth analysis and held that

the subsidiaries’ payments to the captive were deductible. Id. at 252 (“[W]e look

solely to the insured’s assets, * * * and consider only the effect of a claim on those

assets[.]” (citing Clougherty v. Commissioner, 811 F.2d at 1305)). In rejecting our

holding relating to the brother-sister arrangement, the Court of Appeals stated that

“the tax court incorrectly extended the rationale of Carnation and Clougherty in

holding that the premiums paid by the subsidiaries of Humana Inc. to * * * [the

captive], as charged to them by Humana Inc., did not constitute valid insurance

      18
       We need not defer to the Court of Appeals for the Sixth Circuit’s holding
because this matter is appealable to the Court of Appeals for the Fifth Circuit,
which has not addressed this issue. See Golsen v. Commissioner, 54 T.C. 742,
757 (1970), aff’d, 445 F.2d 985 (10th Cir. 1971).
                                       - 30 -

agreements” and concluded that “[n]either Carnation nor Clougherty * * * provide

a basis for denying the deductions in the brother-sister * * * [arrangement].” Id. at

252-253. In response to our rationalization that “[i]f we decline to extend our

holdings in Carnation and Clougherty to the brother-sister factual pattern, we

would exalt form over substance and permit a taxpayer to circumvent our holdings

by simple corporate structural changes”, the Court of Appeals stated:

      Such an argument provides no legal justification for denying the
      deduction in the brother-sister context. The legal test is whether there
      has been risk distribution and risk shifting, not whether Humana Inc.
      is a common parent or whether its affiliates are in a brother-sister
      relationship to * * * [the captive]. We do not focus on the
      relationship of the parties per se or the particular structure of the
      corporation involved. We look to the assets of the insured. * * * If
      Humana changes its corporate structure and that change involves risk
      shifting and risk distribution, and that change is for a legitimate
      business purpose and is not a sham to avoid the payment of taxes,
      then it is irrelevant whether the changed corporate structure has the
      side effect of also permitting Humana Inc.’s affiliates to take
      advantage of the Internal Revenue Code § 162(a) (1954) and deduct
      payments to a captive insurance company under the control of the
      Humana parent as insurance premiums.

Id. at 255-256.

      The Court of Appeals held that “[t]he test to determine whether a

transaction under the Internal Revenue Code § 162(a) * * * is legitimate or

illegitimate is not a vague and broad ‘economic reality’ test. The test is whether

there is risk shifting and risk distribution.” Humana Inc. & Subs. v.
                                       - 31 -

Commissioner, 881 F.2d at 255. The Court of Appeals further addressed our

analysis and stated:

             The tax court cannot avoid direct confrontation with the
      separate corporate existence doctrine of Moline Properties by
      claiming that its decision does not rest on “economic family”
      principles because it is merely reclassifying or recharacterizing the
      transaction as nondeductible additions to a reserve for losses. The tax
      court argues in its opinion that such “recharacterization” does not
      disregard the separate corporate status of the entities involved, but
      merely disregards the particular transactions between the entities in
      order to take into account substance over form and the “economic
      reality” of the transaction that no risk has shifted.

              The tax court misapplies this substance over form argument.
      The substance over form or economic reality argument is not a broad
      legal doctrine designed to distinguish between legitimate and
      illegitimate transactions and employed at the discretion of the tax
      court whenever it feels that a taxpayer is taking advantage of the tax
      laws to produce a favorable result for the taxpayer. * * * The
      substance over form analysis, rather, is a distinct and limited
      exception to the general rule under Moline Properties that separate
      entities must be respected as such for tax purposes. The substance
      over form doctrine applies to disregard the separate corporate entity
      where “Congress has evinced an intent to the contrary” * * *

Id. at 254. In short, we do not look to the parent to determine whether premiums

paid by the subsidiaries to the captive are deductible. Id. at 252. The policies

shifted risk because claims paid by the captive did not affect the net worth of

Humana’s subsidiaries. See id. at 252-253.
                                        - 32 -

             3. Brother-Sister Arrangements May Shift Risk

      We find persuasive the Court of Appeals for the Sixth Circuit’s critique of

our analysis of the brother-sister arrangement in Humana. First, our extension of

Carnation and Clougherty to brother-sister arrangements was improper. As the

Court of Appeals correctly concluded: “Carnation dealt solely with the parent-

subsidiary issue, not the brother-sister issue. Likewise, Clougherty dealt only with

the parent-subsidiary issue and not the brother-sister issue. Nothing in either

Carnation or Clougherty lends support for denying the deductibility of the

payments in the brother-sister context.” Id. at 253-254.

      Second, the opinion of the Court’s extensive reliance on Plotkin’s report to

analyze the brother-sister arrangement was inappropriate. The report in Humana

addressed parent-subsidiary, rather than brother-sister, arrangements. See Humana

Inc. & Subs. v. Commissioner, 88 T.C. at 209; see also supra pp. 26-31. In the

instant cases, Plotkin explicitly addressed brother-sister arrangements and stated:

              Even though the brother, the captive, and the parent are in the
      same economic family, to the extent that a brother has no ownership
      interest in the captive, the results of the parent-captive analysis do not
      apply. It is not the presence or absence of unrelated business, nor the
      number of other insureds (be they affiliates or non-affiliates), but it is
      the absence of ownership, the captive’s capital, and the number of
      statistically independent risks (regardless of who owns them) that
      enables the captive to provide the brother with true insurance as a
      matter of economics and finance.
                                        - 33 -


We agree. Humana’s subsidiaries had no ownership interest in the captive. See

Humana Inc. & Subs. v. Commissioner, 88 T.C. at 201-202. Thus, the parent-

subsidiary analysis employed by the opinion of the Court was incorrect.

        Third, we did not properly analyze the facts and circumstances. See id. at

214. The balance sheet and net worth analysis provides the proper analytical

framework to determine risk shifting in brother-sister arrangements. See Humana

Inc. & Subs. v. Commissioner, 881 F.2d at 252; Clougherty Packing Co. v.

Commissioner, 811 F.2d at 1305. Instead, we implicitly employed a substance-

over-form rationale to recharacterize Humana’s subsidiaries’ payments as amounts

set aside for self-insurance and referenced, but did not apply, the balance sheet and

net worth analysis. Indeed, we did not “examine the economic consequences of

the captive insurance arrangement to the ‘insured’ party to see if that party * * *

[had], in fact, shifted the risk.” See Clougherty v. Commissioner, 811 F.2d at

1305.

              4. The Legacy Policies Shifted Risk

        In determining whether Legacy’s policies shifted risk, we narrow our

scrutiny to the arrangement’s economic impact on RAC’s subsidiaries (i.e., the

insured entities). See Humana Inc. & Subs. v. Commissioner, 881 F.2d at 252-
                                         - 34 -

253; Clougherty Packing Co. v. Commissioner, 811 F.2d at 1305 (“[W]e examine

the economic consequences of the captive insurance arrangement to the ‘insured’

party to see if that party has, in fact, shifted the risk. In doing so, we look only to

the insured’s assets”[.]). In direct testimony respondent’s expert, however,

emphasized that petitioner’s “captive program * * * [did] not involve risk shifting

that * * * [was] comparable to that provided by a commercial insurance program.”

We decline his invitation to premise our holding on a specious comparability

analysis. Simply put, the risk either was, or was not, shifted.

