United States: Illinois Appellate Court Holds Captive Insurance Company Not Included In Combined Corporate Income Tax Return

The Illinois Appellate Court has held that a captive insurance company formed by a restaurant corporation was properly excluded from a combined tax return because the company qualified as an insurance company for Illinois corporate income tax purposes.¹ The captive insurance company met the definition of an insurance company under federal income tax law and engaged in the necessary risk shifting and risk distribution. There was no indication that the captive insurance company was formed as a sham business or lacked a valid business purpose. For these reasons, the company was required to be treated as an insurance company under Illinois law and excluded from the combined return.

Background

The taxpayer, Wendy's, is the parent company of an affiliated group of corporations operating restaurants throughout the United States. Based in Ohio, Wendy's decided to self-insure its risks by creating Scioto Insurance Company in Vermont as a wholly-owned captive insurance company. In order to be qualified as an insurance company under Vermont law, Scioto had to be sufficiently capitalized to cover all of its insurance obligations. Scioto acquired a Wendy's affiliate that held Wendy's trademarks that were valued at more than $900 million. The affiliate licensed the trademarks to Wendy's in exchange for a royalty of 3 percent of its gross sales.

Wendy's included Scioto in its federal consolidated income tax returns. The Internal Revenue Service (IRS) audited the federal consolidated returns for the 2001 through 2006 tax years and did not dispute Scioto's status as an insurance company. Wendy's excluded Scioto from its Illinois unitary business group and Scioto's income was not included in the unitary business group's Illinois combined income tax returns. The Illinois Department of Revenue audited Wendy's for the same tax years and concluded that Scioto was not a true insurance company because: (i) there was not actual risk shifting and risk distribution to constitute insurance for federal income tax purposes; (ii) the majority of Scioto's income was derived from intercompany royalty income; and (iii) Scioto was not regulated in all states in which Scioto wrote premiums. As a result of the audit, the Department issued notices of deficiency.

After paying the deficiency notices under protest, Wendy's filed cases in the circuit court under the Protest Monies Act. Wendy's filed a motion for summary judgment claiming it was not required to include Scioto in its Illinois combined tax returns because Scioto is a bona fide insurance company. The Department filed a motion for summary judgment claiming that Scioto is not an insurance company, and its royalty income is not from an insurance business. The trial court granted the Department's motion for summary judgment determining that Scioto was not an insurance company under Illinois income tax law, and thus, includable in the Illinois combined tax returns. Wendy's subsequently filed a timely appeal.

Insurance Companies Not Included in Combined Return

Under Illinois law, a group of corporations operating as an Illinois unitary business group is treated as a single taxpayer and files a unitary combined return.² However, Illinois law prohibits including companies in a combined return if they are required to apportion their income under a different subsection of the apportionment statute³ than other members of the unitary group.⁴ Because an insurance company is required to apportion its business income under a different subsection of the apportionment statute than noninsurance companies, an insurance company cannot be included in a combined return with its noninsurance company affiliates.⁵

Scioto Qualified as Insurance Company

In reversing the trial court, the Illinois Appellate Court determined that Scioto qualified as an insurance company and therefore could not be included in the Illinois combined return. Wendy's argued that Scioto was an insurance company for Illinois income tax purposes because it constituted an insurance company for federal income tax purposes. The Department noted that while the Illinois income tax statutes do not define an "insurance company," Illinois follows the federal definition of the term.⁶ According to the Department, Scioto should be included in Wendy's unitary business group because it did not meet the federal test for an insurance company for the 2001 through 2006 tax years.

Federal Definition of "Insurance Company"

The Appellate Court held that Scioto was an insurance company for federal income tax purposes for the 2001 through 2006 tax years. Due to a change in federal law, the Appellate Court was required to separately analyze the 2001 to 2003 tax years and the 2004 to 2006 tax years. Prior to 2004, a Treasury regulation defined an "insurance company" as a "company whose primary and predominant business activity during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies."⁷ Furthermore, the regulation provided "it is the character of the business actually done in the taxable year which determines whether a company is taxable as an insurance company under the Internal Revenue Code."⁸

For the 2001 through 2003 tax years, a large percentage of Scioto's income was from royalty and interest income.⁹ Although Scioto's income from insurance premiums was a small percentage of its total income, the Appellate Court noted that "it is not any percentage of income that determines whether a company is taxable as an insurance company but rather the character of the business actually done by the company."¹⁰ The Appellate Court determined that the following factors supported a conclusion that Scioto was engaged in the insurance business: (i) Scioto was licensed by Vermont as an insurance company; (ii) Scioto's only business was to furnish insurance to affiliates; (iii) Scioto owned the trademark company, but it was not engaged in the business of licensing intellectual property; and (iv) Scioto's ownership of the trademark company was directly related to its insurance business because it enabled Scioto to meet the capitalization requirements under Vermont insurance law.

The Appellate Court also held that Scioto was an insurance company for federal income tax purposes for the 2004 through 2006 tax years. In 2004, IRC Section 831(c) was amended to adopt the definition of "insurance company" from IRC Section 816(a). Under this law, an "insurance company" is defined as "any company more than half of the business of which during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies."¹¹ The Appellate Court determined that the facts and circumstances indicated that Scioto was principally engaged in the insurance business for the 2004 through 2006 tax years even though a large percentage of its income was from royalties rather than premiums.¹² Because Scioto generated its own business income separate from the income of the trademark company, the income from trademarks was not considered to be income from Scioto.

