The IRS' War on Captives; The UPS Case, Part I

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The UPS case is the last big captive case.  However, there is a bit of history between UPS and Harper that we need to explain before moving forward.

In the 1990s, the IRS expanded the scope of their captive litigation, targeting bigger companies.  Humana was one of the first truly large, fortune 500 style companies subject to captive litigation.  It was not the last.  Harper (which I discussed last week) was a large, international company.  The service went so far as to argue Allstate -- then a subsidiary of Sears -- was a captive, even though Allstate wrote a a very small part of their business with Sears.  UPS fits with this general case theory of the service generally targeting larger companies after establishing a legal foundation with smaller companies.  However, this tactic did not work.  The dam started to burst with the Humana (see here, here and here).  The service began to abandon the economic family doctrine in the Kidde caseby arguing a corporation was in fact a Nexus of contracts.  However, the court did not buy this argument which meant the service would again have to change their tactics in the UPS case if they wanted to continue litigating against captives.

Many practitioners argue that UPS represents the "final nail in the coffin" of captive litigation.  This is a generous reading that is belied by the facts of the case. First, the IRS won at trial by basing their argument on the assignment of income doctrine.  While the appellate court over-turned the trial court, they should not have as the lower court's decision was the correct outcome.  Simply put, UPS was a poorly designed transaction that should have gone against the taxpayer.  What's surprising about this result is that UPS' counsel was sophisticated enough to propose a diverse share ownership structure to avoid CFC application to the original captive, but completely blind when it came to the issue of anti avoidance law.  The lesson here is clear: if you're involved with captives (or any tax based planning) and you can't name the five anti-avoidance doctrines in US law (or, for good measure, the assignment of income doctrine), you have some CLE in your future.

While the lower court's decision prints at over 105 pages on Lexis, the appellate court's decision is 7 pages.  The lower court's decision goes into extensive detail supporting its decision, reprinting long excerpts from relevant testimony and explaining the law in "law review" detail.  The appellate court , frankly, could care less.  I often wonder whether they even read the entire decision.  They begin their legal analysis thusly: "It is not perfectly clear on what judicial doctrine the holding rests."  A reading of the case would have dispelled this statement, as the lower court was very clear.  In retrospect, I believe UPS represents more exhaustion than legal theory, as the appellate court is basically stating that, regardless of the thoroughness of the arguments at trial, captives will stand as a business tool.

Let's move forward with a basic outline of the case's facts.  The following excerpt is from my book, U.S. Captive Insurance Law: 

United Parcel Service (UPS) charged its clients an extra fee to insure packages above $100 in value.   This was income to UPS.   UPS’ insurance broker suggested UPS restructure this transaction to avoid the addition to UPS’ gross income of excess value charges.   UPS implemented this plan by forming a Bermudan captive named Overseas Partners (OPL) in 1983.   UPS then purchased an insurance policy from National Union Fire Insurance Company (NUF), who in turn purchased reinsurance from OPL.   As a result, the payment from UPS to NUF would be classified as an insurance premium and therefore deductible under 26 USC 162(a). 

The IRS attacked this arrangement, arguing “that the excess-value payment remitted ultimately to OPL had to be treated as gross income to UPS.”   In effect, the IRS was now making an assignment–of-income argument in an attempt to thwart UPS’ captive arrangement.   There were two reasons for this change of tactic.  First, the IRS’ previous arguments were not successful; no court had accepted the “economic family” doctrine, and after the court in Humana rejected that argument, the service made a new and unsuccessful use of the “corporations are a series of contracts” argument.  Secondly, the assignment of income doctrine avoided having to work around the separate corporate entity issue of the captive that had plagued previous captive cases.  


Next, I'll start to look at the lower court's legal reasoning.

The OECD Model Tax Treaty; Residence, Part I

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Article 1 of the OECD treaty states, "This Convention shall apply to persons who are residents of one or both of the Contracting States.."  As such, for a person to claim treaty benefits, they must be residents.  Today, I'll focus on residence for individuals, which is covered in Article four of the treaty:

Article 1, Section 4 states, 

For the purposes of this Convention, the term “resident of a Contracting State” means any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, place of management or any other criterion of a similar nature, and also includes that State and any political subdivision or local authority thereof. This term, however, does not include any person who is liable to tax in that State in respect only of income from sources in that State or capital situated therein.