      The policies at issue shifted risk from RAC’s insured subsidiaries to

Legacy, which was formed for a valid business purpose; was a separate,

independent, and viable entity; was financially capable of meeting its obligations;

and reimbursed RAC’s subsidiaries when they suffered an insurable loss. See

Sears, Roebuck & Co. v. Commissioner, 96 T.C. 61, 100-101 (1991), aff’d in part,

rev’d in part, 972 F.2d 858 (7th Cir. 1992); AMERCO v. Commissioner, 96 T.C.

at 41. Moreover, a payment from Legacy to RAC’s subsidiaries did not reduce the

net worth of RAC’s subsidiaries because, unlike RAC, the subsidiaries did not

own stock in Legacy. Indeed, on cross-examination, respondent’s expert

conceded that the balance sheets and net worth of RAC’s subsidiaries were not

affected by a covered loss and that the policies shifted risk:
                                       - 35 -

      [Petitioner’s counsel:] But if the loss gets paid, whose balance sheet
      gets affected in that case?

      [Respondent’s expert:] What’s hanging me up is that I don’t know
      whether--I guess you’re right, because * * * [RAC’s subsidiary] will
      treat the payment from--the payment that it expects from Legacy as an
      asset, so the loss would hit Legacy’s [balance sheet].

      [Petitioner’s counsel:] But it wouldn’t hit * * * [RAC’s
      subsidiary’s] balance sheet.

      [Respondent’s expert:] I would think that’s right. * * *

      [Petitioner’s counsel:] Why is that not risk-shifting?

      [Respondent’s expert:] That’s an--why is that not risk-shifting?

      [Petitioner’s counsel:] Yes. Why is that not risk-shifting? Why
      hasn’t [RAC’s subsidiary] shifted its risk to Legacy? Its insurance
      risk--why hasn’t it shifted to Legacy in that scenario?

      [Respondent’s expert:] I mean, I would say from an accounting
      perspective, it has managed to have--is it--if we’re going to respect all
      these [corporate] forms, then it will have shifted that risk.

            5. The Parental Guaranty Did Not Vitiate Risk Shifting

      Legacy, in March 2003, petitioned the BMA and received approval, through

December 31, 2003, to treat DTAs as general business assets. On September 17,

2003, RAC issued the parental guaranty to Legacy, which petitioned, and received

permission from, the BMA to treat DTAs as general business assets through

December 31, 2006. Respondent contends that the parental guaranty abrogated
                                       - 36 -

risk shifting between Legacy and RAC’s subsidiaries. We disagree. First, and

most importantly, the parental guaranty did not affect the balance sheets or net

worth of the subsidiaries insured by Legacy. Petitioner’s expert, in response to a

question the Court posed during cross-examination, convincingly countered

respondent’s contention:

      [The Court]: * * * [W]hat impact does the corporate structure have
      on the effect of the parental guarantee?

      [Petitioner’s expert]: I think it has a great impact on it. None of the
      subs, as I understand it, are entering in or [are] a part of that
      guarantee. Only the subs are effectively insureds under the policy.
      They are the only ones who produce risks that could be covered. The
      guarantee in no way vitiates the completeness of the transfer of their
      uncertainty, their risk, to the insuring subsidiary.

      Even if one assumes that the guarantee increases the capital that the
      captive could use to pay losses, none of those payments would go to
      the detriment of the sub as a separate legal entity.

      Second, the cases upon which respondent relies are distinguishable.

Respondent cites Malone & Hyde, Inc. v. Commissioner, 62 F.3d 835, 841 (6th

Cir. 1995) (holding that a reinsurance arrangement was not bona fide because the

captive was undercapitalized and the parent guaranteed the captive’s obligations to

an unrelated insurer), rev’g T.C. Memo. 1993-585; Carnation Co. v.

Commissioner, 71 T.C. at 404, 409 (holding that a reinsurance arrangement lacked

insurance risk where the captive was undercapitalized and, at the insistence of an
                                         - 37 -

unrelated primary insurer, the parent agreed to provide additional capital); and

Kidde Indus., Inc. v. United States, 40 Fed. Cl. 42, 49-50 (1997) (holding that a

reinsurance arrangement lacked risk shifting because the parent indemnified the

captive’s obligation to pay an unrelated primary insurer). Unlike the agreements

in these cases, the parental guaranty did not shift the ultimate risk of loss; did not

involve an undercapitalized captive; and was not issued to, or requested by, an

unrelated insurer. Cf. Malone & Hyde, Inc. v. Commissioner, 62 F.3d at 841-843;

Carnation Co. v. Commissioner, 71 T.C. at 404, 409; Kidde Indus., Inc., 40 Fed.

Cl. at 49-50.

      Third, RAC guaranteed Legacy’s “liabilities under the Act [(i.e., the

Bermuda Insurance Act and related regulations)]”, pursuant to which Legacy was

required to maintain “certain solvency and liquidity margins”. RAC did not pay

any money pursuant to the parental guaranty and Legacy’s “liabilities under the

Act” did not include Legacy’s contractual obligations to RAC’s affiliates or

obligations to unrelated insurers. For purposes of calculating the minimum

solvency margin, Legacy treated a portion of the parental guaranty as a general

business asset. See supra pp. 15-16. In sum, by providing the parental guaranty to

the BMA, Legacy received permission to treat DTAs as general business assets
                                         - 38 -

and ensured its continued compliance with the BMA’s solvency requirements.19

The parental guaranty served no other purpose and was unilaterally revoked by

RAC, in 2006, when Legacy met the BMA’s solvency requirements without

reference to DTAs.

      C. The Legacy Policies Distributed Risk

      Risk distribution occurs when an insurer pools a large enough collection of

unrelated risks (i.e., risks that are generally unaffected by the same event or

circumstance). See Humana Inc. & Subs. v. Commissioner, 881 F.2d at 257. “By

assuming numerous relatively small, independent risks that occur randomly over

time, the insurer smoothes out losses to match more closely its receipt of

premiums.” Clougherty Packing Co. v. Commissioner, 811 F.2d at 1300. This

distribution also allows the insurer to more accurately predict expected future

losses. In analyzing risk distribution, we look at the actions of the insurer because

it is the insurer’s, not the insured’s, risk that is reduced by risk distribution. See

Harper Grp. v. Commissioner, 96 T.C. at 57. A captive may achieve adequate risk

distribution by insuring only subsidiaries within its affiliated group. See Humana




      19
       Legacy used a portion of the parental guaranty as a general business asset.
See supra pp. 15-16. Legacy’s DTAs always exceeded the amount of the parental
guaranty treated as a general business asset. See supra pp. 15-16.
                                       - 39 -

Inc. & Subs. v. Commissioner, 881 F.2d at 257; Rev. Rul. 2002-90, 2002-2 C.B.

985.

       Legacy insured three types of risk: workers’ compensation, automobile, and

general liability. 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. RAC’s subsidiaries operated stores in

all 50 States, the District of Columbia, Puerto Rico, and Canada. RAC’s

subsidiaries had a sufficient number of statistically independent risks. Thus, by

insuring RAC’s subsidiaries, Legacy achieved adequate risk distribution. See

Humana Inc. & Subs. v. Commissioner, 881 F.2d at 257.

       D. The Arrangement Constituted Insurance in the Commonly Accepted
          Sense

       Legacy was adequately capitalized, regulated by the BMA, and organized

and operated as an insurance company. Furthermore, Legacy issued valid and

binding policies, charged and received actuarially determined premiums, and paid

claims. In short, the arrangement between RAC’s subsidiaries and Legacy

constituted insurance in the commonly accepted sense. See Harper Grp. v.

Commissioner, 96 T.C. at 60.
                                      - 40 -

                                    Conclusion

      The payments by RAC’s subsidiaries to Legacy are, pursuant to section 162,

deductible as insurance expenses.

      Contentions we have not addressed are irrelevant, moot, or meritless.

