Carnation Co. v. Comm'r of Internal Revenue

• Decision Date: 26 December 1978
• Docket Number: Docket No. 5793–76.
• Citation: 71 T.C. 400
• Parties: CARNATION COMPANY, PETITIONER v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

71 T.C. 400

CARNATION COMPANY, PETITIONER

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 5793–76.

United States Tax Court

Filed December 26, 1978.

Petitioner and an unrelated insurance company entered into an ‘insurance’ agreement. Simultaneously, the unrelated insurance company ‘reinsured’ 90 percent of its risk under that agreement with petitioner's wholly owned Bermudan subsidiary. However, before the unrelated insurance company would participate in the ‘reinsurance’ agreement, petitioner had to give its wholly owned Bermudan subsidiary access upon demand to an additional $2,880,000 in capital contributions. Without regard to the demand agreement, petitioner's capital contribution to its wholly owned Bermudan subsidiary was $120,000. Held, to the extent that petitioner's risk was ‘reinsured’ with its wholly owned Bermudan subsidiary, its risk of loss had not shifted, its agreement with the unrelated insurance company was not insurance, and its payment, to the unrelated insurance company was not deductible as an ordinary and necessary business expense for insurance. Helvering v. LeGierse, 312 U.S. 531 (1941), followed. Held, further, amounts received by petitioner's wholly owned Bermudan subsidiary pursuant to such ‘reinsurance’ agreement are not includable in petitioner's income under sec. 951, I.R.C. 1954. Held, further, amounts received by petitioner's wholly owned Bermudan subsidiary pursuant to such ‘reinsurance’ agreement are not characterized as income from sources without the United States for purposes of sec. 904, I.R.C. 1954. J. Patrick Whaley and David W. Richmond, for the petitioner.

Alan S. Beinhorn, for the respondent.

OPINION

GOFFE, Judge:

The Commissioner determined a deficiency in the Federal income tax of petitioner for the taxable year 1972 in the amount of $823,632. This matter is before the Court on the parties' motions for summary judgment which were filed pursuant to Rule 121, Tax Court Rules of Practice and Procedure. Due to concessions, three issues remain for our decision:

(1) Whether petitioner is entitled to deduct as an ordinary and necessary business expense the entire amount paid to an unrelated insurance company as insurance premiums if such unrelated company thereafter reinsures 90 percent of the risk that it assumed under petitioner's policy with petitioner's wholly owned Bermudan subsidiary;

(2) Whether the amounts so received by petitioner's subsidiary, which is a controlled foreign corporation, constitute income derived from the insurance or reinsurance of United States risks under section 953, I.R.C. 1954,¹ or constitute contributions to capital under section 118; and

(3) Whether the amounts so received by that subsidiary are attributable to petitioner as subpart F income and are considered income from sources without the United States for purposes of computing petitioner's foreign tax credit limitation under section 904.

For the purpose of these motions, all of the facts have been stipulated. The stipulation of facts and the exhibits attached thereto are incorporated by this reference.

Carnation Co. (hereinafter Carnation or petitioner) filed its Federal income tax return for the taxable year 1972 with the Office of the Internal Revenue Service, Fresno, Calif. For 1972, Carnation and its subsidiary corporations which were required to file Federal income tax returns each filed separate Federal income tax returns rather than a consolidated return.² Carnation, a Delaware corporation, had its principal office in Los Angeles, Calif., during 1972.

Petitioner processes and sells food and other grocery products both within and without the United States. As part of its overall operation, Carnation manufactures cans in sufficient quantity to supply substantially all of its own needs as well as the needs of certain other canners. As a function of these operations, petitioner owns more than 125 plants and other facilities which are located in the United States and Canada. Such facilities are subject to the usual risks of loss ordinarily covered by insurance, and many of such facilities are situated in locales subject to earthquakes.

Carnation maintains an insurance department which is staffed by its own employees. This department recommends to Carnation's management the type and amount of insurance coverage needed and its likely cost. The insurance department's recommendations are made after consultation with Fred S. James & Co., an insurance brokerage firm employed by petitioner to place Carnation's insurance coverage with carriers. For many years, part of Carnation's insurance was placed with American International Group, Inc. (hereinafter AIG).

