Gulf Oil Corp. v. Commissioner , 89 T.C. 1010 ( 1987 )

WHITAKER, Judge:^*

The Commissioner determined deficiencies in petitioner’s Federal income tax for the taxable year 1974 in the amount of $80,813,428, and for the taxable year 1975 in the amount of $166,316,320. Petitioner, respondent, and the Court agreed that certain issues would be severed and tried at a special trial session.¹ One of the issues tried was designated as the “Insco issue.” It involves the following two questions:

(1) Whether petitioner may deduct as ordinary and necessary business expenses amounts paid as insurance premiums by Gulf Oil Corp. and its domestic affiliates to the extent that those payments were ceded to its wholly owned captive insurance company, Insco, Ltd.; and

(2) Whether the payments designated as premiums made by the foreign affiliates of Gulf Oil Corp. which were ceded to Insco, Ltd., and the claims paid by Insco, Ltd., to Gulf Oil Corp. and its domestic affiliates represent constructive dividends to Gulf Oil Corp..

FINDINGS OF FACT

Some of the facts have been stipulated. The stipulation of facts and accompanying exhibits are so found and incorporated by this reference.

Gulf Oil Corp. (hereinafter, referred to as petitioner or Gulf) is a corporation organized under the laws of the Commonwealth of Pennsylvania with its principal office in Pittsburgh, Pennsylvania. During the taxable years at issue, Gulf and certain of its subsidiary corporations constituted an “affiliated group” as that term is defined in section 1504.² Petitioner, directly and through its foreign subsidiaries and affiliates, is engaged in world-wide exploration, development, production, purchase, transportation, and marketing of petroleum products. Petitioner maintained its books of account for the taxable years in issue on the accrual method of accounting using the calendar year as its taxable year. Gulf, as the common parent of an affiliated group of corporations, timely filed consolidated Federal income tax returns for its taxable years 1974 and 1975 on behalf of itself, and certain of its subsidiary corporations, with the Office of the Internal Revenue Service at Pittsburgh, Pennsylvania.

By virtue of their world-wide operations, Gulf and its foreign and domestic subsidiaries and affiliates were exposed to various risks. These risks fall into three general categories: (i) those associated with domestic and foreign on- and off-shore properties, marine hull and machinery, and marine cargo which include, but are not limited to: fire, windstorm, flood, earthquake, spills, pollution, seepage, contamination, shipwreck, collision, seizure, explosion, hurricane, typhoon, cyclone, hail, lightning, and liability to third parties incident thereto; (ii) those associated with general casualty which include, but are not limited to, workmen’s compensation, automobiles and other vehicles, and products liability; and (iii) those associated with disability, life, and accident of employees.

Until the late 1960’s, commercial coverage for the risks of Gulf and its affiliates was available at acceptable rates and adequate coverages. Up until this time, the general policy of Gulf and its affiliates was to self-insure risks up to an amount of $1 million. Insuraiice coverage for risks in excess of $1 million, including catastrophic risks, which were generally considered to be those risks in excess of $10 million, was obtained from third-party primary insurance carriers and reinsurers in the United States and world-wide markets. However, in the late 1960’s, several incidents occurred in the oil industry that caused commercial insurance carriers to increase rates and provide more limited coverage or to altogether eliminate coverage for certain risks. Some of these incidents included a refinery explosion at Lake Charles, Louisiana, an oil spill off the coast of Santa Barbara, California, and Hurricanes Betsy and Camille. Subsequently, Gulf decided that its excellent loss history was not being adequately reflected in the higher rates in the coverages that remained available in the primary and reinsurance markets. In response, Gulf participated in the creation of Oil Insurance Ltd. (OIL) with several other major and independent oil companies and also created its own insurance company subsidiary, Insco, Ltd.

OIL was formed in late 1970 as a petroleum industry mutual insurance company for the purpose of providing insurance coverage of catastrophic risks of its member-shareholders in excess of $10 million. OIL originally included Gulf and seven other shareholder companies. In 1971, OIL was restructured because of concern over the deductibility of premium payments. As part of the restructuring, shareholders could only withdraw from OIL over a 5-year period. The method of calculating premiums was also changed so that they were based upon both the loss experience over the previous 5 years and the gross assets of each shareholder. Gulf was dissatisfied with the new premium formula because it resulted in the subsidy of smaller, independent shareholders by larger shareholders, such as Gulf. Nevertheless, Gulf agreed to participate in OIL as restructured.

In further response to the changes in the third-party primary insurance and reinsurance markets, Gulf contemplated the formation of a captive insurance subsidiary to provide coverage for Gulf and its subsidiaries and affiliates. In 1968, Gulf conducted a feasibility study in concert with Marsh & McLennan, Inc., an insurance brokerage and consulting firm, with regard to the advisability of establishing an affiliated insurance company outside of the United States. This study, which updated a 1964 study, included consideration of the potential tax and financial benefits to be obtained through the operation of such an insurance affiliate. On June 10, 1971, the management of Gulf approved a plan to establish an affiliated insurance company in Bermuda. Under this plan, the insurance affiliate would initially insure only certain foreign risks of domestic subsidiaries. Later, the insurance affiliate was to provide further insurance, including coverage for Gulfs marine fleet and U.S. situs risks. Gulf also contemplated eventually offering insurance coverage to unrelated third parties.

