California Proposes to Disable Itself From Taxing 100% of Surplus Lines Premium

A California legislator has proposed a surplus lines bill — one effect of which will reduce California’s surplus lines premium tax revenues.

On Feb. 9, 2011, California Assembly Member Solario introduced Assembly Bill No. 315 (AB 315), the California Department of Insurance’s proposed legislation to implement the Nonadmitted and Reinsurance Reform Act (NRRA), Subtitle B, Part I, Dodd-Frank Wall Street Reform and Consumer Protection Act.

When the NRRA becomes effective on July 21, 2011, only the Home State – the state of the “insured’s principal place of business” (or “principal residence” for individuals) – may tax surplus lines insurance premium. NRRA Sec. 521(a). For multistate risks, “non-home” states may no longer tax any portion of the surplus lines premium.

The insured’s “principal place of business,” a term of art the NRRA’s drafters wisely did not attempt to define, is generally determinative of Home State as defined by the NRRA.

AB 315, Sec. 9(e)(2), however, defines “principal place of business” in a way that would prevent California from taxing 100 percent of surplus lines insurance premium when it is the NRRA Home State. The Home State instead becomes the state where the “greatest percentage of the insured’s taxable premium for [the] insurance contract is allocated.”

Sec. 9(e)(2) is legally misconceived, will reduce California’s surplus lines premium tax revenues, and conflicts with the NRRA.

Legally Misconceived – The Hertz Case

The NRRA borrowed the term “principal place of business” from 28 U.S.C. §1332(c)(1), the federal statute that defines “diversity-of-citizenship” for purposes of federal court jurisdiction. Federal courts have struggled with “principal place of business” in hundreds of cases and fact patterns for more than a century.

In Hertz v. Friend, [2010 U.S. Lexis 1897 (2010)], the U.S. Supreme Court clarified what the term means when (a) the defendant’s corporate headquarters in New Jersey pulsates with “high-level officer” activity overseeing the empire’s business interests throughout the world, including California, and (b) California plaintiffs wish to sue the corporate “Mother Ship” in California state court.

The Court held that Hertz is a “citizen” of New Jersey, and the California federal court therefore properly had diversity jurisdiction over the matter.

Hertz Recast

Sec. 9(e)(2) reformulates the Hertz “principal place of business” definition in a way that restricts California’s NRRA Home State right to tax 100 percent of surplus lines premium:

“Principal place of business” means, with respect to subparagraph (A) of paragraph (1) determining the home state of the insured, (A) the state where the insured maintains its headquarters and where the insured’s high-level officers direct, control, and coordinate the business activities; or (B) if the insured’s high-level officers direct, control, and coordinate the business activities in more than one state, the state in which the greatest percentage of the insured’s taxable premium for that insurance contract is allocated; or (C) if the insured maintains its headquarters or the insured’s high-level officers direct, control, and coordinate the business activities outside any state, the state to which the greatest percentage of the insured’s taxable premium for that insurance contract is allocated.

If Hertz is the sole insured under a surplus lines policy, one would think that New Jersey is the Home State under the NRRA and entitled to tax 100 percent of the premium. But Sec. 9(e)(2) suggests otherwise. If Hertz’ “high-level officers direct, control and coordinate business activities in more than one state” its “principal place of business” — therefore the NRRA “Home State” for premium tax and regulatory purposes — becomes the state to which the greatest portion of taxable premium is allocated, not necessarily New Jersey.

It can always be said that the insured’s “high-level officers direct, control, and coordinate business activities outside the headquarters state; every business necessarily engages in some form of interstate commerce. California thus rarely, if ever, will be the Home State under a literal reading of Sec. 9(e)(2)(A).

Instead, the Home State of a single surplus lines insured invariably will be “the state to which the greatest percentage of the insured’s taxable premium for that contract is allocated” [Sec. 9(e)(2)(B) and (C)] — a “principal place of business” result that the Hertz court would find absurd, assuming federal diversity jurisprudence were determinative of the correct construction of the NRRA, itself a doubtful matter.

Premium Tax Effect

Under Sec. 9(e)(2), California will tax 100 percent of surplus lines premium only where:

All other surplus lines premium would escape California premium taxation entirely.

Under the NRRA, California is the Home State for surplus lines policies insuring a single California insured unless “100 percent of the insured risk” is located outside California. Thus, if any portion of the premium is allocable to California, the Golden State is entitled to tax 100 percent of surplus lines premium.

Sec. 9(e)(2) has only downsides for California premium tax revenues.

NRRA Preemption

Sec. 9(e)(2) presents at least two federal preemption issues under the NRRA.

First, Sec. 9(e)(2) purports to allow states that are not the NRRA Home State to tax surplus lines premium.

California of course may tax less than the 100 percent of premium it is rightfully entitled to tax as Home State under the NRRA, although no reason suggests itself why it should wish to do so. But the NRRA indicates California may not confer its Home State taxing jurisdiction on another state: “No State other than the Home State of an insured may require any premium tax payment for nonadmitted insurance.”

Surplus lines premium that California chooses not to tax represents premium tax revenue lost forever. Why leave money on the table?

Second, the NRRA Home State definition taxes only one policy at a time: (a) a policy that insures a single insured or (b) a policy that insures more than one named insured that is a member of an “Affiliated Group.”

Under AB 315, Sec. 31, California proposes to tax “the entire premium” for a “single insurance transaction” regardless of whether multiple policies are involved. Each policy has its own Home State under the NRRA. California therefore may not tax a transaction involving multiple policies unless it is the NRRA Home State for each.

Not Fixable

Sec. 9(e)(2) should be stricken in its entirety from AB 315. It is not fixable.

By ridding itself of Sec. 9(e)(2), California will thereby enhance its premium tax revenues. “Principal place of business” will sort itself out in due course. It’s not rocket science; no definition is needed.

Richard Brown is an insurance regulatory attorney who regularly represents surplus lines insurers, surplus lines brokers, and industry organizations in a variety of regulatory and other surplus lines matters. This is one of several articles he has authored about the NRRA and its implementation. He can be contacted at RAB@InsuRegulatory.com. Additional information is available on his website: www.InsuRegulatory.com.