      To reflect the foregoing,


                                               Decisions will be entered under

                                      Rule 155.

      Reviewed by the Court.

      THORNTON, VASQUEZ, WHERRY, HOLMES, BUCH, and NEGA, JJ.,
agree with this opinion of the Court.

      GOEKE, J., did not participate in the consideration of this opinion.
                                       - 41 -

      BUCH, J., concurring: To the extent respondent is arguing that a captive

insurance arrangement between brother-sister corporations cannot be insurance as

a matter of law, we need not reach that issue. In Rev. Rul. 2001-31, 2001-1 C.B.

1348, 1348, the Internal Revenue Service stated that it would “no longer invoke

the economic family theory with respect to captive insurance transactions.” And

in Rauenhorst v. Commissioner, 119 T.C. 157, 173 (2002), we held that we may

treat as a concession a position taken by the IRS in a revenue ruling that has not

been revoked. Because Rev. Rul. 2001-31 has not been revoked, we could treat

the economic family argument as conceded.

      At the same time the IRS abandoned the economic family theory, it made

clear that it would “continue to challenge certain captive insurance transactions

based on the facts and circumstances of each case.” Rev. Rul. 2001-31, 2001-1

C.B. at 1348. Then, in a series of revenue rulings, the IRS shed light on the facts

and circumstances it deemed relevant. See Rev. Rul. 2005-40, 2005-2 C.B. 4;

Rev. Rul. 2002-91, 2002-2 C.B. 991; Rev. Rul. 2002-90, 2002-2 C.B. 985; Rev.

Rul. 2002-89, 2002-2 C.B. 984.

      The concise opinion of the Court sets forth facts and circumstances

supporting its conclusion. I write separately to respond to points made in Judge

Lauber’s dissent.
                                        - 42 -

I.    Legacy’s Policies

      Taking into account the nature of risks that Legacy insured, Legacy was

sufficiently capitalized.

      A.     Long-Tail Coverage

      During each of the years in issue Legacy insured three types of risk:

workers’ compensation, automobile, and general liability. Policies relating to

these risks are generally referred to as long-tail coverage because “claims may

involve damages that are not readily observable or injuries that are difficult to

ascertain.” See Acuity v. Commissioner, T.C. Memo. 2013-209, at *8-*9.

Workers’ compensation insurance, which generated between 66% and 73% of

Legacy’s premiums1 during the years in issue, “is generally long tail coverage

because of the inherent uncertainty in determining the extent of an injured

worker’s need for medical treatment and loss of wages for time off work.” Id. An

insurer pays out claims relating to long-tail coverage over an extended period.

      B.     Rent-A-Center’s Insurance Program

      Rent-A-Center did not obtain insurance solely from Legacy; Rent-A-Center

also obtained insurance from multiple unrelated third parties. Legacy was

      1
       Legacy’s premiums attributable to workers’ compensation liability were
$28,586,597 in 2003; $35,392,000 in 2004; $36,463,579 in 2005; $39,086,374 in
2006; and $45,425,032 in 2007.
                                        - 43 -

responsible for only a portion of each claim (e.g., the first $350,000 of each

workers’ compensation claim during 2003). To the extent that a claim exceeded

Legacy’s coverage, a third-party insurer was responsible for paying the excess

amount. Rent-A-Center obtained coverage from unrelated third-party insurers for

claims of up to approximately $75 million. Therefore, extraordinary losses would

not affect Legacy’s ability to pay claims because they would be covered by

unrelated third parties.

      C.     Allocation Formula

      Premiums were actuarially determined. At trial respondent conceded that

Aon “produced reliable and professionally produced and competent actuarial

studies.” Legacy relied on these studies to set premiums. Once Legacy

determined the premium, Rent-A-Center allocated it to each operating subsidiary

in the same manner that it allocated premiums relating to unrelated insurers. In a

captive arrangement, a parent may allocate a premium among its subsidiaries. See

Humana Inc. & Subs. v. Commissioner, 881 F.2d 247, 248 (6th Cir. 1989)

(“Humana Inc. allocated and charged to the subsidiaries portions of the amounts

paid representing the share each bore for the hospitals each operated.”), aff’g in

part, rev’g in part and remanding 88 T.C. 197 (1987); Kidde Indus., Inc. v. United

States, 40 Fed. Cl. 42, 45 (1997) (“National determined the premiums that it
                                       - 44 -

charged Kidde based in part on underwriting data supplied by Kidde’s divisions

and subsidiaries * * * Kidde used these same data to allocate the total premiums

among its divisions and subsidiaries.”).

II.   The Parental Guaranty

      Citing a footnote in Humana, Judge Lauber’s dissenting opinion asserts that

the existence of a parental guaranty is enough to justify disregarding the captive

insurance arrangement. That footnote, however, addresses only situations in

which there is both inadequate capitalization and a parental guaranty, concluding:

“These weaknesses alone provided a sufficient basis from which to find no risk

shifting and to decide the cases in favor of the Commissioner.” Humana Inc. &

Subs. v. Commissioner, 881 F.2d at 254 n.2 (emphasis added). Here, the fact

finder did not find inadequate capitalization. And the mere existence of a parental

guaranty is not enough for us to disregard the captive insurer; we must look to the

substance of that guaranty.

      As the opinion of the Court finds, the parental guaranty was created to

convert deferred tax assets into general business assets for regulatory purposes.

See op. Ct. p. 35. The circumstances relating to its issuance, including that the

parental guaranty was issued to Legacy and that it was limited to $25 million--or,

less than 10% of the total premiums paid to Legacy--support the conclusion that it
                                         - 45 -

was created solely to encourage the Bermuda Monetary Authority to allow Legacy

to treat DTAs as general business assets.

        In contrast, the cases that have found that a parental guaranty eliminates any

risk shifting involved either a blanket indemnity or a capitalization agreement that

resulted in a capital infusion in excess of premiums received. And even then, the

indemnity or capitalization agreement was coupled with an undercapitalized

captive. Accordingly, those cases are distinguishable from the situation presented

here.

        Malone & Hyde, Inc. v. Commissioner, 62 F.3d 835 (6th Cir. 1995), rev’g

T.C. Memo. 1993-585, involved an insurance subsidiary established to provide

reinsurance for the parent and its subsidiaries. After incorporating the captive,

Malone & Hyde entered into an agreement with a third-party insurer to insure both

its own and its subsidiaries’ risks. Id. at 836. The third-party insurer then

reinsured the first $150,000 of coverage per claim with the captive. Id. Because

the captive was thinly capitalized--it had no assets other than $120,000 of paid-in

capital--Malone & Hyde executed “hold harmless” agreements in favor of the

third-party insurer. Id. These agreements provided that if the captive defaulted on

its obligations as reinsurer, then Malone & Hyde would completely shield the

third-party insurer from liability. Id. In deciding whether the risk had shifted, the
                                        - 46 -

court held that “[w]hen the entire scheme involves either undercapitalization or

indemnification of the primary insurer by the taxpayer claiming the deduction, or

both, these facts alone disqualify the premium payments from being treated as

ordinary and necessary business expenses to the extent such payments are ceded

by the primary insurer to the captive insurance subsidiary.” Id. at 842-843. In

short, Malone & Hyde, Inc. had a thinly capitalized captive insurer and a blanket

indemnity. Here, neither of those facts is present.

