In a recently released memorandum, the Internal Revenue Service suggests an expansion of those risks qualifying for the favorable tax treatment accorded insurance risks.
On January 12, the US Internal Revenue Service (IRS) released ILM 201802014—Coverage of Foreign Currency Fluctuation by Captive (the ILM)—that considered whether “insurance” for US federal income tax purposes includes the risk of foreign currency fluctuation. Reversing its prior position in light of the US Tax Court’s recent decision in R.V.I. Guaranty Co. v. Commissioner (R.V.I.), the ILM concluded that the risk of currency fluctuation can be an insurable risk. (The ILM also concluded, however, that the taxpayer’s contract, for reasons unrelated to the insurance risk issue, did not constitute insurance.)
The ILM related to a group of affiliated businesses (Taxpayer Group), including a captive insurance company (Captive) that under state law could insure only risks of its parent (Taxpayer) and affiliated entities. Taxpayer entered into two contracts with Captive on behalf of US members of Taxpayer Group to cover the risks of currency fluctuation for (i) manufacturing and sales to foreign customers and (ii) debt owed to related foreign entities in foreign currency. The ILM analyzed whether the insurance contracts were insurance under the relevant case law, specifically, whether the contract (1) involved insurable risks; (2) shifted risk of loss to the insurer and distributed risks among policyholders; and (3) was insurance in its commonly accepted sense.
Because the contracts did not, in the IRS’s opinion, satisfy all three elements, the ILM concluded that neither contract constituted insurance for federal income tax purposes. The ILM, however, did conclude that foreign currency risk can be an insurance risk and cited repeatedly in its analysis to R.V.I. In R.V.I., the IRS argued that the risk of greater-than-expected decline of the residual value of depreciable property was inherently an uninsurable investment risk. The IRS contended, in relevant part, that the policies did not involve insurance risk because the risk of greater-than-expected decline of residual value is analogous to a put option that protects against investment losses. The Tax Court rejected all of the IRS’s arguments in R.V.I. and concluded that the policies were insurance contracts for federal income tax purposes because they satisfied the relevant factors for insurance products.
Although the ILM reiterates the IRS’s position that certain business risks are per se not insurance risks, the ILM’s conclusion that foreign currency risk can be an insurance risk, together with the ILM’s citations to R.V.I., suggest that the IRS has expanded its understanding of what business risks constitute insurance risks. In particular, the ILM’s citation to R.V.I. suggests that the IRS agrees that the analysis in R.V.I., which provides a basis for insuring against a wider range of risks,should apply when analyzing insurance for tax purposes, including for captive insurance companies. Overall, the conclusions in the ILM and R.V.I. suggest an expansion of what contracts may qualify for favorable tax treatment as insurance contracts.
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 ILM 201511021 (March 13, 2015).
 145 T.C. 209 (2015).
 Although the ILM does not specify, it is likely that Captive was a member of the same consolidated group as the US members of the Taxpayer Group. In such case, Captive’s special status as an insurance company would be respected and its insurance transactions would be excepted from single entity treatment for intercompany transactions under Reg. § 1.1502-13. Because the insured members could deduct premiums paid to Captive in the year of payment under Section 162, but Captive could deduct a portion of the premiums received as reserves under Section 832(b)(5), the Taxpayer Group would obtain an overall deferral on the amount of premiums paid. In 2007, the IRS proposed regulations that would have prevented such deferral in a consolidated group. The proposed regulations were heavily criticized by the captive insurance industry and were quickly withdrawn.