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State & Local Tax Bulletin (May 2002)

California Begins Taxing Workers'
Compensation Deductibles

By Anthon S. Cannon, Jr., a tax partner in the Los Angeles office of Pillsbury Winthrop Shaw Pittman LLP, Jeffrey M. Vesely, a tax partner in the firm's San Francisco office and Arsineh Voskanian, formerly an associate in the firm's Los Angeles office.

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Taxation of the Business of Insurance in California

Insurance companies doing business in California are liable for insurance taxes based on "gross premiums" that are "received" by the insurer. (Cal. Const., art. XIII, §28; Cal. Rev. & Tax Code § 12221). The California Supreme Court has explained that the purpose of the tax on gross premiums is to "exact payments from insurers doing business in California; the gross premiums measure is apparently designed to approximate the volume of business done in this state, and thus the extent to which insurers have availed themselves of the privilege of doing business in California." (Metropolitan Life v. State Board of Equalization, 32 Cal.3d 649, 656 (1982)).

Taxation of Workers' Compensation Deductibles

Beginning on January 1, 1995, insurers have been permitted to offer workers' compensation policies with deductibles. (Cal. Ins. Code § 11735). Under these policies, insurance companies are obligated to pay all benefits directly to the injured employee. However, the insurer can seek reimbursement for such losses up to the deductible amount specified in the policy. In return for assuming a portion of the risk, the policyholder pays a significantly lower premium than it otherwise would for a conventional policy.

Until recently, the California Department of Insurance ("DOI") had not subjected the deductible amounts to the gross premium tax. However, on February 25, 2002, the DOI issued a notice stating that the "deductible amounts" received from insured employers are considered "gross premiums" and are therefore subject to the 2.35 percent premium tax rate during the tax year in which the amounts are actually paid. The notice stated that the amounts must be reported on the 2001 Premium Tax Return, due on or before April 1, 2002, and that proposed assessments would be issued with respect to tax years 1997 through 2000 "in the near future." The DOI is relying upon subsections (2) and (7) of Section 11735(e) of the California Insurance Code for the interpretation that amounts paid under the deductibles should be treated as "gross premiums" subject to tax for purposes of California's taxing statutes.

Firm Experience

Pillsbury Winthrop LLP is currently advising an insurance association and insurance companies with regards to this matter. In addition, Pillsbury Winthrop Shaw Pittman LLP has been actively involved in insurance premium tax litigation in the past, including its successful representation of Prudential Insurance Company in Prudential Insurance Company of America v. State Board of Equalization, 21 Cal.App.4th 458 (1993). In Prudential, the court held that Prudential Insurance was entitled to a refund of gross premium insurance taxes on group health insurance contracts under which employers agreed to pay employees' claims up to an annual maximum, because the cost of claims paid by employers were not taxable as gross premiums received by and inuring to the benefit of the insurance company.

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