On November 3, 1971, Gulf incorporated Insco, Ltd. (Insco), as a foreign wholly owned subsidiary authorized to conduct general insurance business under the laws of Bermuda. Although an initial capitalization of $10 million was authorized, Insco initially issued 1,000 shares with a value of $1,000 per share of which only 12 percent was paid up. Insco established its office in Hamilton, Bermuda, with a staff of two, consisting of A.W. Gregg, president, and a secretarial assistant. Gregg was a Gulf employee who had been in the insurance division of Gulf’s treasury department. In addition, David B. Vaughn of Marsh & McLennan Management, Ltd., a Bermuda subsidiary of Marsh & McLennan, Inc., served as vice president, and R.S.L. Pearman of Conyers, Dill & Pearman, solicitors for Insco, served as assistant secretary. W.H. Burkhiser and J.C. Kelly, both employees of Gulf, served as treasurer and secretary of Insco, respectively. Pursuant to an agreement dated November 10, 1971, Marsh & McLennan Management, Ltd., agreed to provide Insco with all underwriting, premium rating, claims, reinsurance, record keeping, banking, and check disbursement services relative to its operations.

Generally, but not uniformly, the following depicts the relationship between Gulf, its affiliates, primary commercial carriers, Insco Ltd., OIL, and reinsurers of catastrophic risks. Gulf and its affiliates entered into insurance contracts with third-party commercial carriers relative to their respective risks. By prearrangement with these insurance carriers, a significant portion of the primary carrier’s exposure was reinsured with Insco Ltd.¹ Gulf and its affiliates paid premiums directly to the primary commercial carriers. To the extent the primary carriers reinsured the risks of Gulf and its affiliates with Insco. Ltd., premiums paid them by Gulf and its affiliates were ceded to Insco Ltd. The primary carriers retained a commission for acting as a fronting or ceding company for Insco Ltd. The risks assumed by Insco Ltd. from primary carriers relative to Gulf and its affiliates were limited to $10 million but did not include the first $1 million of loss. This latter amount was self-insured by Gulf and its affiliates. It was the practice of primary carriers and Insco Ltd. to reinsure catastrophic risks, i.e., those exceeding $10 million, with third-party reinsurers on the worldwide reinsurance market or place them in OIL. A portion of the premiums received by Insco Ltd. attributable to its insurance of a portion of the risks of Gulf and its affiliates was ceded to reinsurers who accepted the catastrophic risks of Gulf and its affiliates exceeding $10 million.

Relative to the risks of Gulf and its affiliates associated with on-shore properties, such as refineries and chemical plants, it was the general practice to self-insure such properties up to a $1 million deductible level. Risk exposures in excess of $1 million up to a $40 million level were placed with a primary carrier such as Oil Insurance Association, a third-party commercial insurance concern. By prearrangement, the first $10 million of coverage, exclusive of the $1 million deductible, was reinsured with Insco Ltd. Risk exposures between $10 million and $40 million were retained by the primary carrier. Risk exposures exceeding $40 million, up to a level of $150 million, were placed with OIL. Upon Gulfs phased withdrawal from OIL, risk exposures exceeding the $40 million limit were reinsured in the worldwide commercial reinsurance market.

Relative to risks associated with off-shore properties such as drilling rigs and production equipment, the practice of Gulf and its affiliates was to self-insure up to a level of a $1 million deductible. Risk exposures in excess of $1 million were insured by a primary carrier who was frequently a member of the American International Group. The limit of coverage in the case of off-shore properties was determined by the value of the properties involved. By prearrangement, generally 50 percent of the pripiary carrier’s coverage limit, up to a $10 million level, was reinsured with Insco Ltd. The primary carrier retained coverage in excess of $10 million and often reinsured a portion of this coverage in the worldwide reinsurance market or with OIL.

Relative to the risks of Gulf and its affiliates associated with marine hull, i.e., oil tankers and other vessels, it was the practice of Gulf and its affiliates to self-insure up to a $1 million deductible level. Risk exposures in excess of the $1 million, deductible, were placed with a primary carrier such as Lloyd’s of London, American International Group, or Argonau Mid-West Insurance Co. The limits of the liability of the primary carrier depended upon the value of the particular hull being insured. By prearrangement with the primary carrier, 50 percent of the primary carrier’s coverage up to a $10 million level was reinsured with Insco Ltd. The primary carrier retained coverage in excess of $10 million and often reinsured a portion of this coverage in the worldwide reinsurance market, generally through the London reinsurance market. OIL did not assume any catastrophic coverage relative to the marine hull risk exposures of Gulf and its affiliates.

Relative to the risks of Gulf and its affiliates associated with marine cargo, it was the practice to self-insure up to a $1 million deductible level. Risk exposures in excess of the $1 million deductible level were placed with a primary carrier such as the Insurance Co. of North America. The amount of coverage held by the primary carrier was dependent upon the limit of the policy of insurance. By prearrangement with the primary carrier, the latter’s coverage was reinsured with Insco Ltd. up to a level of $10 million. The primary carrier retained coverage in excess of $10 million and often reinsured a portion of this coverage in the worldwide reinsurance market or with OIL.

Gulf made available to its employees a group life insurance benefit plan in which employees could participate. This plan was written through a policy issued by Connecticut General. The benefit plan included a provision which continued life insurance for employees who were disabled, with Gulf paying a premium for such life insurance while they were so disabled. By prearrangement, 100 percent of Connecticut General’s exposure was reinsured with Insco Ltd. while the employee was disabled. The premium for this exposure was ceded to Insco Ltd. Connecticut General received a fee for administrative services provided to Insco Ltd.

Insco’s premium income received from Gulf, Gulf’s affiliates, and third parties consisted of earned and unearned premiums. Earned premiums relate to amounts paid in a particular year for coverage in that year, while unearned premiums relate to amounts paid in a particular year for coverage in a subsequent year.