The above paragraph has several key points as noted in the accompanying commentary.  "The definition refers to the concept of residence adopted in the domestic law."  Put another way, the model treaty melds with the existing domestic law to create a hybrid concept.  Second, "the definition aims at covering the various forms of personal attachment to a State which, in the domestic taxation laws, form the basis of comprehensive liability."  What the treaty is looking for is some outward, easily documented manifestation of an individual's presence in the state.  Also note, this definition does not extend to companies that are taxed in a jurisdiction simply because of their business done in the state.

In the event a person is a resident of both contracting states, the treaty has a comprehensive list of "tie-breaking" provisions:

a)  he shall be deemed to be a resident only of the State in which he has a permanent home available to him; if he has a permanent home available to him in both States, he shall be deemed to be a resident only of the State with which his personal and economic relations are closer (centre of vital interests);

b)  if the State in which he has his centre of vital interests cannot be determined, or if he has not a permanent home available to him in either State, he shall be deemed to be a resident only of the State in which he has an habitual abode;

c)  if he has an habitual abode in both States or in neither of them, he shall be deemed to be a resident only of the State of which he is a national

d)  if he is a national of both States or of neither of them, the competent authorities of the Contracting States shall settle the question by mutual agreement.

The criteria start with an easily understood concept: where is the individual's physical home?  If only one exists, the investigation stops.  If there are two homes, then we need to determine where his "center of vital interests" exists -- where he has his closest community.  Here we look at where he has friends, which community he more actively participates in etc... 

The preceding two points are typically where most inquiries stop.  However,  in the event it's difficult to determine, we next look to a "habitual abode."  Habitual abode refers more to the length of time an individual stays in a particular location, regardless of the type of residence (which could even be a hotel).  Finally, if that test doesn't work, we look to nationality and then an agreement between the countries.

In reality, most inquiries are easily handled under these rules.  Typically it stops at at section (a).  

Next, we'll talk about residence for business entities.

 

The IRS' War on Captives; The Harper Test

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Today's posting will be a bit shorter than most.  Although they lost the Humana case, the service continued to file challenges to various captive insurance arrangements.  The Harper case -- which was a 1991 decision -- is important because it gives us a three prong test which a captive must comply with in order to be a "bona fide" captive.  The following is from my book:

The court introduced a new three-prong test to determine “the propriety of claimed insurance deductions by a parent or affiliated company to a captive insurance company.”   The three prongs are:
 
(1) whether the arrangement involves the existence of an “insurance risk”;

(2) whether there was both risk shifting and risk  distribution; and

(3) whether the arrangement was for “insurance” in its commonly accepted sense.


In addition,

the tax treatment of an alleged insurance payment by a parent or affiliated company to a captive insurance company is to be governed by (1) the facts and circumstances of the particular case, and (2) principles of Federal taxation, rather than economic and risk management theories.
 
Regarding the first point, the court noted:  “Basic to any insurance transaction must be risk.  An insured faces some hazard; an insurer accepts a premium and agrees to perform some act if or when the loss event occurs.”   This is a fairly easy point to prove, as all companies face at least general liability.  The second point is further codification of Helvering v. LeGierse, which was explained earlier.  Regarding the third point, the court will look at the facts to determine if the company was in fact a legitimate insurance company.  In this case, the court analyzed the facts thusly:


Rampart was organized and operated as an insurance company.  It was regulated by the Insurance Registry of Hong Kong.  The adequacy of Rampart’s capitalization is not in dispute.  The premiums charged by Rampart to its affiliates, as well as to its shippers, were the result of arm’s-length transactions.  The policies issued by Rampart were valid and binding.  In sum, such polices were insurance policies and the arrangements between the Harper domestic subsidiaries and Rampart constituted insurance, in the commonly accepted sense. 