      The facts in Kidde Indus., Inc. are quite similar to those in Malone & Hyde,

Inc. Kidde incorporated a captive and entered into an insurance agreement with a

third-party insurer who in turn entered into a reinsurance agreement with the

captive. Kidde Indus., Inc., 40 Fed. Cl. at 45. As in Malone & Hyde, Inc., the

captive was significantly undercapitalized, and Kidde executed an indemnification

agreement to provide the third-party insurer with the “level of comfort” needed

before it would issue the policies. Id. at 48. Again, the court held that Kidde

retained the risk of loss and could not deduct the premiums. Id.

      Carnation Co. v. Commissioner, 71 T.C. 400 (1978), aff’d, 640 F.2d 1010

(9th Cir. 1981), involved slightly different facts. A captive reinsured 90% of the

third-party insurer’s liabilities under Carnation’s policy. Id. at 403. As part of this

arrangement, the third-party insurer ceded 90% of the premiums to the captive and
                                        - 47 -

the captive paid the third-party insurer a 5% commission based on the net

premiums ceded. Id. Carnation provided $3 million of capital to the captive--an

amount that was well in excess of the total annual premiums paid to the captive--

because the third-party insurer had concerns about the captive’s capitalization. Id.

at 404. The Court held that the reinsurance agreement and the agreement to

provide additional capital counteracted each other and voided any insurance risk.

Id. at 409. In affirming the Tax Court, the Court of Appeals for the Ninth Circuit

held that, in considering whether the risk had shifted, the key was that the third-

party insurer would not have issued the policies without the capitalization

agreement. Carnation Co. v. Commissioner, 640 F.2d at 1013.

      Those cases are distinguishable because they all involved undercapitalized

captives. As explained previously, the opinion of the Court found that Legacy was

adequately capitalized. Further, in each of the three cases above, the parent

provided either indemnification or additional capitalization in order to persuade a

third-policy insurer to issue insurance policies. Here, Discover Re provided

insurance before Legacy’s inception and continued providing coverage after

Legacy was formed. The parental guaranty was issued to Legacy for the singular

purpose of allowing Legacy to treat the DTAs as general business assets.

Additionally, the guaranty amounted to only $25 million. This small fraction of
                                        - 48 -

the $264 million in premiums for policies written by Legacy during the years in

issue does not rise to the level of protection provided by the total indemnities in

Malone & Hyde, Inc. and Kidde Indus., Inc.

       When we consider the totality of the facts, the parental guaranty appears to

have been immaterial. This conclusion is bolstered by the facts that the parental

guaranty was unilaterally withdrawn by Rent-A-Center in 2006 and that Rent-A-

Center never contributed any funds to Legacy pursuant to that parental guaranty.

III.   Consolidated Groups

       Judge Lauber’s dissent refers to a hodgepodge of facts about how Rent-A-

Center operated its consolidated group as evidence that Legacy’s status as a

separate entity should be disregarded. Examples of the facts cited in that dissent

are that Legacy had no employees and that payments between it and other

members of the Rent-A-Center consolidated group were handled through journal

entries.

       In the real world of large corporations, these practices are commonplace.

For ease of operations, including running payroll, companies create a staff leasing

subsidiary and lease employees companywide. Or they hire outside consultants to

handle the operations of a specialty business such as a captive insurer. Legacy,

like Humana, hired an outside management company to handle its business
                                       - 49 -

operations. Compare op. Ct. p. 6 n.6 (Legacy engaged Aon to provide

management services) with Humana Inc. & Subs. v. Commissioner, 88 T.C. at 205

(Humana engaged Marsh & McLennan to provide management services). And it

is unrealistic to expect members of a consolidated group to cut checks to each

other. Rent-A-Center and Legacy did what is commonplace--they kept track of

the flow of funds through journal entries. So long as complete and accurate

records are maintained, the commingling of funds is not enough to require the

disregarding of a separate business. See, e.g., Kahle v. Commissioner, T.C.

Memo. 1991-203 (finding that the taxpayer “maintained complete and accurate

records” notwithstanding the commingling of business and personal funds).

      Corporations filing consolidated returns are to be treated as separate

entities, unless otherwise mandated. Gottesman & Co. v. Commissioner, 77 T.C.

1149, 1156 (1981). It may be advantageous for a corporation to operate through

various subsidiaries for a multitude of reasons. These reasons may include State

law implications, creditor demands, or simply convenience, but “so long as that

purpose is the equivalent of business activity or is followed by the carrying on of

business by the corporation, the corporation remains a separate taxable entity.”

Moline Props., Inc. v. Commissioner, 319 U.S. 436, 438-439 (1943). Even the

consolidated return regulations make clear that an insurance company that is part
                                        - 50 -

of a consolidated group is treated separately. See sec. 1.1502-13(e)(2)(ii)(A),

Income Tax Regs. (“If a member provides insurance to another member in an

intercompany transaction, the transaction is taken into account by both members

on a separate entity basis.”). Thus, if a corporation gives due regard to the

separate corporate structure, we should do the same.

IV.   Conclusion

      The issue presented in these cases is ultimately a matter of when, not

whether, Rent-A-Center is entitled to a deduction relating to workers’

compensation, automobile, and general liability losses.2 Because the IRS has

conceded in its rulings that insurance premiums paid between brother-sister

corporations may be insurance and the Court determined that, under the facts and

circumstances of these cases as found by the Judge who presided at trial, the

policies at issue are insurance, Rent-A-Center is entitled to deduct the premiums

as reported on its returns. See op. Ct. pp. 21-40.

      FOLEY, GUSTAFSON, PARIS, and KERRIGAN, JJ., agree with this
concurring opinion.

      2
        If the Court had determined that the policies were not insurance, then Rent-
A-Center would nevertheless have been entitled to deduct the losses as they were
paid or incurred. See sec. 162. By forming Legacy and giving due regard to its
separate structure, Rent-A-Center achieved some acceleration of deductions
relating to losses that would otherwise be deductible, along with other nontax
benefits. See op. Ct. pp. 17-18.
                                        - 51 -

      HALPERN, J., dissenting:

      "'The principle of judicial parsimony' (L. Hand, J., in Pressed Steel Car Co.

v. Union Pacific Railroad Co., * * * [240 F. 135, 137 (S.D.N.Y. 1917)]), if nothing

more, condemns a useless remedy." Sinclair Ref. Co. v. Jenkins Petroleum

Process Co., 289 U.S. 689, 694 (1933). While usually invoked by a court to

justify a stay in discovery on other issues when one issue is dispositive of a case,

8A Charles Allen Wright, Arthur R. Miller & Richard L. Marcus, Federal Practice

and Procedure, sec. 2040, at 198 n.7 (3d ed. 2010), I think the principle should

guide us in declining to overrule Humana Inc. & Subs. v. Commissioner, 88 T.C.

197 (1987), aff'd in part, rev'd in part and remanded, 881 F.2d 247 (6th Cir. 1989),

to the extent that it holds that a captive insurance arrangement between brother-

sister corporations cannot be insurance as a matter of law.

      These cases are before the Court Conference for review, see sec. 7460(b),

because we perceive that Judge Foley's report is in part overruling Humana,

although Judge Foley does not in so many words say so. He says: "We find

persuasive the Court of Appeals for the Sixth Circuit's critique of our analysis the

brother-sister arrangement in Humana." The Court of Appeals said: "We reverse

the tax court on * * * the brother-sister issue." Humana Inc. & Subs v.

Commissioner, 881 F.2d at 257. Under our Conference procedures, the
                                          - 52 -

Conference may not adopt a report overruling a prior report of the Court absent the

affirmative vote of a majority of the Judges entitled to vote on the case. Six of the

sixteen Judges entitled to vote on these cases join Judge Foley, for a total of seven

clearly affirmative votes. Six Judges voted "no". Three Judges voted "concur in

result", and those votes, under our procedures, are counted as affirmative votes.

