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transaction,' but a sham." Malone & Hyde, Inc. v. Commissioner,
62 F.3d at 841.
The Court of Appeals stated:
If Humana's scheme had involved a thinly-capitalized
captive foreign insurance company that ended up with a large
portion of the premiums paid to a commercial insurance
company as primary insurer, and had included a hold harmless
agreement from Humana indemnifying the unrelated insurer
against all liability, we believe the result in Humana would
have been different. This court accepted the bona fides of
the transaction in Humana and recognized the premiums paid
to the captive insurance company as deductible business
expenses since Humana established the captive to address a
legitimate business concern (the loss of insurance
coverage), and the captive was not a sham corporation; the
captive in Humana was fully capitalized, domestically
incorporated, and established without guarantees from the
parent or other related corporations. Because Humana acted
in a straightforward manner, without any evidence of an
intent to create an unwarranted tax deduction based on
payments that largely ended up in its subsidiary's coffers,
this court accepted the bona fides of the transaction before
examining the brother-sister issue.
We disagree with Malone & Hyde's contention that
footnote 2 in Humana refers only to the question of whether
Humana's premium payments for its own coverage, as opposed
to the coverage extended its subsidiaries, involved risk
shifting. Footnote 2 clearly applies to the fundamental and
decisive question of whether there was risk shifting from
any insured--parent or subsidiary--to the captive insurer.
When the entire scheme involves either undercapitalization
or indemnification of the primary insurer by the taxpayer
claiming the deduction, or both, these facts alone
disqualify the premium payments from being treated as
ordinary and necessary business expenses to the extent such
payments are ceded by the primary insurer to the captive
insurance subsidiary.
It is true that Eastland operated as an insurance
company. As the tax court found, it "established reserve
accounts, paid claimed losses only after the validity of
those claims had been established, and was profitable." For
purposes of determining the correct tax treatment of
premiums paid to Eastland by Malone & Hyde, however, we
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