A Sept. 21, 2015, Tax Court opinion held that residual value insurance constitutes insurance for federal income tax purposes. Residual value insurance commonly is used by leasing companies to eliminate downside exposure if the residual value of a leased property is less than originally projected. This decision is the first time the Tax Court has addressed residual value insurance, and the court’s decision is counter to the guidance provided by Technical Advice Memorandum 201149021.
In rel="noopener noreferrer" R.V.I. Guaranty Co., Ltd. & Subsidiaries v. Commissioner, the Tax Court held that a company that issued residual value insurance contracts was an insurance company for federal income tax purposes for the year in question. The IRS argued that the residual value contracts covered only an investment risk and not an insurance risk. The result was that the company failed to qualify as an insurance company for tax purposes. The customers of RVI were unrelated third parties that either leased assets or financed leases.
The IRS made a number of arguments for why the policies were not insurance. It argued that a nonstandard provision in the contracts caused them to differ from insurance policies. Specifically, the residual value policies did not immediately pay upon a fortuitous event. Instead, the policies paid only if on the last day of policy the value of the insured item was less than the insured value. The Tax Court rejected this argument and indicated that such policies were similar to municipal bond insurance, which historically has qualified as insurance for federal income tax purposes. The IRS also argued that the policies involved only investment risk, not insurance risk. The Tax Court held that since the premium charged was about 4 percent of the insured value, the taxpayer was exposed to underwriting risk because the losses clearly could have exceeded the amount of premiums charged.
In finding that the policies were insurance, the Tax Court also noted that several state courts had determined that such residual value policies were insurance for regulatory purposes, that such contracts were treated as insurance for statutory accounting principles, that external auditors and state departments of insurance generally agreed such contracts were contracts of insurance, and that the insurance marketplace treated such policies as insurance. The Tax Court also dismissed the IRS’ contention that certain years with low claims indicated that risk of loss did not transfer to the company because the policies involved low-frequency or high-severity risks, and many of the policies could not have a loss until the last day of the lease.
The IRS still can appeal the decision and has not acquiesced to it. However, the decision does offer some comfort to companies that issue or hold residual value contracts.