Whether the Court has in fact overruled a portion of Humana undoubtedly will be

unclear to many readers of this report. The resulting confusion is unnecessary.

Moreover, by putting his report overruling Humana before the Conference, Judge

Foley has put before the Conference his subsidiary findings of fact and his

ultimate finding that the brother-sister payments were correctly characterized as

insurance premiums. That has attracted two side opinions, one characterizing

Judge Foley's opinion as "concise" (Judge Buch) and emphasizing evidence in the

record that supports his findings and the other characterizing his ultimate findings

as "conclusory" (Judge Lauber) and contending "the undisputed facts of the entire

record warrant the opposite conclusion * * *, [that] the Rent-A-Center

arrangements do not constitute 'insurance' for Federal income tax purposes."

Whether I describe Judge Foley's analysis as concise or as conclusory, simply put,

there is insufficient depth to it to persuade me to join his findings (i.e., that there is

risk shifting, that there is risk distribution, and, in general, that there is a bona fide
                                       - 53 -

insurance arrangement). I do agree with Judge Lauber that "[w]hether the facts

and circumstances, evaluated in the aggregate, give rise to 'insurance' presents a

question of proper characterization. It is thus a mixed question of fact and law."

Nevertheless, had Judge Foley steered clear of Humana, I believe that we could

have avoided Conference consideration and have left it to the appellate process (if

invoked) to determine whether Judge Foley's findings are persuasive.

      And I believe that Judge Foley could have steered clear of Humana. As

both Judges Buch and Lauber point out, the Commissioner has given up on

arguing that captive insurance arrangement between brother-sister corporations

cannot be insurance as a matter of law. See, e.g., Rev. Rul. 2001-31, 2001

C.B. 1348. Judge Foley ignores that ruling and its progeny when, pursuant to

Rauenhorst v. Commissioner, 119 T.C. 157, 173 (2002), he could have relied on

the Commissioner's concessions to steer clear of revisiting Humana. I agree with

Judge Foley that Humana is not dispositive of the brother-sister insurance question

in these cases, but not because I would overrule Humana on that issue; rather, I see

no reason to address Humana in the light of the Commissioner's present

administrative position. While I agree with Judge Foley that the facts and
                                      - 54 -

circumstances test provides the proper analytical framework, I otherwise dissent

from his opinion.

      LAUBER, J., agrees with this dissent.
                                         - 55 -

      LAUBER, J., dissenting: These cases, like Humana Inc. & Subs. v.

Commissioner, 88 T.C. 197 (1987), aff’d in part, rev’d in part and remanded, 881

F.2d 247 (6th Cir. 1989), involve what I will refer to as a “classic” captive

insurance company. In these cases, as in Humana, the captive has no outside

owners and insures no outside risks. Rather, it is wholly owned by the parent of

the affiliated group and it “insures” risks only of the parent and the operating

subsidiaries, which stand in a brother-sister relationship to it.

      In Humana we held that purported “insurance” premiums paid to a captive

by other members of its affiliated group--whether by the parent or by the sister

corporations--were not deductible for Federal income tax purposes. An essential

requirement of “insurance” is the shifting of risk from insured to insurer. Helver-

ing v. LeGierse, 312 U.S. 531, 539 (1941). We held in Humana that “there was

not the necessary shifting of risk” from the operating subsidiaries to the captive,

and hence that none of the purported “premiums” constituted amounts paid for

“insurance.” 88 T.C. at 214. The Court of Appeals for the Sixth Circuit affirmed

as to amounts paid to the captive by the parent, but reversed as to amounts paid to

the captive by the sister corporations. 881 F.2d at 257.

      The opinion of the Court (majority) adopts the reasoning and result of the

Sixth Circuit, overrules Humana in part, and holds that amounts charged to the
                                        - 56 -

captive’s sister corporations constitute deductible “insurance premiums.” I dissent

both from the majority’s decision to overrule Humana and from its holding that

amounts charged to the sister corporations constituted payments for “insurance”

under the totality of the facts and circumstances.

I.    Background

      The captive insurance issue has a rich history to which the majority refers

only episodically. It has been clear from the outset of our tax law that taxpayers

(other than insurance companies) cannot deduct contributions to an insurance

reserve. Steere Tank Lines, Inc. v. United States, 577 F.2d 279, 280 (5th Cir.

1978); Spring Canyon Coal Co. v. Commissioner, 43 F.2d 78, 80 (10th Cir. 1930).

Thus, if a unitary operating company maintains a reserve for self-insurance,

amounts it places in that reserve are not deductible as “insurance premiums.”

      One strategy by which taxpayers sought to avoid this nondeductibility rule

was to place their self-insurance reserve into a captive insurance company. In

cases involving “classic” captives--i.e., captives that have no outside owners and

insure no outside risks--the courts have uniformly held that this strategy does not

work. Employing various legal theories, every court to consider the question has
                                       - 57 -

held that amounts paid by a parent to a classic captive do not constitute “insurance

premiums.”1

      Insurance and tax advisers soon devised an alternative strategy for avoiding

the bar against deduction of contributions to a self-insurance reserve--namely,

adoption of or conversion to a holding company structure. In essence, an

operating company would drop its self-insurance reserve into a captive; drop its

operations into one or more operating subsidiaries; and have the purported

“premiums” paid to the captive by the sister companies instead of by the parent.

In Humana, we held that this strategy did not work either, reasoning that “we

would exalt form over substance and permit a taxpayer to circumvent our holdings


      1
       See Beech Aircraft Corp. v. United States, 797 F.2d 920 (10th Cir. 1986);
Stearns-Roger Corp. v. United States, 774 F.2d 414, 415-416 (10th Cir. 1985);
Humana Inc. & Subs. v. Commissioner, 88 T.C. 197, 207 (1987), aff’d in part,
rev’d in part and remanded, 881 F.2d 247 (6th Cir. 1989); Clougherty Packing Co.
v. Commissioner, 84 T.C. 948 (1985), aff’d, 811 F.2d 1297, 1307 (9th Cir. 1987);
Carnation Co. v. Commissioner, 71 T.C. 400 (1978), aff’d, 640 F.2d 1010, 1013
(9th Cir. 1981). On the other hand, the courts have held that parent-captive
payments may constitute “insurance premiums” where the captive has a sufficient
percentage of outside owners or insures a sufficient percentage of outside risks.
See, e.g., Sears, Roebuck & Co. v. Commissioner, 96 T.C. 61 (1991)
(approximately 99.75% of insured risks were outside risks), supplemented by 96
T.C. 671 (1991), aff’d in part and rev’d in part, 972 F.2d 858 (7th Cir. 1992);
Harper Grp. v. Commissioner, 96 T.C. 45 (1991) (approximately 30% of insured
risks were outside risks), aff’d, 979 F.2d 1341 (9th Cir. 1992); AMERCO v.
Commissioner, 96 T.C. 18 (1991) (between 52% and 74% of insured risks were
outside risks), aff’d, 979 F.2d 162 (9th Cir. 1992).
                                         - 58 -

[involving parent-captive payments] by simple corporate structural changes.” 88

T.C. at 213. In effect, we concluded in Humana that conversion to a holding-

company structure--without more--should not enable a taxpayer to accomplish

indirectly what it cannot accomplish directly, achieving a radically different and

more beneficial tax result when there has been absolutely no change in the

underlying economic reality.