In other words, courts will now look at the entire insurance structure to determine if the company is a legitimate, stand-alone insurer.  If so, it will pass the Harper test.

End excerpt.

What's important about this test is the court is now adopting a facts and circumstances test to determine the validity of a captive insurance arrangement. Instead of the IRS arguing for an application of the economic family argument and the taxpayer defending with Moline Properties, the court will now look at the totality of the transaction to determine of the captive is in fact a viable, stand-alone insurance company.

The lesson for practitioners is clear: the captive must perform its affairs as a standard-alone company.  Accounts must be separate, regular meetings must be performed, separate and complete corporate records must be maintained, stock certificates must be issued, voting records must be kept, portfolios must look like an insurance company's portfolio, contracts must be up to date (not back-dated) etc....

Fraudulent Transfer Law: Transfer to an Insider

Under the Uniform Fraudulent Transfer Act, a transfers made with the "intent to hinder, delay or defraud" any creditor of the debtor can be voided by the court.  In some situations, these transfers are considered to be fraudulent as to both present and future foreseeable creditors.  Under the Act, there are certain "badges of fraud" -- that is, facts which in and of themselves imply that the creditor's intent was to defraud.  The presence of one or more of these fact patterns "may be relevant evidence as to the debtor's actual intent, buy does not create a presumption that the debtor has made a fraudulent transfer or incurred a fraudulent obligation."  In looking at the case, the court "should evaluate all the relevant circumstances involving a challenged transfer or obligation."  

Remember that fraud is seldom a public event; it reality, most of the time it's done covertly.  As such, most fraud cases rely on circumstantial evidence -- a fact recognized by the UFTA.

Last time, we looked at below market transfers.  Today, I'll look at transfers to an insider.  It's important to understand who an insider is, which depends on who (or what) is making the transfer.  Let's start with an individual making a transfer.  In that situation, the following would be considered insiders: 

(A) a relative of the debtor or of a general partner of the debtor;  
(B) a partnership in which the debtor is a general partner; 
(C) a general partner in a partnership described in clause (B); or 
(D) a corporation of which the debtor is a director, officer, or person in control. 

A relative of the debtor (or a relative of the general partner if the GP is an individual) would obviously be sympathetic to the debtor and would still allow him to use the item.  Under general partnership principles, a general partner controls the affairs and the property of a partnership; therefor a transfer to a partnership where the debtor is a GP is a suspect transaction.  A general partner who is in charge of a partnership is the legal equivalent of a transfer to yourself, and a corporation where the debtor is a director/officer or in control is the legal equivalent of transfer to yourself as well.  In short, in all the above situations there has not been a meaningful relinquishment of control of the item transferred; hence the transfer is inherently suspect.

If the person making the transfer is a partnership, the following are considered insiders:

(A) a general partner in the debtor;
(B) a relative of a general partner in, or a general partner of, or a
person in control of the debtor;
(C) another partnership in which the debtor is a general partner;
(D) a general partner in a partnership described in clause (C); or
(E) a person in control of the debtor 

As with situation for an individual transfer, in all the above situations, the debtor really isn't relinquishing control of the item. A general partner in the debtor is presumed to be sympathetic to the debtor's situation, as is a relative of the general partner.  A partnership where the debtor is a general partner was previously explained.  A general partner who is in business with the debtor is obviously a friendly individual.  A person in control of the debtor may actually be getting paid for services; at minimum, he's sympathetic.

Finally, if a person making the transfer is a corporation, the following transactions are suspect


A transfer to
(A) a director of the debtor;
(B) an officer of the debtor;
(C) a person in control of the debtor;
(D) a partnership in which the debtor is a general partner;
(E) a general partner in a partnership described in clause (D); or
(F) a relative of a general partner, director, officer, or person in
control of the debtor;

The first three individuals control the corporation in some manner and as such are going to treat the debtor kindly.  Situations (D) and (E) and (F) were explained above.

Remember that a transfer to any of the above people in the above situations is a "badge of fraud" -- meaning the court will look at the transaction with a great deal of suspicion.  They will examine the facts very closely to determine if a transfer should be voided.