Set forth below are the gross premiums written and the net premium income reported by Insco on its financial statements for the years 1972 through 1983:

Year Gross premiums written Net premium income

1972 $1,064,000 $569,000

1973 8,118,000 2,505,000

1974 12,344,000 11,816,000

1975 21,300,000 16,177,000

1976 31,770,000 30,079,000

1977 40,269,000 41,238,000

Year Gross premiums written Net premium income

1978 $85,017,000 $73,926,000

1979 112,630,000 75,812,000

1980 153,670,000 87,621,000

1981 154,022,000' 94,758,000

1982 140,454,000 98,158,000

1983 . 114,090,000 82,264,000

Net premium income is gross premiums written, less the increase or decrease in unearned premiums relative to the prior year, minus commissions, expenses, and premium taxes.

Set forth below is a schedule of Insco’s yearly and cumulative investment income (primarily consisting of interest income) for the years 1972 through 1980.

Yearly . Cumulative

Year investment income investment income

1972 $8,197 $8,197

1973 85,433 93,630

1974* 1,151,290 1,244,920

1975* 2,439,525 3,684,445

1976* 4,102,747 7,787,192

1977 6,886,287 " 14.673.479

1978 9,260,000 ⁸ 23.933.479

1979 14,188,000 38.121.479

1980 21,285,000 59.406.479

(Amounts are computed on a consolidated basis where appropriate. Years with asterisks end 11/30; all other years end 12/31.)

For the years 1972 through 1983, the amounts that Insco had available to meet insurance loss claims (that is, the value of Insco’s assets minus its liabilities (other than estimated unpaid losses and loss expenses³)) were as follows:

Year Amount

1972 . $0.7 million

1973 . 3.0 million

1974*. 1.5 million

1975*. 34.3 million

1976*. 61.2 million

1977 . 79.7 million

1978 . 124.7 million

1979 . 171.6 million

Year Amount

1980 . $223.9 million

1981 . 260.1 million

1982 . 285.4 million

1983 . 305.4 million

(Amounts are computed on a consolidated basis, where appropriate. Years with asterisks are years ending 11/30. All other years end 12/31.)

Set forth below is a schedule of Gulf and its foreign and domestic affiliates whose risks were reinsured with Insco during the taxable years 1974 and 1975 along with their respective country of incorporation:

Country of

Name incorporation

Gulf Oil Corp. U.S.

Mene Grande Oil Co. U.S.

Ecuadorian Gulf Oil Co. U.S.

Zaire Gulf Oil Co. U.S.

Key International Drilling Co., Ltd. Bermuda

Britama Tankers, Ltd. England

Belgulf Tankers, NV. Belgium

Nedgulf Tankers, NV. Belgium

Fuel Transport Co., Ltd.. Liberia

Compannia Marítima Rio Gulf Co,, SA. Spain

Gulf Oil Company (Nigeria), Ltd . Nigeria

Afran Transport Co. Liberia

Gulftankers, Inc. Liberia

Insco paid claims to primary carriers relative to all risks it reinsured totaling $1,001,444 and $3,107,212 for the years 1974 and 1975, respectively. No part of the claims paid in 1974, and only $48,018 of the claims paid in 1975 related to the risks of unrelated third parties.

Members of the American International Group, Inc. (AIG), served as primary insurers for a substantial amount of the risks of Gulf and its affiliates that were reinsured with Insco. On December 20, 1973, Gulf executed a guaranty in favor of AIG that obligated Gulf to indemnify AIG in the event Insco could not meet its obligations regarding the risks it reinsured. The AIG guaranty remained in effect throughout the relevant years. On December 20, 1973, Gulf also executed a similar guaranty relative to the risks reinsured by Oil Industry Association. The latter guaranty, or a substituted version thereof, was in effect throughout the relevant years. Gulf was never required to indemnify any primary insurers under these guaranties.

In 1975, several changes in the operation and structure of Insco were made. Among these changes, Gulf transferred ownership of Insco to Transocean Gulf Oil Co. (Transocean), a wholly owned Gulf holding company. At this time, Insco called its issued but non-paid-up shares and Transocean contributed capital of $880,000. Concurrently, Insco issued 9,000 new shares at a value of $1,000 per share. These shares were fully paid up by Transocean thereby increasing the paid-in capital of Insco to $10 million. Gulf and its affiliates no longer directly placed catastrophic coverage with OIL or other third-party reinsurers, but rather placed those risks with Insco, which, in turn, reinsured those risks.

In 1975, Insco first began insuring risks of unrelated parties. Net premium income from the insurance of non-Gulf risks represented 2 percent of the total net premium income of Insco for the taxable year-1975. Gulf also determined that it should withdraw from OIL and commenced doing so over the minimum 5-year period. In October 1975, J.M. Turnbull, of Gulfs financial department, replaced A.W. Gregg as president of Insco.

In a statutory notice of deficiency mailed to petitioner, the Commissioner determined that payments made by Gulf and its domestic affiliates to primary insurers were not deductible insurance premiums to the extent those payments were ceded to Insco. As a result, the Commissioner disallowed insurance expense deductions claimed by Gulf and its domestic affiliates as follows:

Insurance expense disallowed

1974 1975

Gulf Oil Corp. $8,970,653 $9,426,308

Mene Grande Oil Co. 1,059,306 1,168,453

Ecuadorian Gulf Oil Co. 214,398 185,414

Total 10,244,357 10,780,175

With the consent of petitioner, the Commissioner amended his pleadings to disallow additional deductions claimed for insurance premiums ceded to Insco in the amounts of $40,973 and $119,906 for the taxable years 1974 and 1975, respectively.