      While the Commissioner had success litigating the parent-captive pattern,

he had surprisingly poor luck litigating the brother-sister scenario. The Tenth

Circuit, like our Court, agreed that brother-sister payments to a classic captive are

not deductible as “insurance premiums.”2 By contrast, the Sixth Circuit in

Humana reversed our holding to this effect. And after some initial ambivalence,

the Court of Federal Claims appears to have concluded that brother-sister

“premium” payments are deductible.3


      2
       See Beech Aircraft Corp., 797 F.2d at 922; Stearns-Roger Corp., 774 F.2d
at 415-416.
      3
        Compare Mobil Oil Corp. v. United States, 8 Cl. Ct. 555, 566 (1985) (“[B]y
deducting the premiums on its tax returns, [the affiliated group] achieved indirect-
ly that which it could not do directly. It is well settled that tax consequences must
turn upon the economic substance of a transaction[.]”), with Kidde Indus., Inc. v.
United States, 40 Fed. Cl. 42 (1997) (brother-sister payments deductible for years
for which parent did not provide indemnity agreement). See generally Ocean
Drilling & Exploration Co. v. United States, 988 F.2d 1135, 1153 (Fed. Cir. 1993)
                                                                          (continued...)
                                         - 59 -

          The Commissioner had even less success persuading courts to adopt the

“single economic family” theory enunciated in Rev. Rul. 77-316, 1977-2 C.B. 53,

upon which his litigating position was initially based. That theory was approved

by the Tenth Circuit4 and found some favor in the Ninth Circuit.5 But it was

rejected by our Court6 as well as by the Sixth and Federal Circuits.7

      Assessing this track record, the Commissioner made a strategic retreat. In

2001 the IRS announced that it “will no longer invoke the economic family theory



      3
      (...continued)
(1991) (brother-sister payments deductible where captive insured significant
outside risks).
          4
      See Beech Aircraft Corp., 797 F.2d 920; Stearns-Roger Corp., 774 F.2d at
415-416. See generally Humana, 881 F.2d at 251 (“Stearns-Roger, Mobil Oil, and
Beech Aircraft * * * each explicitly or implicitly adopted the economic family
concept.”).
          5
       See Clougherty Packing, 811 F.2d at 1304 (“[W]e seriously doubt that the
use of an economic family concept in defining insurance runs afoul of the
Supreme Court’s holding in Moline Properties.”); id. at 1305 (finding
“considerable merit in the Commissioner’s [economic family] argument” but
finding it unnecessary to rely on that theory); Carnation Co., 640 F.2d at 1013.
          6
        See Humana, 88 T.C. at 214 (rejecting the Commissioner’s “economic
family” concept); Clougherty Packing, 84 T.C. at 956 (same); Carnation Co., 71
T.C. at 413 (same).
          7
        See Malone & Hyde, Inc. v. Commissioner, 62 F.3d 835 (6th Cir. 1995)
(rejecting “economic family” theory but ruling against deductibility of payments to
captive based on facts and circumstances), rev’g T.C. Memo. 1993-585; Ocean
Drilling & Exploration Co., 988 F.2d at 1150-1151; Humana, 881 F.2d at 251.
                                        - 60 -

with respect to captive insurance transactions.” Rev. Rul. 2001-31, 2001-1 C.B.

1348, 1348. In 2002 the IRS likewise abandoned its position that there is a per se

rule against the deductibility of brother-sister “premiums,” concluding that the

characterization of such payments as “insurance premiums” should be governed,

not by a per se rule, but by the facts and circumstances of the particular case. Rev.

Rul. 2002-90, 2002-2 C.B. 985; accord Rev. Rul 2001-31, 2001-1 C.B. at 1348

(“The Service may * * * continue to challenge certain captive insurance

transactions based on the facts and circumstances of each case.”).

II.   Overruling Humana

      We decided Humana against a legal backdrop very different from that which

we confront today. The Commissioner in Humana urged a per se rule, predicated

on his “single economic family” theory, against the deductibility of brother-sister

“insurance premiums.” The Commissioner has long since abandoned both that per

se rule and the theory on which it was based. Given this change in the legal

environment, I see no need for the Court to reconsider Humana, which in a

practical sense may be water under the bridge.

      Respondent’s position in the instant cases is consistent with the ruling

position the IRS has maintained for the past 12 years--namely, that characterization

of intragroup payments as “insurance premiums” should be determined on the basis
                                         - 61 -

of the facts and circumstances of the particular case. See Rev. Rul. 2001-31, 2001-

1 C.B. at 1348. The majority adopts this approach as the framework for its legal

analysis. See op. Ct. p. 22 (“We consider all of the facts and circumstances to

determine whether an arrangement qualifies as insurance.”). The Court need not

overrule Humana to decide (erroneously in my view) that respondent should lose

under the facts-and-circumstances approach that respondent is now advancing. In

Humana, “we emphasize[d] that our holding * * * [was] based upon the factual

pattern presented in * * * [that] case,” noting that in other cases “factual patterns

may differ.” 88 T.C. at 208. That being so, the Court today could rule for

petitioners on the basis of what the majority believes to be the controlling “facts

and circumstances,” distinguishing Humana rather than overruling it. Principles of

judicial restraint counsel that courts should decide cases on the narrowest possible

ground.

III.   The “Facts and Circumstances” Approach

       Although I do not believe it necessary or proper to overrule Humana, the

continuing vitality of that precedent does not control the outcome. These cases can

and should be decided in respondent’s favor under the “facts and circumstances”

approach that he is currently advancing. In Rev. Rul. 2002-90, 2002-2 C.B. at 985,

the IRS concluded that brother-sister payments were correctly characterized as
                                        - 62 -

“insurance premiums” where the assumed facts included the following (P = parent

and S = captive):

      P provides S adequate capital * * *. S charges the 12 [operating]
      subsidiaries arms-length premiums, which are established according to
      customary industry rating formulas. * * * There are no parental (or other
      related party) guarantees of any kind made in favor of S. * * * In all
      respects, the parties conduct themselves in a manner consistent with the
      standards applicable to an insurance arrangement between unrelated parties.

      The facts of the instant cases, concerning both “risk shifting” and conformity

to arm’s-length insurance standards, differ substantially from the facts assumed in

Rev. Rul. 2002-90, supra. The instant facts also differ substantially from the facts

determined in judicial precedents that have characterized intragroup payments as

“insurance premiums.” Whether the facts and circumstances, evaluated in the

aggregate, give rise to “insurance” presents a question of proper characterization.

It is thus a mixed question of fact and law.

      The majority makes certain findings of basic fact, which I accept for

purposes of this dissenting opinion. In many instances, however, the majority

makes no findings of basic fact to support its conclusory findings of ultimate fact.

In other instances, the majority does not mention facts that tend to undermine its

ultimate conclusions. In my view, the undisputed facts of the entire record warrant

the opposite conclusion from that reached by the majority and justify a ruling that
                                          - 63 -

the Rent-A-Center arrangements do not constitute “insurance” for Federal income

tax purposes.

         A.    Risk Shifting

               1.    Parental Guaranty

         Rent-A-Center, the parent, issued two types of guaranties to Legacy, its

captive. First, it guaranteed the multimillion-dollar “deferred tax asset” (DTA) on

Legacy’s balance sheet, which arose from timing differences between the captive’s

fiscal year and the parent’s calendar year. Normally, a DTA cannot be counted as

an “asset” for purposes of the (rather modest) minimum solvency requirements of

Bermuda insurance law. The parent’s guaranty was essential in order for Legacy to

secure an exception from this rule.

         Second, the parent subsequently issued an all-purpose guaranty by which it

agreed to hold Legacy harmless for its liabilities under the Bermuda Insurance Act

up to $25 million. These liabilities necessarily included Legacy’s liabilities to pay

loss claims of its sister corporations. This all-purpose $25 million guaranty was

eliminated at year-end 2006, but it was in existence for the first three tax years at

issue.

