The Internal Revenue Service says it will treat a captive cell arrangement as insurance for income tax purposes if the cell insures several different subsidiaries of the corporation that owns control of the cell.

The IRS will not treat the captive cell arrangement as insurance if the cell simply covers the corporation directly, officials write in IRS Revenue Ruling 2008-8.

The ruling deals with efforts by companies to reduce the cost of setting up captive insurance operations by setting up captive arrangements through “protected cell companies.”

Protected cell companies establish many different accounts, or cells, and each of the cells insures one company, or collection of corporate siblings.

Offshore jurisdictions have started allowing protected cell company arrangements to help users cut the overhead costs associated with running captive insurers, according to officials with the Isle of Man Insurance and Pensions Authority.

Even if a wholly owned subsidiary that insures one parent company behaves in all other respects as if it were an independent insurance company, “a transaction between a parent and its wholly owned subsidiary does not satisfy the requirements of risk shifting and risk distribution if only the risks of the parent are insured,” IRS officials write in the revenue ruling.

But the IRS would treat an insurance company subsidiary that insured several sibling companies as an insurance company, and it will extend that same kind of treatment to a captive cell that insures several different subsidiaries of the corporation that controls the captive cell, IRS officials write.

In a captive cell arrangement that is eligible for treatment as insurance, “premiums are pooled such that a loss by one subsidiary is not in substantial part paid from its own premiums,” officials write.

The ruling refers to a professional liability company, but life insurers and reinsurers also can use captive cell arrangements.

Scottish Re Group Ltd., Hamilton, Bermuda, a life reinsurer, announced in March 2001 that a unit would be helping banks use offshore captive cells to back any annuities that they might underwrite.

In related news, the IRS says it wants to treat a cell of a protected cell company as an insurance company if a corporation engaging in the same activities would count as an insurance company, and if the “protected cell company” and other cells cannot tap the assets of the cell to pay insurance claims or handle other liabilities.

The IRS has published a description of the proposed guidance in IRS Notice 2008-19.

To be treated as an insurance company, the cell itself would have to handle its own U.S. income taxes.

The proposed guidance would take effect for the first taxable year starting more than 12 months after the date the guidance was published in final form, officials write.

The IRS is asking for comments about what transition rules should apply, what reporting rules should apply to the individual cells, whether special rules should apply to foreign entities, and whether more guidance is needed in connection with the rules governing consolidated tax returns.

A copy of the captive cell arrangement ruling is available ‘>Document Link

A copy of the proposed captive cell guidance and request for comments is available