Rent-A-Center, Inc. v. Comm'r
| Decision Date | 14 January 2014 |
| Docket Number | 142 T.C. No. 1,Docket No. 6909-10,Docket No. 8320-09,Docket No. 21627-10 |
| Parties | RENT-A-CENTER, INC. AND AFFILIATED SUBSIDIARIES, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent |
| Court | U.S. Tax Court |
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.
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, theDistrict 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.
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,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 toensure 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.
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.,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 byreference 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.
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 amonthly 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.
Pursuant to the Legacy policies, coverage began on December 31 of each year. Because petitioner was a calendar year...
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