         When approving the brother-sister premiums in Rev. Rul. 2002-90, 2002-2

C.B. at 985, the IRS explicitly excluded from the hypothesized facts the existence
                                         - 64 -

of any parental or related-party guaranty executed in favor of the captive.

Numerous courts have likewise ruled that the existence of a parental guaranty,

indemnification agreement, or similar instrument may negate the existence of

“insurance” purportedly supplied by a captive. See, e.g., Malone & Hyde, 62 F.3d

835, 842-843 (6th Cir. 1995) (finding no “insurance” where parent guaranteed cap-

tive’s liabilities), rev’g T.C. Memo. 1993-585; Humana, 881 F.2d at 254 n.2

(presence of parental indemnification or recapitalization agreement may provide a

sufficient basis on which to find no “risk shifting”); Carnation Co., 71 T.C. 400,

402, 409 (1978) (finding no “insurance” where parent agreed to supply captive

with additional capital), aff’d, 640 F.2d 1010 (9th Cir. 1981); Kidde Indus., Inc. v.

United States, 40 Fed. Cl. 42, 50 (1997) (finding no “insurance” where parent

issued indemnification letter).

      By guaranteeing Legacy’s liabilities, Rent-A-Center agreed to step into

Legacy’s shoes to pay its affiliates’ loss claims. In effect, the parent thus became

an “insurer” of its subsidiaries’ risks. The majority cites no authority, and I know

of none, for the proposition that a holding company can “insure” the risks of its

wholly owned subsidiaries. The presence of this parental guaranty argues strongly

against the existence of “risk shifting” here.
                                          - 65 -

      The majority asserts that Rent-A-Center’s parental guaranty “did not vitiate

risk shifting” and offers three rationales for this conclusion. See op. Ct. pp. 35-38.

None of these rationales is convincing. The majority notes that the parent “did not

pay any money pursuant to the parental guaranty” and suggests that the guaranty

was really designed only to make sure that Legacy’s DTAs were counted in calcu-

lating its Bermuda minimum solvency margin. See id. pp. 37-38. The fact that the

parent was never required to pay on the guaranty is irrelevant; it is the existence of

a parental guaranty that matters in determining whether a captive is truly providing

“insurance.” And whatever may have prompted the issuance of the guaranty, the

fact is that it literally covers all of Legacy’s liabilities up to $25 million. The

DTAs never got above $9 million during 2003-06. See id. p. 16. Legacy’s

“liabilities” obviously included Legacy’s liability to pay the insurance claims of its

sister companies.

      The majority contends that the judicial precedents cited above “are distin-

guishable” because the guaranty issued by Rent-A-Center “did not shift the

ultimate risk of loss; did not involve an undercapitalized captive; and was not

issued to, or requested by, an unrelated insurer.” See op. Ct. pp. 36-37. The

majority’s first asserted distinction begs the question because it assumes that risk

has been shifted to Legacy, which is the proposition that must be proved. The
                                        - 66 -

majority’s second asserted distinction is a play on words. While Legacy for most

of the period at issue was not “undercapitalized” from the standpoint of Bermuda’s

(modest) minimum solvency rules, it was very poorly capitalized in comparison

with real insurance companies. See infra pp. 67-70. Moreover, the Court of

Appeals for the Sixth Circuit in Humana indicated that a parental guaranty alone,

without regard to the captive’s capitalization, can “provide[] a sufficient basis from

which to find no risk shifting.” 881 F.2d at 245 n.2. The majority’s third asserted

distinction is a distinction without a difference. While Rent-A-Center’s guaranty

was not requested by “an unrelated insurer,” it was demanded by Legacy’s nominal

insurance regulator as a condition of meeting Bermuda’s minimum solvency

requirements.

      As the “most important[]” ground for deeming the guaranty irrelevant, the

majority asserts that the parental guaranty “did not affect the balance sheets or net

worth of the subsidiaries insured by Legacy.” See op. Ct. p. 36. The majority here

reprises its argument that the “net worth and balance sheet analysis” must be

conducted at the level of the operating subsidiaries. See id. pp. 25, 33. Whatever

the merit of that argument generally, as applied to the guaranty it clearly proves too

much. A parental guaranty of a captive’s liabilities will never affect the balance

sheet or net worth of the sister company that is allegedly “insured.” But the Sixth
                                         - 67 -

Circuit, the Federal Circuit, and this Court have all held that the existence of a

parental guaranty may negate the existence of “insurance” within an affiliated

group.

             2.     Inadequate Capitalization

      When blessing the brother-sister premium payments in Rev. Rul. 2002-90,

supra, the Commissioner hypothesized that the parent had supplied the captive with

“adequate capital.” Numerous judicial opinions have likewise held that risk cannot

be “shifted” to a captive unless the captive is sufficiently capitalized to absorb the

risk. See, e.g., Beech Aircraft, 797 F.2d at 922 n.1 (no “insurance” where captive

was undercapitalized); Carnation Co., 71 T.C. at 409 (same).

      The majority bases its conclusion that Legacy was “adequately capitalized”

on the fact that Legacy “met Bermuda’s minimum statutory requirements” once the

parental guaranty of the DTA is counted. See op. Ct. pp. 20-21. The fact that a

captive meets the minimum capital requirements of an offshore financial center is

not dispositive as to whether the arrangements constitute “insurance” for Federal

income tax purposes. Indeed, the Sixth Circuit in Malone & Hyde held that intra-

group payments were not “insurance premiums” even though the captive met “the

extremely thin minimum capitalization required by Bermuda law.” 62 F.3d at 841.
                                         - 68 -

      In fact, Legacy’s capital structure was extremely questionable during 2003-

06. The only way that Legacy was able to meet Bermuda’s extremely thin

minimum capitalization requirement was by counting as general business assets its

DTAs, and those DTAs could be counted only after Rent-A-Center issued its par-

ental guaranty. The DTAs were essentially a bookkeeping entry. Without treating

that bookkeeping entry as an “asset,” Legacy would have been undercapitalized

even by Bermuda’s lax standards.

      The extent of Legacy’s undercapitalization is evidenced by its premium-to-

surplus ratio, which was wildly out of line with the ratios of real insurance com-

panies. The premium-to-surplus ratio provides a good benchmark of an insurer’s

ability to absorb risk by drawing on its surplus to pay incurred losses. In this ratio,

“premiums written” serves as a proxy for the losses to which the insurer is exposed.

Expert testimony in these cases indicated that U.S. property/casualty insurance

companies, on average, have something like a 1:1 premium-to-surplus ratio. In

other words, their surplus roughly equals the annual premiums for policies they

write. By contrast, Legacy’s premium-to-surplus ratio--ignoring the parental

guaranty of its DTA--was 48:1 in 2003, 19:1 in 2004, 11:1 in 2005, and in excess

of 5:1 in 2006 and 2007. In other words, Legacy’s surplus covered only 2% of

premiums for policies written in 2003 and only 5% of premiums for policies
                                        - 69 -

written in 2004, whereas commercial insurance companies have surplus coverage

in the range of 100%. Even if we allow the parental guaranty to count toward

Legacy’s surplus, its premium-to-surplus ratio was never better than 5:1.

      Legacy’s assets were undiversified and modest. It had a money market fund

into which it placed the supposed “premiums” received from its parent. This fund

was in no sense “surplus”; it was a mere holding tank for cash used to pay

“claims.” Apart from this money-market fund, Legacy appears to have had no

assets during the tax years at issue except the following: (a) the guaranties issued

by its parent; (b) the DTA reflected on its balance sheet; and (c) Rent-A-Center

treasury stock that Legacy purchased from its parent. For Federal tax purposes, the

parental guaranties cannot count as “assets” in determining whether Legacy was

adequately capitalized. They point in the precisely opposite direction.