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An Overview of the OECD Tax Treaty: Some Background

Assume that company XYZ -- which is domiciled in the US -- wants to sell goods to Germany.   While this looks like a great idea on paper it may wind up being counter-productive.  Why?  Because the transaction may be subject to double taxation.  The US taxes income of its residents on a world wide basis -- meaning that wherever in the world you earn money, if you're a US citizen you have to pay US tax on the earnings.  In addition, Germany will also tax the transaction because it occurs within its geographic borders.  So, if the US company sells a good in Germany, it will pay both a US tax and a German tax on the transaction, making this a possibly money losing proposition. 

Thankfully, this problem of double taxation has long been recognized as a possible impediment to world trade and various parties have sought to prevent its effects from happening.  In fact, one of the goals of the original League of Nations was to establish international tax norms (this is where the phrase "permanent establishment" was originally developed).  This task eventually fell to the OECD, who issued their first tax treaty in 1963 largely in reaction to the post WWII increase in international trade.  This treaty was revised in 1977 and again 1992 when it was released in loose-leaf form, allowing for periodic updates and revisions. The UN issued its model treaty in 1979, which was based on the OECD model, but which was more oriented towards capital importers rather than capital exporters.  The US issued their first model treaty in 1977, which was replaced in 1981 and again in 1996.

There is a tremendous amount of overlap between the treaties, with the following difference: The US treaty has a "savings clause" which simply means the US reserves the right to continue to tax its "residents" on a world wide basis.  The UN Treaty is considered more beneficial to countries that are capital importers.  But aside from these differences, the overlap between all three treaties is profound.  Going forward, I'll be using the OECD model treaty as the basis for the analysis, while throwing in some points from the US and UN as needed.

The avoidance of double taxation is a primary reason why countries sign double tax treaties.  There are many others.  First, treaties allocate the right tax between jurisdictions -- they essentially say, "country A can tax X and country B and tax Y."  Second, tax treaties create certainty.  When I'm looking at a possible international transaction, my first question is, "does a tax treaty exist between the two countries."  If it does, there are already a number of assumptions I can make about the overall environment.  Additionally, because of the large number of treaties already in effect, the underlying concepts of these treaties (who can tax what when) have already filtered down into the national structures of most if not all countries.  Finally, all of the preceding points have promoted international trade because we have a better idea of what we can expect when money and business involves two or more jurisdictions. 

There is one more point to mention before moving forward: in order to levy a tax, a "nexus" must exist.  According to Dictionary.com, a nexus is "a means of connection; tie; link."  There are two ways to establish a taxing nexus: residency and through a permanent establishment.  Next time, we'll start with an explanation of residency under the OECD tax treaty.   

 

The IRS' War on Captives; Humana, Part III

For background, please see Humana Part I and Humana Part II:

By way of background, in Part I, we looked at the background facts of the case, and learned that Human was a near-perfect set-up for a captive.   The company was forced by business circumstances to form a captive, considered a variety of options (and obviously documented same) and then formed a stand-alone company that was adequately capitalized, independently managed and charged a fair price for its insurance.  In Part II, we see a very well tried case for the plaintiff who take full advantage of the facts.  In addition, we get the first real explanation (at lease in a case record) of the thinking behind the economic family doctrine.  Finally, we see the first real cracks in the economic family doctrine, thanks to some of the insureds not being owners of captive stock.  As such, the appellate court gives us the first taxpayer victory in a captive case.

