First Railroad & Banking Company of Georgia, Plaintiff-appellee, v. United States of America, Defendant-appellant, 514 F.2d 675 (5th Cir. 1975)

The Government appeals from a judgment granting First R.R. & Banking Company of Georgia's (taxpayer's) prayer for recovery of a deficiency assessment, paid for the years 1961 through 1964. It is argued the District Court erroneously held taxpayer was entitled to exclude the income of a sub-subsidiary, First of Georgia Life Insurance Company (Insurer)¹  from its consolidated return. Sections 801 and 1504(b) (2).²  We agree and reverse.

Both on appeal and in the District Court, the Government challenges Insurer's ability to satisfy the 50% reserve ratio test of § 801.³  The success of the challenge depends upon whether a Reinsurance Treaty between Insurer and Reinsurer effectively transferred a substantial block of non-qualifying⁴  accident and health (A&H) insurance reserves from Insurer to Reinsurer, thereby raising the proportion of life insurance reserves above the 50% level.

Reinsurer desired to enter the credit⁵  life and A&H business. Georgia law requires an insurance company writing such policies to qualify as a life insurance company. Insurer was organized for the purpose of qualifying, because Reinsurer could not.

Insurer was capitalized with $400,000. Georgia requires that insurers maintain cash reserves to cover payment of potential insurance liabilities. These reserves must equal the total "unearned premium".⁶  Assets exceeding reserves are "surplus", and Georgia insurance officials measure a company's solvency by comparing surplus to reserves. The record shows that Georgia permits reserves to reach a level one and a half to two times surplus.

In Insurer's case, this limit was approached rather quickly because of a "provisional commission" arrangement with its agents. Under the arrangement, each agent initially retained 50% of all premiums collected but Insurer was nevertheless required to maintain reserves equal to 100% of the policy-premiums. As Insurer wanted to undertake a greater volume of business, it entered into the Reinsurance Treaty with Reinsurer, its parent.

Basically, the Treaty provided that 60%⁷  of Insurer's A&H policies (i.e., 60% of each policy) was reinsured by Reinsurer but none of the life policies. Insurer was then entitled, under Georgia law, to continue writing insurance, because the corresponding A&H reserves shifted to Reinsurer, while Insurer's surplus remained the same.

But non-basically, the true nature of the Reinsurance Treaty can only be seen when the commission arrangement is detailed. Reinsurer agreed to pay Insurer a 96% commission on all business the Reinsurer received under the Treaty. The commission was payable, however, only at the end of the coverage period and then only after "adjustment". And the adjustment was a dollar-for-dollar deduction of any loss (paid-out claim) experienced under the policies. Further, if the claim-loss exceeded the premium on that particular policy, Reinsurer was further entitled to set-off the excess against commissions payable on policies against which no claims had been asserted. And still further, if the claim-loss for any accounting period exceeded commission payable for that period, the excess could be carried forward, and set-off against succeeding commission payments.

In short, the economic substance of the arrangement was that as between taxpayer's issue, Insurer suffered or enjoyed fate's capricious precipitation of policy-claims, while the Reinsurer, for a 4% fee, provided in effect a line of credit in case periodic claims reached abnormally high levels. And since the record shows that claim-losses over time averaged only about 22% of total premiums received there was no likelihood that Reinsurer as an economic matter would ever sustain any losses. Reinsurer under the arrangement did not bear any risks except the outside possibility of insolvency of Insurer.⁸  We hold therefore there was no substance to the agreement as reinsurance.

We in no way denigrate the salutary holding of Gregory v. Helvering, 1935, 293 U.S. 465, 55 S. Ct. 266, 79 L. Ed. 596, that taxpayers are free to arrange their affairs in a way which entitles them to tax advantages. Nor do we question the validity of everyone's business reasons for establishing this Treaty arrangement indeed we have carefully explained it, ante. But the issue is not whether the Treaty will be recognized for tax purposes vel non, but given the Treaty, what are its tax consequences and that depends on whether it really amounts to reinsurance as contemplated in the Act.

The Seventh Circuit recently considered this credit-insurance reinsurance reserve problem.⁹  But they did not reserve the question they considered very carefully the legislative history of § 801. They concluded that Congress intended by that section to charge the company actually experiencing the risk of claim losses with the corresponding "reserves" for the purpose of determining who was in the insurance business as opposed to the loan business.¹⁰ 

We have examined the Seventh Circuit's rationale as well as Judge Stevens' dissent and the various post-argument papers submitted by all the parties in our case. We think the majority's is the sounder approach relying as it does on underlying Congressional intent and an analysis of the arrangement in the light of practical realities. We accept its reasoning and result.¹¹ 

Reversed.

RONEY, Circuit Judge (dissenting):

I respectfully dissent for the reasons set forth in Judge Alaimo's opinion in this case, and in Judge Steven's dissent in Economy Finance Corp. v. United States, 501 F.2d 466 (7th Cir. 1974), cert. denied, --- U.S. ---, 95 S. Ct. 1328, 43 L. Ed. 2d 425 (1975). Had Congress desired to define a life insurance company in terms of the ultimate risk, it could have easily done so. The judicial overlay to that effect is an unnecessary intrusion into the legislative process. Reserves being the lodestar, they should control. Although the majority holds there was no substance to the reinsurance agreement, without even a bow to the clearly erroneous rule, the district court having found factually to the contrary, there was certainly legal substance. The reinsurer was required to commit its assets to reserve status for insurance purposes and to pay tax on the reserve income for tax purposes. It bore all of the legal consequences of required reserves, the reinsured none. This decision throws confusion into a statutory enactment that deserves simpler application.