The Commissioner also recharacterized the insurance premium payments made by foreign affiliates of Gulf as constructive dividends to Gulf to the extent those premiums were ceded to Insco. In the statutory notice of deficiency, the Commissioner determined that Gulf received dividend income in the amounts of $2,659,410 and $4,662,192⁴ for the taxable years 1974 and 1975, respectively. In addition, with the consent of petitioner, the Commissioner amended his pleadings to reflect that Gulf had additional taxable income from constructive dividends arising from the payment of insurance premiums to Insco by foreign affiliates of Gulf in the amount of $1,369,236 for the taxable year 1974. The parties agree that for the taxable year 1974, each of the Gulf foreign affiliates who paid premiums to Insco, through third-party primary insurers, had sufficient current or accumulated earnings and profits equal in amount to the constructive dividends determined by respondent. The parties agree that with the exception of Belgulf Tankers, NV, Britama Tankers, Ltd., Gulftankers, Inc., and Gulf Oil (Great Britain) Ltd., each of the Gulf foreign affiliates who paid premiums to Insco in 1975, through third-party primary insurers, had sufficient current or accumulated earnings and profits equal in amount to the constructive dividends determined by respondent.

In the statutory notice of deficiency, the Commissioner also treated claims paid by Insco in the taxable years 1974 and 1975, relative to the reinsurance of the risks of Gulf and its domestic affiliates, as constructive dividends directly to Gulf or to Gulf through Transocean. These payments of claims, which were treated as constructive dividends, totaled $1,001,441 and $3,059,194 for the taxable years 1974 and 1975, respectively. However, the Commissioner determined that Gulf and its domestic affiliates sustained deductible uninsured losses under section 165 for the taxable years 1974 and 1975 totaling $1,001,444 and $3,059,194, respectively.

From 1976 to the present, Insco increased its underwriting of third-party risks and continued to underwrite additional risks of Gulf and its affiliates. In April 1977, Insco hired Leslie Dew to guide the expansion of Insco’s underwriting efforts. He was named vice president and chief operating officer for underwriting, and was appointed to Insco’s executive committee and board of directors. Dew is well respected in the insurance industry. He has an extensive background as a non-marine insurance underwriter at Lloyd’s of London, with one of the major underwriting syndicates. He served as deputy chairman of Lloyd’s of London immediately prior to commencing work with Insco.

In 1978, Insco terminated its service agreement with Marsh & McLennan Management, Ltd. Subsequently, Insco systematically assembled the necessary staff to perform all the services previously performed by Marsh & McLennan Management, Ltd. Based upon the recommendation of Dew, Insco formed Britamco, Ltd., as a wholly owned Bermuda subsidiary. Britamco, Ltd.’s business activity was to act as an agent for Insco and other insurance companies in writing third-party insurance and reinsurance business. In order to underwrite third-party reinsurance risks in the United States, Insco entered into a trust agreement with Citibank, New York, New York, pursuant to which Insco set aside $10 million in liquid assets as security for its U.S. insureds and reinsureds relative to claims payable in U.S. currency. By establishing the $10 million trust fund, Insco was able to qualify as a non-admitted surplus line insurer in various States throughout the United States.

Set forth below is a schedule of the net premium income earned by Insco from reinsuring the risks of Gulf and its associates and third parties, as well as the amount of net premium income earned from reinsuring third-party risks as a percentage of total net premium income for the years 1976 through 1983:

Percentage of

Year Gulf-related risks Third-party risks third-party risks

1976 $29,049,000 $2,235,000 7 percent

1977 32,295,000 6,008,000 16 percent

1978 32,615,000 33,902,000 51 percent

Percentage of

Year Gulf-related risks Third-party risks third-party risks

1979 $30,871,000 $36,214,000 54 percent

1980 36,202,000 40,881,000 53 percent

1981 39,312,000 46,544,000 54 percent

1982 46,497,000 42,381,000 48 percent

1983 29,011,000 46,520,000 62 percent

It was the practice of Insco Ltd. to limit its individual loss occurrence exposure relative to third-party risk to $500,000 or less. Reinsurance was placed with unrelated reinsurers at appropriate terms and conditions to accomplish this.

The following is a schedule of claims paid by Insco during the years 1976 through 1980:

Year Claims paid

1976 . $4,718,000

1977 . 12,698,000

1978. 5,989,000

1979 . 15,169,000

1980 . 25,947,000

Set forth below is a schedule of the dividends paid by Insco to Transocean during the years 1976 through 1983:

Year Dividends

1976 . 0

1977 .$10,000,000

1978 . 13,000,000

1979 . 10,000,000

1980 . 10,000,000

1981 . 10,000,000

1982.10,000,000

1983 . 11,000,000

During the year 1982, Insco advanced $30 million to Transocean without providing for the payment of interest. This advance was to be repaid out of anticipated future dividends of Insco.

OPINION

In this case, we must decide whether Gulf may deduct as ordinary and necessary business expenses amounts paid as insurance premiums to its wholly owned captive, Insco, in 1974 and 1975. In each of our prior opinions in which we have addressed the captive insurance issue, we concluded that payments to the captive subsidiary, designated as premiums, whether from the parent corporation or from other subsidiaries, did not represent payments for insurance. Carnation Co. v. Commissioner, 71 T.C. 400 (1978), affd. 640 F.2d 1010 (9th Cir. 1981); Clougherty Packing Co. v. Commissioner, 84 T.C. 948 (1985), affd. 811 F.2d 1297 (9th Cir. 1987); Humana v. Commissioner, 88 T.C. 197 (1987).⁵ In each of those situations, the captive was wholly owned by its parent, and the captive insured risks only within the affiliated group. In this case, we are for the first time faced with a wholly owned captive that insures unrelated third-party risks as well as those of its affiliated group. The issue before us is whether the insurance of these risks produces a result different from our prior decisions.