      The DTA and treasury stock have in common several features that make

them poor forms of insurance capital. First, neither yields income. The DTA was

an accounting entry that by definition cannot yield income, and the Rent-A-Center

treasury stock paid no dividends. No true insurance company would invest 100%

of its “reserves” in non-income-producing assets. With no potential to earn

income, the “reserves” could not grow to afford a cushion against risk.
                                         - 70 -

      Moreover, neither the DTA nor the treasury stock was readily convertible

into cash. The DTA had no cash value. The treasury stock by its terms could not

be sold or alienated, although the parent agreed to buy it back at its issue price. In

effect, Legacy relied on the availability of cash from its parent, via repurchase of

treasury shares, to pay claims in the event of voluminous losses.8

      Finally, Legacy’s assets were, to a large degree, negatively correlated with

its insurance risks. During 2004-06, Legacy purchased $108 million of Rent-A-

Center treasury stock, while “insuring” solely Rent-A-Center risks. Thus, if

outsized losses occurred, those losses would simultaneously increase Legacy’s

liabilities and reduce the value of the Rent-A-Center stock that was Legacy’s

principal asset. No true insurance company invests its reserves in assets that are

both undiversified and negatively correlated to the risks that it is insuring.

      In sum, when one combines the existence of the parental guaranty, Legacy’s

extremely weak premium-to-surplus ratio, the speculative nature and poor quality

of the assets in Legacy’s “insurance reserves,” and the fact that Legacy without the

parental guaranty would not even have met “the extremely thin minimum capi-


       8
       Because Legacy “insured” losses only below a defined threshold, there was
a cap on the size of any individual loss that it might have to pay. See op. Ct. p. 8.
However, the number of individual loss events within that tranche could exceed
expectations.
                                        - 71 -

talization required by Bermuda law,” Malone & Hyde, 62 F.3d at 841, the absence

of “risk shifting” seems clear. Under the totality of the facts and circumstances, I

conclude that there has been no transfer of risk to the captive and hence that the

Rent-A-Center arrangements do not constitute “insurance” for Federal income tax

purposes.

      B.     Conformity to Insurance Industry Standards

      When blessing the brother-sister premiums in Rev. Rul. 2002-90, supra, the

IRS hypothesized that “the parties [had] conduct[ed] themselves in a manner

consistent with the standards applicable to an insurance arrangement between

unrelated parties.” Our Court has similarly ruled that transactions in a captive-

insurance context must comport with “commonly accepted notions of insurance.”

Harper Grp. v. Commissioner, 96 T.C. 45, 58 (1991), aff’d, 979 F.2d 1341 (9th Cir.

1992). Because risk shifting is essential to “insurance,” Helvering v. LeGierse, 312

U.S. at 539, the absence of risk shifting alone would dictate that the Rent-A-Center

payments are not deductible as “insurance premiums.” However, there are a

number of respects in which Rent-A-Center, its captive, and the allegedly “insured”

subsidiaries did not conduct themselves in a manner consistent with accepted

insurance industry norms. These facts provide additional support for concluding

that these arrangements did not constitute “insurance.”
                                        - 72 -

      Several facts discussed above in connection with “risk shifting” show that

the Rent-A-Center arrangements do not comport with normal insurance industry

practice. These include the facts that Legacy was poorly capitalized; that its

premium-to-surplus ratio was way out of line with the ratios of true insurance

companies; and that is “reserves” consisted of assets that were non-income-

producing, illiquid, undiversified, and negatively correlated to the risks it was

supposedly “insuring.” No true insurance company would act this way.

      It appears that Legacy had no actual employees during the tax years at issue.

It had no outside directors, and it had no officers apart from people who were also

officers of Rent-A-Center, its parent. Legacy’s “operations” appear to have been

conducted by David Glasgow, an employee of Rent-A-Center, its parent.

“Premium payments” and “loss reimbursements” were effected through bookkeep-

ing entries made by accountants at Rent-A-Center’s corporate headquarters.

Legacy was in practical effect an incorporated pocketbook that served as a

repository for what had been, until 2003, Rent-A-Center’s self-insurance reserve.

      Legacy issued its first two “insurance policies” before receiving a certificate

of registration from Bermuda insurance authorities. According to those authorities,

Legacy was therefore in violation of Bermuda law and “engaged in the insurance
                                        - 73 -

business without a license.” (Bermuda evidently agreed to let petitioners fix this

problem retroactively.)

      For the first three months of its existence, Legacy was in violation of Ber-

muda’s minimum capital rules because the DTA was not cognizable in determining

capital adequacy. Only upon the issuance of the parental guaranty in March 2003,

and the acceptance of this guaranty by Bermuda authorities, was Legacy able to

pass Bermuda’s capital adequacy test.

      There was no actuarial determination of the premium payable to Legacy by

each operating subsidiary based on the specific subsidiary’s risk profile. Rather, an

outside insurance adviser estimated the future loss exposure of the affiliated group,

and Rent-A-Center, the parent, determined an aggregate “premium” using that

estimate. The parent paid this “premium” annually to Legacy. The parent’s

accounting department subsequently charged portions of this “premium” to each

subsidiary, in the same manner as self-insurance costs had been charged to those

subsidiaries before Legacy was created. In other words, in contrast to the facts

assumed in Rev. Rul. 2002-90, supra, there was in these cases no determination of

“arms-length premiums * * * established according to customary industry rating

formulas.” To the contrary, the entire arrangement was orchestrated exactly as it
                                        - 74 -

had been orchestrated before 2003, when the Rent-A-Center group maintained a

self-insurance reserve for the tranche of risks purportedly “insured” by Legacy.

      From Legacy’s inception in December 2002 through May 2004, Legacy did

not actually pay “loss claims” submitted by the supposed “insureds.” Rather, the

parent’s accounting department netted “loss reimbursements” due to the

subsidiaries from Legacy against “premium payments” due to Legacy from the

parent. Beginning in July 2004, the parent withdrew a fixed, preset amount of cash

via weekly bank wire from Legacy’s money-market account. These weekly

withdrawals depleted Legacy’s money-market account to near zero just before the

next annual “premium” was due. This modus operandi shows that Rent-A-Center

regarded Legacy not as an insurer operating at arm’s length but as a bank account

into which it made deposits and from which it made withdrawals.

      These facts, considered in their totality, lead me to disagree with the majori-

ty’s conclusory assertions that “Legacy entered into bona fide arm’s-length

contracts with [Rent-A-Center]”; that Legacy “charged actuarially determined

premiums”; that Legacy “paid claims from its separately maintained account”; and

that Legacy “was adequately capitalized.” See op. Ct. pp. 20-21. In my view, the

totality of the facts and circumstances could warrant the conclusion that Legacy

was a sham. At the very least, the totality of the facts and circumstances makes
                                       - 75 -

clear that the arrangements here did not comport with “commonly accepted notions

of insurance,” Harper Grp., 96 T.C. at 58, and that the Rent-A-Center group of

companies did not “conduct themselves in a manner consistent with the standards

applicable to an insurance arrangement between unrelated parties,” Rev. Rul. 2002-

90, 2001-2 C.B. at 985. The departures from accepted insurance industry practice,

combined with the absence of risk shifting to the captive from the alleged

“insureds,” confirms that these arrangements did not constitute “insurance” for

Federal income tax purposes.

      COLVIN, GALE, KROUPA, and MORRISON, JJ., agree with this dissent.
