Illinois Appellate Court Holds Captive Insurance Company Not Included In Combined Corporate Income Tax Return

The Illinois Appellate Court has held that a captive insurance company formed by a restaurant corporation was properly excluded from a combined tax return because the company qualified as an insurance company for Illinois corporate income tax purposes.1 The captive insurance company met the definition of an insurance company under federal income tax law and engaged in the necessary risk shifting and risk distribution. There was no indication that the captive insurance company was formed as a sham business or lacked a valid business purpose. For these reasons, the company was required to be treated as an insurance company under Illinois law and excluded from the combined return.

Background

The taxpayer, Wendy's, is the parent company of an affiliated group of corporations operating restaurants throughout the United States. Based in Ohio, Wendy's decided to self-insure its risks by creating Scioto Insurance Company in Vermont as a wholly-owned captive insurance company. In order to be qualified as an insurance company under Vermont law, Scioto had to be sufficiently capitalized to cover all of its insurance obligations. Scioto acquired a Wendy's affiliate that held Wendy's trademarks that were valued at more than $900 million. The affiliate licensed the trademarks to Wendy's in exchange for a royalty of 3 percent of its gross sales.

Wendy's included Scioto in its federal consolidated income tax returns. The Internal Revenue Service (IRS) audited the federal consolidated returns for the 2001 through 2006 tax years and did not dispute Scioto's status as an insurance company. Wendy's excluded Scioto from its Illinois unitary business group and Scioto's income was not included in the unitary business group's Illinois combined income tax returns. The Illinois Department of Revenue audited Wendy's for the same tax years and concluded that Scioto was not a true insurance company because: (i) there was not actual risk shifting and risk distribution to constitute insurance for federal income tax purposes; (ii) the majority of Scioto's income was derived from intercompany royalty income; and (iii) Scioto was not regulated in all states in which Scioto wrote premiums. As a result of the audit, the Department issued notices of deficiency.

After paying the deficiency notices under protest, Wendy's filed cases in the circuit court under the Protest Monies Act. Wendy's filed a motion for summary judgment claiming it was not required to include Scioto in its Illinois combined tax returns because Scioto is a bona fide insurance company. The Department filed a motion for summary judgment claiming that Scioto is not an insurance company, and its royalty income is not from an insurance business. The trial court granted the Department's motion for summary judgment determining that Scioto was not an insurance company under Illinois income tax law, and thus, includable in the Illinois combined tax returns. Wendy's subsequently filed a timely appeal.

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