Gulf argues that this case is distinguishable because Insco’s intention to insure the risks of unrelated third parties had been established for years prior to the taxable years in issue, that in 1975, one of the years before the Court, Insco did in fact insure unrelated parties, and that the large amount of unrelated third-party risks insured in later years demonstrates that Insco is and should be treated as an unrelated insurance company. Respondent argues that Insco’s writing of third party insurance is irrelevant to the existence of risk transfer, that the economic family concept precludes deductible insurance premiums to the extent that the captive insures any risks of an affiliated corporation.

In Carnation, Clougherty, and Humana, we were attempting to determine whether the arrangements between the affiliated parties were insurance as defined by the Supreme Court in Helvering v. Le Gierse, 312 U.S. 531 (1941). We concluded in each situation that they were not.⁶ Central to our holdings are two principles. First, to have insurance, risk transfer and risk distribution must be present. Second, payments designated as premiums for insurance, which are the equivalent of nondeductible payments to a reserve for losses, are not payments for insurance; there is no risk transference in such situations. Although technically, transfer of risk may occur when a captive is involved that is a separate, viable entity, financially capable of meeting its obligations, we simply decline to recognize it as such when the arrangement is merely, in substance, the equivalent of a reserve for losses or self-insurance.

To have a true transfer of risk, another risk-bearer must replace the insured; to speak of a transfer of risk to a fund or reserve established by the insured is merely to describe self-insurance in the jargon of insurance. [K. O’Brien & K. Tung, “Captive Offshore Insurance Corporations,” 31 N.Y.U. Thirty-First Ann. Inst, on Fed. Tax. 665, 678-684 (H. Sellin ed. 1973). Fn. refs, omitted.]

Furthermore,

It is apparent that the nature of the captive-insurance device involves not only the element of insurance through “transfer” of risks, but also the notion of self-insurance since the “owners” of the risks insured therein are the “owners” of the insurer. The fortunes of the two entities are interlocked to the extent that the risks insured in the captive are not reinsured. In this sense, captive insuring can be considered a risk-retention device similar to self-insurance. In fact, if self-insurance involves the conduct of risk management “according to all the sound principles and practices employed by insurance companies” it might be argued that captive insuring is the epitome of the self-insurance device * * * . [Robert S. Goshay, “Captive Insurance Companies,” Risk Management, Ch. VI, Richard D. Irwin, Inc., Homewood, Illinois, 1964, pp. 80-121, at p. 85, as referenced in Humana v. Commissioner, 88 T.C. at 211.]

In addition, we rejected the “economic family” theory espoused in Rev. Rui. 77-316, 1977-2 C.B. 53. Under that theory, we could have reached the same result, but we would have foreclosed a wholly owned captive from ever being considered a separate insurance company, payments to which are deductible by its owners.⁷ Recognizing that there may in fact be such situations, we declined to adopt this theory. We specifically reserved any discussion of the tax consequences of payments to captives with unrelated owners and/or unrelated insureds. Clougherty Packing Co. v. Commissioner, 84 T.C. at 960; Humana v. Commissioner, 88 T.C. at 210.

We are now faced with one of these situations.⁸ The facts of this case are for all purposes identical to those in Carnation, Clougherty, and Humana (with respect to the parent-subsidiary relationship), except that Insco, Gulf’s wholly owned subsidiary, began insuring risks of third parties in 1975, one of the years before the Court. The net premium income from the insurance of third-party risks in 1975 was only 2 percent of Insco’s total net premium income. However, in the years 1978 through 1981, and 1983, net premium income from third parties exceeded 50 percent of the total. In 1975, Insco paid total claims of $3,107,212, of which $48,018 represented claims paid to third parties. The issue before us is the effect, if any, of this unrelated business, on a holding that would otherwise be controlled by our prior cases.

Under principles of the insurance industry, risk transfer and risk distribution occur only when there are sufficient unrelated risks in the pool for the law of large numbers to operate.⁹ As the number of unrelated risks is increased,

protection is improved against the chance that the severity and number of harmful events will be spread over time or in other ways in groupings

disproportionate to the overall risk. That is, with an increasing number of ventures in a combined pool, the unusually favorable and unusually harmful experiences tend to stay more nearly in balance * * * [R. Keeton, Insurance Law Basic Text 6-7 (1971). Emphasis added; fn. refs, omitted.]

In this instance “unrelated” risks need not be those of unrelated parties; a single insured can have sufficient unrelated risks to achieve adequate risk distribution.¹⁰

When the law of large numbers operates, the risk of each policyholder is divided into small units and is transferred to and distributed among the policyholders. As the Supreme Court stated in Group Life & Health Ins. Co. v. Royal Drug Co., 440 U.S. 205, 211 (1979):

It is characteristic of insurance that a number of risks are accepted, some of which involve losses, and that such losses are spread over all the risks so as to enable the insurer to accept each risk at a slight fraction of the possible liability upon it. [Citations omitted.]

Thus, risk transfer and risk distribution occur upon the issuance of each policy.¹¹

The premium allocable to each insured contributes to the payment of aggregate losses whether or not that insured actually suffers any loss. The cost of future estimated losses is capable of reasonably accurate estimation; what is uncertain is the identity of the insureds (or properties) which will suffer losses.¹² Thus:

Insurance allows the individual insured to substitute a small, definite cost (the premium) for a large but uncertain loss (not to exceed the amount of the insurance) under an agreement whereby the fortunate who may escape loss will help compensate the unfortunate few who suffer loss. [R. Mehr, Fundamentals of Insurance 33 (1983).]