Risk Shifting and Risk Distribution

Wendy's successfully argued that Scioto was engaged in the insurance business because it effectuated risk shifting and risk distribution. Under federal law, risk shifting and risk distribution are necessary components of an insurance business.¹³ Courts have held that an arrangement between an insurance subsidiary and its affiliates qualifies as insurance for federal income purposes, even if there are not outside policyholders, if the risk shifting and risk distribution requirements are met.¹⁴ The Appellate Court explained that Scioto was formed to provide insurance to Wendy's and its affiliates. Scioto provided a broad range of insurance coverage and issued policies and charged premiums that reflected fair market rates. Because Scioto provided insurance contracts and engaged in risk shifting and risk distribution, it was an insurance company for federal income tax purposes.

Other Factors

The Appellate Court considered other factors that supported a conclusion that Scioto was an insurance company for purposes of Illinois income tax. Due to the fact that Scioto was recognized as an insurance company by Vermont and the IRS, Scioto should similarly be treated as an insurance company by Illinois. The conformity with federal and state law resulted in the advantages of predictability and certainty.

Commentary

This case addresses a long-standing area of contention between taxpayers and the Department – whether captive insurance companies are "true" insurance companies for purposes of the special apportionment formula for insurance companies set forth in the Illinois Income Tax Act. However, in light of the related-party expense addback legislation enacted in 2008, this decision is much less important for taxable years after the enactment of the addback legislation.

The Illinois Income Tax Act does not contain a definition of "insurance company." The Department has also never adopted regulations to define this term. In reliance on the federal definition of the term "insurance company," in addition to containing the captive insurance function in Scioto, Wendy's was able to hold its various trademarks in Scioto. For the tax years at issue, this provided Wendy's with an effective way to reduce the income of the unitary group through the licensing of the trademarks.

This is a favorable decision for a relatively limited set of taxpayers and may be used to support arguments that captive insurance companies constitute bona fide insurance companies and should not be included in unitary groups for Illinois combined reporting purposes. However, the captive insurance company must meet the requirements specified by the court and be primarily engaged in the business of providing insurance. In addition, there may be some situations where the exclusion of the insurance entity from the combined group does not result in an overall benefit. The determination of whether it is beneficial to exclude an insurance entity may ultimately depend on the facts and circumstances of the combined group other than the insurance company. Also, the exclusion of the insurance entity from the unitary group appears to be mandatory. Thus, a taxpayer with the same facts as Wendy's would be required to exclude the insurance entity.

As noted above, the presence of related-party expense addback legislation for taxable years ending on or after December 31, 2008 largely eliminates the potential benefit for certain taxpayers resulting from excluding insurance entities from the combined group. Under this legislation, an addback of intangible expenses and costs otherwise allowed as a deduction that were paid to a person who would be a member of the same unitary business group but for the fact that the person is prohibited from being included because he or she is required to apportion income under a different subsection of the apportionment statute is required.¹⁵ Also, for taxable years ending on or after December 31, 2008, a similar provision expressly requires taxpayers to add back insurance premium expenses and costs.¹⁶ These addback provisions did not apply to the instant case because it concerned the 2001 to 2006 tax years.

The Illinois statutory exclusion from a unitary group of entities required to apportion income under a different subsection also applies to entities such as financial organizations¹⁷ and transportation services.¹⁸ Thus, financial organizations and transportation service providers potentially could use this case to support an argument that they should not be included in a unitary group with other types of entities in open tax years, to the extent the addback rule does not apply to these entities' transactions.

Footnotes

1. Wendy's International, Inc. v. Hamer, Illinois Appellate Court, 4th Dist., No. 4-11-0678, Oct. 7, 2013.

2. 35 ILL. COMP. STAT. 5/502(e).

3. 35 ILL. COMP. STAT. 5/304.

4. 35 ILL. COMP. STAT. 5/1501(a)(27).

5. Id.

6. See 35 ILL. COMP. STAT. 5/102.

7. Treas. Reg. § 1.801-3(a), as in effect prior to 2004.

8. Id.

9. For the 2001 tax year, Scioto had total income of $65,422,910, comprised of $47,157,394 of royalty income, $108,757 of interest income and $18,156,759 of income from premiums. For the 2002 tax year, Scioto had total income of $237,897,091, comprised of $207,384,178 of royalty income, $5,543,883 of interest income and $25,059,030 of income from premiums. For the 2003 tax year, Scioto had total income of $246,353,284, comprised of $217,620,152 of royalty income, $13,772,406 of interest income and $14,960,726 of income from premiums.

10. Service Life Insurance Co. v. United States, 189 F. Supp. 282 (D. Neb. 1960).

11. IRC § 816(a).

12. For the 2004 tax year, Scioto had total income of $271,003,820, comprised of $234,470,739 of royalty income, $18,228,723 of interest income and $18,304,358 of income from premiums. For the 2005 tax year, Scioto had total income of $278,598,453, comprised of $231,413,458 of royalty income, $27,658,079 of interest income and $19,526,916 of income from premiums. For the 2006 tax year, Scioto had total income of $389,354,096, comprised of $327,546,586 of royalty income, $42,566,583 of interest income and $19,940,927 of income from premiums.

13. Helvering v. Le Gierse, 312 U.S. 531 (1941).

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

15. 35 ILL. COMP. STAT. 5/203(b)(2)(E-13).

16. 35 ILL. COMP. STAT. 5/203(b)(2)(E-14).

17. 35 ILL. COMP. STAT. 5/304(c).

18. 35 ILL. COMP. STAT. 5/304(d).

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