The IRS' War on Captives; UPS, Part II

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In analyzing UPS’ situation before and after it established the captive, the tax court noted that UPS performed all the work related to the EVCs before and after the transaction:

Before January 1, 1984, petitioner performed all the functions and activities related to the EVC's and was liable for the damage or loss of packages up to their declared value.  After January 1, 1984, petitioner continued to perform all the functions and activities related to EVC's, including billing for and receiving EVC's, and remained liable to shippers whose shipments were damaged or lost while in petitioner's possession.  Petitioner continued to receive shippers' claims for lost or damaged goods, investigate and adjust such claims, and pay such claims out of the EVC revenue that it had collected from shippers.  The difference between petitioner's EVC activity before and after January 1, 1984 was that after that date it remitted the excess of EVC revenues over claims paid, i.e. gross profit, to NUF, which, after subtracting relatively small fronting fees and expenses, paid the remainder to OPL, which was essentially owned by petitioner's shareholders.

The only difference between UPS’ pre- and post-1984 arrangement was the insertion of NUF and OPL into the equation.   However, if that arrangement did not have economic substance, the court would not recognize the arrangement.   Hence, at trial this case’s focus was the objective and subjective substance of the transactions between UPS and NUF and NUF and OPL.

UPS first stated it created the transaction between UPS, NUF and OPL out of concern that the EVCs were insurance for which UPS did not have the requisite state licenses.   As a result, UPS’ business purpose for the transaction was to bring an existing business practice in line with various state laws.  However, for this claim to be valid, UPS would have to demonstrate that it “was motivated by a good faith concern that it was illegal for petitioner to continue to receive the excess value income.”   But UPS never obtained a legal opinion regarding the possible legal status of the ECV program.    In addition, after the program was in place, UPS continued to sell ECV policies to shippers in the same manner as before the transaction was established.   Finally, at trial, UPS did not offer any documentary evidence to back up this assertion.

Other of petitioner’s arguments were proven inaccurate by documentary evidence or testimony at trial.  First, UPS argued that its business purpose for establishing OPL was to create a viable insurance company as a profit center for the company overall.  However, the court noted that there were plenty of ways UPS could capitalize this new venture without diverting excess value premiums to OPL.  UPS also argued its business purpose was to allow the company to raise insurance rates.   But this assertion was proven incorrect by testimony from petitioner’s own witness at trial.   UPS also argued the new arrangement was a form of asset protection – that it lowered UPS’ exposure to risk and therefore protected the company’s core assets.   However, UPS continued to be primarily liable on many aspects of the ECV after the implementation of the captive insurance company.   Therefore, the company was still essentially liable, and its claim was proven incorrect by the facts. 

The court next determined whether the rate charged by UPS for its ECV policy was an arm’s length price.  The service procured an expert named Mr. Kelly to demonstrate that the rates charged for EVCs were higher than would be charged in a competitive market.   To demonstrate this fact, Mr. Kelly noted that OPL had a loss ratio of 33% – meaning the company paid out approximately 33% of premiums received in the form of payment for claims.   Mr. Kelly testified that this rate of profit retention would have driven clients away.   The court also noted that another UPS subsidiary named PIP charged a lower rate (0.125 cents per $100 – about half the ECV rate) for its insurance.  Several other experts backed-up this claim.  Even an expert procured by the petitioner conceded that UPS’ ECV rates were high.   As such, the court determined that the rates charged were not at arm’s length, making the transaction a sham for tax purposes.

Finally, the court noted that the petitioner’s sole purpose for entering in the transaction was lowering its federal tax burden.   The petitioner’s insurance broker prepared an original report stating that UPS could save $16 million in federal taxes the first year the plan was put in effect.   Other documents procured at trial demonstrated that tax reasons were the petitioner’s primary motivation for entering into the transaction.  

For all of the reasons listed, the court ruled that the payments UPS deducted as insurance premiums were not legitimate business deductions.   UPS appealed the decision.