If all of the insureds are related, the insurance is merely self-insurance because the group’s premium pool is used only to cover the group’s losses. By adding unrelated insureds, the pool, from which losses are paid no longer, is made up of only the affiliated group’s premiums. When a sufficient proportion of premiums paid by unrelated parties is added, the premiums of the affiliated group will no longer cover anticipated losses of all of the insureds; the members of the affiliated group must necessarily anticipate relying on the premiums of the unrelated insureds in the event that they are “the unfortunate few” and suffer more than their proportionate share of the anticipated losses.¹³

Thus, when the aggregate premiums paid by the captive’s affiliated group is insufficient in a substantial amount to pay the aggregate anticipated losses of the entire group, the affiliates and unrelated entities, the premiums paid by the affiliated group should be deductible as insurance premiums and should no longer be characterized as payments to a reserve from which to pay losses.¹⁴ Risk distribution and risk transfer would be present, and the arrangement is no longer in substance equated with self-insurance.

With these principles in mind, we turn to the facts of the present case. For the year 1974, the facts of this case are in all material respects the same as those in our prior decisions, and therefore those decisions control. The amounts paid to Insco by Gulf and its affiliates are not deductible as insurance premiums. With respect to the year 1975, we reach the same result for the same reasons, with one noted difference. We have considered Insco’s unrelated business in order to determine whether it is sufficient to affect the premium pool such that risk transfer has occurred, and have concluded that we do not have enough facts to determine the same.¹⁵ However, even without additional evidence we have concluded that the addition of 2 percent of unrelated premiums is de minimis and would not satisfy us that risk transfer has occurred.¹⁶ We reserve judgment, however, on years other than those before the Court.¹⁷

The second issue is whether the payments designated as premiums made by the foreign affiliates, and the payments of claims by Insco to Gulf and its domestic affiliates, represent constructive dividends to Gulf.

Under section 61(a)(7), gross income includes dividends. The term “dividend” is defined in section 316(a) as a distribution of property by a corporation to its shareholders out of its earnings and profits. There is no requirement that the dividend be formally declared or even intended by the corporation. See, e.g., Sachs v. Commissioner, 277 F.2d 879 (8th Cir. 1960), affg. 32 T.C. 815 (1959). Distributions by a corporation will be treated as dividends to the shareholder if the distributions are made for the shareholder’s personal benefit; the funds need not be distributed directly to the shareholder. Rushing v. Commissioner, 441 F.2d 593 (5th Cir. 1971), affg. 52 T.C. 888, 893 (1969); Rapid Electric Co. v. Commissioner, 61 T.C. 232, 239 (1973).

Because we have decided that the arrangement between Gulf and Insco does not represent insurance, respondent contends that payments of claims by Insco to Gulf represent constructive dividends to Gulf. We disagree. Our holding is limited to a finding that the arrangement between Gulf and Insco is not insurance and, therefore, the payments are not deductible for Federal income tax purposes. This does not alter the fact that a captive insurance company may be a useful and legitimate tool in risk management. Insco was organized and operated to provide Gulf with sufficient protection for certain risks of loss, as well as to obtain tax benefits which we have disallowed. The payments of claims by Insco to Gulf were made in consideration for the premiums paid by Gulf and ceded to Insco.

Respondent also contends that the payments designated as premiums made by the foreign affiliates, and the payments of claims by Insco to the domestic affiliates, represent constructive dividends to Gulf. It is clear that a transfer of property from one corporation to another corporation can constitute a constructive dividend to their common shareholder. Sammons v. Commissioner, 472 F.2d 449 (5th Cir. 1972), affg. in part, revg. in part, and remanding a Memorandum Opinion of this Court. However, before we will characterize a transfer of property from one corporation to another as a constructive dividend to a common owner, we must first examine the transfer under a two-part test set forth in Sammons v. Commissioner, supra. See Gulf Oil Corp. v. Commissioner, 87 T.C. 548 (1986).

The first part of the test is objective, i.e., did the transfer cause funds or other property to leave the control of the transferor corporation, and did it allow the stockholder to exercise control over such funds or property either directly or indirectly through some instrumentality other than the transferor corporation. The first part of the test has been satisfied. The funds were transferred from foreign affiliates to Insco in the form of insurance premiums, and from Insco to the domestic affiliates as payments of claims. As is typical in these cases, the critical inquiry is whether the second part of the Sammons test has been met.

The second part of the test is subjective — whether the transfer was prompted by a business purpose of the transferor corporation or a shareholder purpose of the common owner. The transferor corporations had a business purpose for making the transfers and, therefore, we hold that the second part of the test has not been satisfied. Although payments made by the foreign affiliates to Insco are not classified as deductible insurance premiums, nevertheless, such payments were for the benefit of the affiliates because they provided coverage for their risks as separate entities. While the payments made to this captive insurance company are equivalent to additions to a reserve for losses, Insco, nevertheless, represents a useful and legitimate tool in risk management. The same rationale applies to the payments of claims by Insco to the domestic affiliates. The payments were for the primary benefit of the affiliate which received them, not for the benefit of the parent, Gulf.

Accordingly, we hold that the payments designated as premiums made by the foreign affiliates, and the payments of claims by Insco to Gulf and its domestic affiliates, do not represent constructive dividends to Gulf. See Mobil Oil Corp. v. United States, 8 Cl. Ct. 555 (1985).

An appropriate order will be issued.

Reviewed by the Court.

Nims, Korner, Shields, Hamblen, Clapp, Swiet, Jacobs, Gerber, Wright, Parr, and Williams, JJ., agree with the majority opinion. WELLS, J., did not participate in the consideration of this case.

