Saturday, January 28, 2012

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

If you're interested in forming a captive insurance company, please click this link.

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.

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