Will Tax Insurance Catch On?

An IRS moratorium on private letter rulings could spark corporate interest in tax opinion coverage.
Marie LeoneAugust 12, 2003

Last Friday, tax-free spin-offs got a whole lot more… well… taxing.

On that day, the Internal Revenue Service officially ceased issuing private letter rulings (PLRs) for tax-free transactions. Experts say the year-long pilot program, a dramatic policy shift for the IRS, could lead corporate executives to scuttle spin-offs that don’t concretely meet the government’s strict guidelines for tax-free status.

Corporate executives, and their tax advisors, often use PLRs as assurance that proposed spin-off transactions will qualify for tax-free status under Sec. 355 of the IRS Code. The code states, among other things, that there must be a legitimate business purpose underpinning a spin-off to merit tax-free status. In other words, the transaction cannot be a tax-avoidance scheme.

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In the past, PLRs have given executives an extra layer of comfort regarding the “business purpose” test, which some tax experts say is subjective in nature. The benefit of passing the test is obvious: it assures a company — and its shareholders — won’t be subject to capital gains taxes. Generally, a company that uses a Sec. 355 vehicle doesn’t recognize gains or losses. Therefore, it isn’t subject to the attendant taxes when the corporation distributes the stock of a controlled subsidiary to its original shareholders as part of a spin-off deal.

The danger of getting it wrong, says Lewis Steinberg, a tax attorney and partner at Cravath, Swaine & Moore LLP, is equally obvious: A corporation could be hit with a massive, after-the-fact tax bill. That nasty little scenario can happen if the stock of a spun-off subsidiary appreciates at the time of the transaction, and the parent is stripped of its tax-free status for failing any one of the Sec. 355 criteria.

With the new year-long moratorium on PLRs, corporate executives won’t know whether a spin-off fails to meet the IRS standard until the transaction is audited — usually two or three years after a deal has closed.

The uncertainty surrounding tax-free spin-offs is forcing some corporates to rethink plans for spins-offs. Those that forge ahead without a PLR will likely look for some sort of safety net to limit liability. Indeed, experts say, the added risk now surrounding tax-free spin-offs may lead to increased interest in a relatively obscure insurance policy, called tax-opinion insurance.

Says Robert Willens, a tax expert at Lehman Brothers: “Canceling PLRs is exactly the kind of situation that leads companies to find other means of protection.”

All Stretched Out

To date, only a handful of companies have purchased tax-opinion policies, which generally pay tax penalties, fines, and interest. Georgia-Pacific was one of the first large-cap companies to buy the coverage, forking out $25 million in June 2001 for a policy for Plum Creek Timber Co. The insurance indemnified up to $500 million in tax liabilities for a $3.8 billion spin-off/merger deal between a subsidiary called The Timber Co. and Plum Creek Timber Co, both real estate investment trusts (REITs).

Georgia-Pacific executives spent the better part of a year trying to coax a private letter ruling out of the IRS on the proposed deal. But the agency backed away from issuing a PLR because the Plum Creek deal was too controversial, sources say.

For one thing, the IRS was still debating whether REITs satisfied the Sec. 355 requirement that spin-offs be involved in “active business or trade.” In fact, some in the IRS believed that REITs were purely tax-avoidance schemes — after all, they do shelter income from taxes provided the bulk of profits is distributed to shareholders. Observers say that some internal revenue officials worried that a tax-free ruling in the Plum Creek case might have been perceived as a stretching of the business-purpose definition.

The IRS subsequently concluded that REITs do in fact engage in active business. Soon after, Georgia-Pacific locked in the tax opinion insurance. The move to minimize the tax risk of the deal was not without its own risk, however. Nemo Perera, managing partner at specialty insurance broker Risk Capital Partners, says some risk managers believe tax-opinion policies are red flags. Purchasing such coverage, they argue, alerts the IRS to overly aggressive transactions and weak tax shelter arguments.

But the IRS recently dispelled that notion with Treasury Decision 9046. On April 11, the Treasury Department exempted tax insurance from the IRS listing and reporting requirements aimed at shutting down tax shelter promoter scams. In fact, the decision implied that tax insurers may be the only non-governmental entity motivated to judge tax positions conservatively. Essentially, by blessing a transaction by underwriting a policy, insurers and reinsurers are putting their money where their collective mouths are.

In fact, some IRS-watchers say tax insurance is taking the place of Sec. 355 PLRs. Says Steinberg: “Tax-opinion insurers have slipped into the breech to offer companies protection.”

Big Cushion

In the past, tax insurance has been bought mostly by high-net-worth individuals or closely-held private companies. But since 2001, brokers have found corporate niches, including coverage for recognition of goodwill, Sec. 29 alternative fuel credits, and spin-offs.

Premiums for tax-opinion policies will likely run high — between 5 and 10 percent of the coverage limit — as availability is tight. Sources say the supply-side crunch can be attributed to ultra-conservative underwriting stemming from losses tied to recent accounting scandals.

Nevertheless, Perera expects his company to broker between 20 to 30 corporate tax insurance policies this year. That translates into about 200 deals nationwide.

He notes that a company with legitimate business purposes might want to forge ahead with a spin-off deal anyway, even without a PLR. But doing so will likely require the building up of a sizable capital cushion — just in case the IRS steps in. Insurance, Perera says, offers a cheaper alternative. By using insurance rather than a reserve, a company’s effective tax rate shrinks, boosting a corporation’s bottom line.

That would seem to be a sound strategy. “I would hope the IRS views tax insurance as a prudent management decision,” asserts Lehman’s Willens, who counsels insurance companies to do a better job of disseminating information about tax-opinion products.

Why the push? He and others are not yet sure whether the overloaded IRS staff intends to make the PLR moratorium permanent.