APPENDIX

Discussion of Prior Captive Insurance Cases

In Carnation, the taxpayer corporation insured its risks with an unrelated company, which in turn reinsured 90 percent of those risks with the corporation’s wholly owned captive. The captive was capitalized with $120,000, the requisite legal minimum in Bermuda. Before agreeing to this insurance and reinsurance arrangement, the unrelated insurer required Carnation to agree to increase the captive’s capital up to $3 million, if necessary, for the captive to meet its reinsurance obligations. We determined that this arrangement was not insurance, and that therefore premiums paid to the third-party insurer which were ceded to the captive were not deductible. Relying on the Supreme Court decision in Helvering v. Le Gierse, 312 U.S. 531 (1941), we held that the contracts, when taken together, were void of risk because the agreement to increase the captive’s capital bound the taxpayer to an investment risk that was directly tied to the loss experience of its captive, which was, in turn, wholly contingent on the taxpayer’s losses. The Ninth Circuit affirmed our decision agreeing that as in Le Gierse, the agreements effectively neutralized risk for purposes of insurance. Carnation Co. v. Commissioner, 640 F.2d at 1013.

Le Gierse is based on the principle that an agreement may resemble insurance in form, yet lack an essential ingredient to insurance. Carnation Co. v. Commissioner, 71 T.C. at 415. This principle applies regardless of whether the parent and captive are considered separate entities for tax purposes. Carnation Co. v. Commissioner, 71 T.C. at 408.

In Clougherty, the operative facts were essentially the same as in Carnation, although no collateral capitalization agreement was present. Clougherty Packing Co. v. Commissioner, 84 T.C. 948 (1985), affd. 811 F.2d 1297 (9th Cir. 1987). Regardless of this distinction, we held that the arrangement was not insurance; the risk of loss was not shifted from the parent to its captive. We stated “to deduct insurance premiums it is essential to decide whether the relationship giving rise to the payment constitutes insurance.” Clougherty Packing Co. v. Commissioner, 84 T.C. at 957. We held that the payments to the captive for premiums, which were used to pay losses of the parent and its affiliates only, were not deductible; they were essentially the same as nondeductible payments to a reserve for losses. We reasoned that payments are not insurance premiums unless they are paid to shift the risk away from the taxpayer who seeks to deduct them. Clougherty Packing Co. v. Commissioner, 84 T.C. at 958. We declined to decide how the result might be affected, however, if the captive had business from unrelated customers. Clougherty Packing Co. v. Commissioner, 84 T.C. at 960.

The Ninth Circuit affirmed our result, but on the theory that the risk of loss was not shifted, because the losses paid by the subsidiary reduce the value of its stock, and thus, correspondingly reduced the value of the corporation’s assets. Clougherty Packing Co. v. Commissioner, 811 F.2d 1297 (9th Cir. 1987).¹

Humana v. Commissioner, 88 T.C. 197 (1987), presented a slightly different fact pattern, but we again reached the same result. In Humana, both the parent and its affiliates paid premiums to the parent’s captive, again a wholly owned subsidiary that insured only the risks of the affiliated group. We held that the tax consequences of the payments by the parent to the captive were controlled by our prior decisions in Carnation and Clougherty. Humana v. Commissioner, 88 T.C. at 207. With respect to the affiliates, the situation was no longer parent-subsidiary but instead was brother-sister. We reached the same result, however, extending the rationale of Carnation and Clougherty, and reclassifying the payments as nondeductible additions to a reserve for losses. Humana v. Commissioner, 88 T.C. at 209. We stated “If we decline to extend our holdings in Carnation and Clougherty to the brother-sister factual pattern, we would exalt form over substance and permit a taxpayer to circumvent our holdings by simple corporate structural changes.” Humana v. Commissioner, 88 T.C. at 213. We thus concluded that there was not the necessary shifting of risk from the operating subsidiaries of the parent to the captive, and therefore the arrangement was not insurance. Humana v. Commissioner, 88 T.C. at 214.

* This case was reassigned by order of the Chief Judge dated Nov. 24, 1987.

1 This is the final opinion on the severed issues. The other opinions are reported at: 87 T.C. 548 (1986) (constructive dividends and payables); 87 T.C. 324 (1986) (intangible drilling and development costs); 87 T.C. 135 (1986) (worthless properties); 86 T.C. 937 (1986) (Kuwait nationalization); 86 T.C. 115 (1986) (Iranian foreign tax credit); 84 T.C. 447 (1985) (North Sea farmout).

2 A11 section references are to the Internal Revenue Code of 1954 as amended and in effect during the taxable years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.

3 Insco made provision for the estimated unpaid amounts of losses, and loss expenses, arising from incidents reported to Insco during the year, together with an allowance for losses incurred, but not yet reported.

4 This figure includes a reduction of $5,917 in the amount actually determined in the statutory notice of deficiency resulting from the concession of respondent. Premiums in the amount of $5,917 were ceded by Insco to an unrelated third-party reinsurer.

5 Other courts that have confronted the captive insurance company issue have also disallowed deductions for purported premium payments to a captive insurance subsidiary, albeit on theories not necessarily adopted by us. Beech Aircraft Corp. v. United States, 797 F.2d 920 (10th Cir. 1986); Stearns-Roger Corp. v. United States, 774 F.2d 414 (10th Cir. 1985); Mobil Oil Corp. v. United States, 8 Cl. Ct. 555 (1985); contra Crawford Fitting Co. v. United States, 606 F. Supp. 136 (N.D. Ohio 1985).

6 See Appendix at pp. 1030-1032 for discussion of our prior decisions.

7 The “economic family” concept is based on the theory that when a captive receives a dollar, its net worth and its parent’s net worth increases by that amount, and that when the captive pays out a dollar the converse occurs. Recent articles illustrate the conflict between this and petitioner’s positions: Barker, “Federal Income Taxation and Captive Insurance,” 6 Virginia Tax Review 267 (1986); Bradley & Winslow, “Self-Insurance Plans and Captive Insurance Companies — A Perspectived on Recent Tax Developments,” 4 American Journal of Tax Policy 217 (1986).