On August 20, 1971, the board of directors of Carnation resolved to organize an insurance company in Bermuda to carry on the business of insurance and reinsurance of various multiple line risks including those of petitioner and its subsidiaries. On August 26, 1971, Carnation caused Three Flowers Assurance Co., Ltd. (hereinafter Three Flowers), to be incorporated as petitioner's wholly owned Bermudan subsidiary. Three Flowers is a controlled foreign corporation within the meaning of section 957. Under an agreement dated September 1, 1971, Carnation's initial contribution to the capital of Three Flowers was the purchase of 120,000 shares of common stock at its par value of $1 per share. By the same agreement dated September 1, 1971, petitioner and Three Flowers agreed that, on demand of either of them, petitioner would purchase up to 288,000 additional shares of Three Flowers' common stock at $10 per share. Three Flowers therefore had access upon demand to $3 million in capital contributions from its parent.

Carnation purchased a blanket insurance policy from American Home Assurance Co. (hereinafter American Home), which is a member company of AIG, providing for 3 years of insurance coverage commencing September 22, 1971. Such policy provided coverage of up to $500,000 per loss arising out of any one event at any one location with a $10,000 per loss deductible. Covered events included fire, lighting, vandalism, malicious mischief, sprinkler leakage, flood, and earthquake shock. Except for a small portion which covered Canadian risks, the entire coverage pertained to property located within the United States.

Also effective September 22, 1971, American International Underwriters Overseas, Ltd., of Hamilton, Bermuda (hereinafter Overseas), agreed to be Three Flowers' managing agent in Bermuda. Overseas specializes in the management of Bermudan insurance companies and is a member company of AIG.

Also on September 22, 1971, Three Flowers contracted to reinsure 90 percent of American Home's liability under Carnation's policy. Article I of that agreement provided as follows:

1. The Company agrees to cede and the Reinsurer agrees to accept a 90% quota share part of all such insurances issued by the Company. Such insurance shall exclude the following:

a. As respects vessels:

Losses, Damage, or Expenses caused by or resulting from capture, seizure, arrest, restraint or detainment, or the consequences thereof or of any attempt thereat, or any taking of the vessel by requisition or otherwise, whether in time of peace or war and whether lawful or otherwise; also losses, damages or expenses from all consequences of hostilities or war-like operations (whether there be a declaration of war or not), but the foregoing shall not exclude collision or contact with aircraft, rockets or similar missiles, or with any fixed or floating object (other than a mine or torpedo), stranding, heavy weather, fire or explosion unless caused directly (and independently of the nature of the voyage or service which the vessel concerned, or, in the case of a collision any other vessel involved therein, if performing) by a hostile act by or against a belligerent power, and for the purpose of the exclusion, ‘power’ includes any authority maintaining naval, military or air forces in association with a power; also excluded, whether in time of peace or war, all losses, damage or expenses caused by any weapon of war employing atomic or nuclear fission and/or fusion or other reaction or radioactive force or matter; also losses, damage or expenses from the consequence of civil war, revolution, rebellion, insurrection, or civil strife arising therefrom, or piracy.

b. As respects other property:

Losses, damage or expenses from any consequence whether direct or indirect, of war, invasion, act of foreign enemy, hostilities (whether war be declared or not), civil war, rebellion, revolution, insurrection or military or usurped power.

2. The premium due the Reinsurer shall be its proportionate share of the net premiums (i.e., gross premium less cancellations and returns) less the commission specified in ARTICLE II(4).

American Home ceded to Three Flowers 90 percent of the premium received from Carnation. Three Flowers paid American Home a 5-percent commission based on net premiums ceded and reimbursed American Home for premium taxes. As a result of this reinsurance contract, American Home was liable to Carnation under the insurance policy described above and was required to pay claims made by Carnation under that policy; Three Flowers was required to reimburse American Home under the terms of their reinsurance contract.

Prior to the consummation of the reinsurance agreement between American Home and Three Flowers, American Home had expressed its concern to petitioner about the financial ability of Three Flowers to cover losses pursuant to the contemplated reinsurance agreement. American Home requested that petitioner deliver its letter of credit or other guarantee to American Home. Petitioner refused to do so. However, petitioner did represent that it would provide for the capitalization of Three Flowers up to $3 million. Therefore, petitioner and Three Flowers entered into the agreement dated September 1, 1971, and described above. There were no other...