Internal Revenue Service Technical Advice Memorandum on Manufacturer's Warranty Risks
The Internal Revenue Service (IRS) recently issued Technical Advice Memorandum 200827006, addressing whether manufacturer’s original warranty risks covered by reimbursement policies purchased by a retailer constitute insurable risks for federal tax purposes. The IRS ruled that manufacturer’s warranty risks do not involve an insurable risk. Therefore, reimbursement policies covering those warranty risks do not constitute an insurable risk for federal tax purposes.
Factual Background
Taxpayer is a multiline retailer that sells both manufacturer and Taxpayer-branded goods. Many of these products carry manufacturer warranties. Taxpayer and a manufacturer agreed that Taxpayer would be the party responsible for the manufacturer’s warranty. Taxpayer was thus deemed to step into the shoes of the manufacturer with respect to the warranties. Taxpayer had previously reported warranty repair costs as a non-deductible expense reserve in its audited consolidated financial statements. In an attempt to improve its tax position, Taxpayer entered into a reimbursement policy with a wholly-owned offshore captive insurer to reimburse Taxpayer for the expenses it incurred for repair and service of the products. The reimbursement policy did not cover any costs incurred by Taxpayer as a result of extended warranties. The captive insurer elected to be taxed as a domestic corporation under § 953(d) and was included in the consolidated annual U.S. federal income tax returns filed by Taxpayer.
IRS Rationale
The IRS reasoned that for a contract to constitute “insurance” for federal tax purposes, it must:
- Involve an insurable risk
- Have risk shifting and risk distribution
- Fall within the “commonly accepted sense of insurance”
- Involve a fortuitous or accidental loss
The IRS focused on whether a loss under a manufacturer’s warranty is “fortuitous or accidental,” or rather, whether the loss is controllable by the manufacturer or retailer. It asserted that a manufacturer’s warranty is a guaranty of the integrity of the products. It protects against defects that existed at the time of the sale — defects that are typically within the control of the manufacturer (here, Taxpayer). The IRS stated: “A warranty that covers goods sold with defects that likely existed in the goods at the time of the sale is not insurance in the commonly accepted sense.” On the other hand, an insurance agreement is protection against an uncontrolled or outside peril such as insurance against fire or theft. Hence, a manufacturer’s warranty is not insurance.
The IRS then concluded that a reimbursement policy that covers manufacturer warranties is not an insurance contract. It stated that the mere fact that a captive insurer is inserted as a third-party indemnitor does not give rise to an insurable risk. If the underlying risk (in this case, the manufacturer’s warranty) is not an insurable risk, then an agreement with a third party to assume that risk does not transform that risk into an insurance contract for federal tax purposes.
The IRS recognized, however, that a warranty that goes beyond the goods, or defects in the goods, to compensate for losses caused by factors unrelated to the product integrity can be the subject of an insurance agreement. For example, an extended warranty indemnifies the purchaser against losses that occur outside of the manufacturer’s warranty. Any loss incurred by the consumer is fortuitous because, unlike the manufacturer in the manufacturer’s warranty situation, the consumer has no control over the risk. Therefore, extended warranty contracts may qualify as insurance.
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Please contact your Foley attorney if you have any questions about these issues or want additional information regarding insurance matters:
Authors and editors:
Richard Bromley
Chicago, Illinois
312.832.4517
[email protected]
A. John Richter
Milwaukee, Wisconsin
414.319.7050
[email protected]