With regard to the second issue, the brother-sister issue, we believe that the tax court incorrectly extended the rationale of Carnation and Clougherty in holding that the premiums paid by the subsidiaries of Humana Inc.  to Health Care Indemnity, as charged to them by Humana Inc., did not constitute valid insurance agreements with the premiums deductible under Internal Revenue Code § 162(a) (1954).  We must treat Humana Inc., its subsidiaries and Health Care Indemnity as separate corporate entities under Moline Properties.  When considered as separate entities, the first prong of LeGierse is clearly met.  Risk shifting exists between the subsidiaries and the insurance company.  There is simply no direct connection in this case between a loss sustained by the insurance company and the affiliates of Humana Inc. as existed between the parent company and the captive insurance company in both Carnation and Clougherty

While Humana -- the parent company -- owned the captive in the form of stock ownership, Humana subsidiaries did not own captive stock.  As such, the crux of the economic family argument -- that a payment from the captive to the parent would decrease the captive's stock value thereby preventing any real risk shifting from occurring -- did not apply.  And while the captive was part of the same economic family, the court had to treat it as a legally separate entity under the Moline Properties doctrine.  Also of importance was the Crawford case, which was the only economic family case that had separate and extremely divided ownership of the captive.

There is a second point from the court's reasoning that should be mentioned.  From the case:

The tax court misapplies this substance over form argument.  The substance over form or economic reality argument is not a broad legal doctrine designed to distinguish between legitimate and illegitimate transactions and employed at the discretion of the tax court whenever it believes that a taxpayer is taking advantage of the tax laws to produce a favorable result for the taxpayer … In general, absent specific congressional intent to the contrary, as is the situation in this case, a court cannot disregard a transaction in the name of economic reality and substance over form absent a finding of sham or lack of business purpose under the relevant tax statute

Throughout captive litigation, the service had hinted at an anti-avoidance argument, but never made a full argument along these lines.  What the court is saying above is this: if the service is going to rely on an anti-avoidance argument, they need to make the argument openly.  At his time (the late 1980s) the two primary anti-avoidance arguments were the sham transaction and (lack of) business purpose doctrines (an argument could be made that the sham transaction had morphed into economic substance doctrine by this time, but I think the point is clear).  Please stop hinting at the argument.

Humana was a watershed case accomplished several important goals.  First, it stopped the IRS' momentum in the captive cases.  Put in military terms, this case stopped the IRS' advance.  Secondly, it exposed the primary flaw of the economic family doctrine -- that a captive which insures a non-parent (a subsidiary of the parent) is providing insurance.  Third, it provided taxpayers with a planning blueprint for moving forward. 

 

The IRS' War on Captives; Humana, Part II

Below is an excerpt from my book on the Humana case.  As an aside, if you get a bit confused by some of the terms used, you may want to go back and read some of the earlier posts on the captive cases; see the box on the right for more detail.

Humana lost the trial case but filed a petition for reconsideration.   The tax court withdrew its memorandum opinion and issued a full opinion after review by the 19-person court.   The written opinion contains a 12-member majority opinion, an 8-person concurrence, a 2- member concurring and a 7-member dissent.   The sole reason for Humana’s petition was to get a long opinion which the company could use for the basis of an appeal.

The court first notes the many captive cases heard before Humana that apply directly to the non-deductibility of premiums from a parent to a wholly owned subsidiary.   In this case, that would represent the payments from the Humana parent to the subsidiary.  Next, the court notes “payments to a captive insurance company are equivalent to additions to a reserve for losses.”   If these payments are not deducible as insurance payments they are not deductible at all.   The court quickly dealt with this issue – the payments from the parent to the subsidiary – by citing previous cases (such as Carnation  and Clougherty ) and disallowing the deductions.    

The court next turns to the issue of the payments from Humana’s subsidiaries to the captive, which is referred to as the brother-sister issue.  In this situation, it is important to remember the logic of the non-deductibility of payments to the captive from the parent.  A payment from the captive would reduce the value of the captive’s stock.  Because the parent owned allthe captive’s stock, the captive’s payment would lower the value of the parent’s assets on its respective balance sheet.  Therefore, there was no risk shifting according to the standard established in Helvering v. LeGierse.  In Humana, the majority “extend[ed] the rationale [of Carnation and Clougherty] to the brother-sister fact pattern.”   They did so even though none of the subsidiaries owned any of the captive’s stock. 