8 In Mobil Oil Corp. v. United States, 8 Cl. Ct. 555, 563 (1985), the Claims Court found that one of the captive insurance subsidiaries insured risks of unrelated third parties. In Beech Aircraft Corp. v. United States, an unreported case (D. Kan. 1984), 54 AFTR 2d 84-6173, 84-2 USTC par. 9803, affd. 797 F.2d 920 (10th Cir. 1986), the District Court indicated that the captive insurance subsidiary insured risks of unrelated third parties in the years subsequent to the year before the court. In Stearns-Roger Corp. v. United States, 577 F. Supp. 833, 834 (D. Colo. 1984), affd. 774 F.2d 414 (10th Cir. 1985), the District Court found that the captive insurance subsidiary, in addition to insuring the risks of its parent and brother sister subsidiaries, insured certain risks of the parent’s customers. In holding that the premium payments from the parent to the captive insurance subsidiary were not deductible, the courts did not discuss the effect of insuring unrelated third-party risks.

9 As a theoretical matter, risk distribution or pooling requires:

(i) Mass— * * *,

(ii) Homogeneity— * * *, and

(iii) Independence— * * *

If these requirements are met to some minimum extent, the principles of average and large numbers operate so that the risk carried by an insurer is far less than the sum of the risks of the insured. * * * To the extent that these requirements are not satisfied, the insurer can offer security to the insured only through sheer financial power. * * * If there is neither adequate distribution of risk nor the financial power to withstand the simultaneous occurrence of all or a significant portion of the insured risks, there can be no transfer of risk, and hence no insurance. [K. O’Brien & K. Tung, “Captive Offshore Insurance Corporations,” 31 N.Y.U. Thirty-First Ann. Inst, on Fed. Tax 665, 678-684 {H. Sellin ed. 1973). Fn. refs, omitted.]

10 See, e.g., Bradley & Winslow, “Self-Insurance Plans and Captive Insurance Companies — A Perspective on Recent Tax Developments,” supra at 233-234 n. 59, and at 255 n. 121; K. Tucker & D. Van Mieghen, Federal Taxation of Insurance Companies, par. 20.10, at 2012, P-H Services (1983).

11 This concept has been recognized by the Internal Revenue Service. See Ltr. Rul. 8111087, which states in part:

“Under insurance theory risks are distributed and shifted not through the capital structure of the company, but rather through the premiums (and resulting surplus and investment income) created by the policyholders. * * *”

12 R. Goshay, Corporate Self-Insurance and Risk Retention Plans 23 (1964); R. Keeton, Insurance Law 7 (1971).

13 See, e.g., Bradley & Winslow, “Self-Insurance Plans and Captive Insurance Companies — A Perspective on Recent Tax Development,” supra at 237 n. 69, and at 242-243 n. 87.

14 Without expert testimony, we decline to determine what proportion of unrelated premiums would be sufficient for the affiliated group’s premiums to be considered payments for insurance. However, if at least 50 percent are unrelated, we cannot believe that sufficient risk transfer would not be present. This anticipated sharing of premiums paid by unrelated insureds is similar in concept to a mutual insurance arrangement. See, e.g., Rev. Rui. 80-120, 1980-1 C.B. 41; Rev. Rul. 78-338, 1978-2 C.B. 107.

15 In order to determine whether a substantial proportion of unrelated premiums are paid to a captive, we must assume that reliable actuarial estimations of risk of loss have been used to arrive at the amount of each insured's premium payment. The parties in this case did not directly address the issue of whether premiums paid to Insco were negotiated on this basis, and at arm’s length. It appears that during 1974 and 1975, the premiums paid were greatly in excess of the actual losses paid. While this could be due to an extraordinarily low loss year, it could also be a result of excessive premiums. Without concluding which may have been the case here, we note that excessively large premium payments can be indicative of what is in substance a risk-retention arrangement, which would support our conclusion that risk transfer was not present in those years.

16 Petitioner argues on brief that the years 1974 and 1975 constituted a “startup phase” for Insco, and that payments made in these years should be treated similarly to payments made subsequent to the substantial increase in third-party business for the years 1978-83. We recognize that the startup phase of a business enterprise may not reflect the ultimate intentions and future prospects of the venture. For instance, a determination as to whether an activity constitutes a “trade or business” may require a review of activities over time, as might a determination as to whether an activity is engaged in for profit. See Allen v. Commissioner, 72 T.C. 28, 33-34 (1979); Boyer v. Commissioner, 69 T.C. 521, 537 (1977) (has been appealed); Benz v. Commissioner, 63 T.C. 375, 383 (1974). Similarly, the deduction or amortization of startup costs requires a review of expenditures incurred prior to the active conduct of a trade or business. See sec. 195; Richmond Television Corp. v. United States, 345 F.2d 901 (4th Cir. 1965), vacated and remanded on other issues 382 U.S. 68 (1965). In this instance, however, we are concerned with determining the character of payments made to Insco based upon the degree of risk shifting and risk distribution present in the years before the Court. While it may not be necessary to make this determination on an annual basis, we are confident that the 2 percent of unrelated business is not sufficient to satisfy the minimum level of risk shifting and risk distribution necessary to qualify for the deduction.

17 In our findings of fact, we have set forth the extent of third-party risks for 1976 through 1983, although those years are not before the Court in this case. At trial, respondent objected to the admissibility of such evidence on the ground of relevancy. We overruled his objection, but admitted the evidence for the limited purpose of demonstrating the consistency or lack of consistency of petitioner in carrying out its avowed purpose described as phase two of its captive insurance program, i.e., to solicit insurance business from third-party sources.

1 We have not adopted and do not adopt this theory.