The following is an excerpt from my book U.S. Captive Insurance Law:
After mentioning the general facts, the appellate court first noted, “It is not perfectly clear on what judicial doctrine the holding rests.” Next, the court noted that this was essentially a sham transaction case, with the IRS arguing that the court should not respect the transaction, because its only motive was tax avoidance. The court first outlined the basic concept of the sham transaction doctrine:
This economic-substance doctrine, also called the sham-transaction doctrine, provides that a transaction ceases to merit tax respect when it has no “economic effects other than the creation of tax benefits.” Even if the transaction has economic effects, it must be disregarded if it has no business purpose and its motive is tax avoidance.In other words, the plaintiff must prove that there is a legitimate, non-tax business purpose to the transaction in order to avoid the application of the sham-transaction doctrine.
The appellate court noted that “economic effects” include the creation of genuine obligations enforceable by an unrelated party. The court noted that a legitimate insurance contract existed between OPL and NUL, which NUL had the right to enforce. The tax court “dismissed these obligations” because of the reinsurance agreement between NUL and OPL, arguing that NUL was nothing more than a conduit for payment from UPS to OPL. In addition, UPS actually lost the income, given OPLs separate taxable status. Finally, the court noted that the tax court was stretching the business purpose doctrine farther than it was intended to go. The court sided with UPS and remanded the case back to the trial level.
I previously noted that the UPS appellate decision is incredibly weak. The above excerpt explains why. The appellate court completely ignored the assignment of income doctrine, which was fully developed and painstakingly documented by the lower court. Instead, we see the incredibly weak, "a valid contract was created" argument, followed by the statement this is adequate grounds to uphold the transaction and satisfy the economic substance doctrine.
To put it bluntly, the appellate court has absolutely no idea or concept regarding the economic substance doctrine, which is a two prong test that has both an objective and subjective component. In addition, many transactions voided by previous courts because they lacked economic substance contained valid contracts. Either the court knew this and chose to ignore it, or they didn't know it and marched forward. Either way, their decision is at best laughable.
However. it is also apparent from the lack of true legal justification for their decision, that the appellate court was sending a message: we will not void a captive insurance transaction, period. As this was the last case brought by by the IRS, it's obvious they got the message.