This is a very large conceptual problem and illustrates a few very important salient points.  First, we're dealing with a very small and highly technical area of the law and finance.  And while the tax court is full of judges who are obviously verses in the tax code, they are obviously not as versed in the nature of the insurance business.  Secondly, as I noted at the end of the economic family cases, the taxpayers who originally defended captive cases versus the IRS put on a remarkable unsophisticated  defense.  Putting these two points together, it was imperative to this case that Human's counsel lead the court to water -- which they did.  I should also add that this case is a great demonstration of a very good litigation team in action.

The trial court relied extensively on the expert opinion of the IRS' witnesses.  As this was the first case which outlined their thoughts and reasoning, I'll quote them at length:

Commercial insurance is a mechanism for transferring the financial uncertainty arising from pure risks faced by one firm to another in exchange for an insurance premium.  Such financial uncertainty is caused by the possibility of certain types of occurrences that may have only adverse financial consequences.  A corporation such as Humana that places its risks in a captive insurance company that it owns, either directly or through a parent corporation, subsidiary, or a fronting company, is not relieving itself of this financial uncertainty.  The reason for this is simply that such corporation, through its ownership position, still holds the benefits and burdens of retaining the financial consequences of its own risks.  It has a dollar-for-dollar economic interest in the result of any ‘insured‘ peril.


A term frequently used for the act of insuring is underwriting.  An essential element of the concept of underwriting is the transference of uncertainty from one firm to another, generally from the one whose activities naturally give rise to the uncertainty to one whose investors are in the business of accepting such uncertainty for the potential profit they can earn thereby.


Thus, insurers, and the interests that own them, are risk takers.  They assume the financial consequences of the risks for others in return for a premium payment.


A question that perplexes some when initially confronted with the captive insurance area is whether or not respondent has chosen to treat, either directly or indirectly, two separate legal entities as one single economic unit.  One's first impression might be that, since a parent corporation can deal at arm's length with a subsidiary in other areas besides insurance and have such transactions respected by respondent, “insurance premiums” paid to a captive should not be treated any differently.  The answer to this paradox lies in the unique nature of insurance transactions relative to other types of parent/subsidiary transactions.


True insurance relieves the firm's balance sheet of any potential impact of the financial consequences of the insured peril.  For the price of the premiums, the insured rids itself of any economic stake in whether or not the loss occurs … however as long as the firm deals with its captive, its balance sheet cannot be protected from the financial vicissitudes of the insured peril.

The above quote explains why many practitioner's (myself included) refer to the economic family argument as the balance sheet argument.  The IRS' argument is essentially that the parents ownership of captive stock did not relieve the parent of the economic loss caused by the captive's payment to the parent.  There are a few major problems with this theory.  First, it assumes the correct -- and only -- method of valuing a company (here the captive) is the pure balance sheet method, namely that assets-liabilities = book value.  There are, in fact, many ways to value a company, most of which involve cash flow -- or some multiple thereof.  In addition, another popular and often used valuation method involves a multiple of EBITDA, which the above valuation method does not take into account in any fashion.  

In addition, the above statements do not take into account the relationship between the subsidiaries and the Humana -- in which the subs did not own any Humana stock.  This structure was a big part of the Crawford Fitting case -- which most likely provided some type of blueprint for the Humana structure and argument.  Here is a summation of that structure

Crawford involved three sets of companies.  The first set was Crawford, Nupro, Whitey and Cajon, all of which manufactured “valves and fittings … used in numerous applications.”  The second set of companies was the regional warehouses that purchased the manufacturers’ products.  The warehouses were broken down regionally, with one warehouse each for the eastern, southern, central and western U.S.  Each of these warehouses sold to a group of independent and exclusive Crawford distributors.  Mr. Fred Lennon was the sole owner of Crawford  and was also a majority owner of each regional warehouse.  In order to obtain reasonable products and general liability insurance, the Crawford companies created Constance Insurance Company in March 1978.  Each regional warehouse owned 20% of Constance while the remaining 20% was owned by a Crawford executive and one attorney who did extensive work for Crawford.

The diverse ownership structure was very important, and a fundamental reason the court ruled in favor of the taxpayer.  We'll build on this point in the next (and final) installment of the Humana case.