Friday, May 31, 2013

An Inquiry Into The Legitimacy Of Offshore Tax Planning; Part I the Parameters

Apple's tax plan -- and subsequent appearance before Congress defending their plan -- has again drawn attention to the idea of offshore planning.  The overall debate has fallen into the fairly predictable pattern of the political right saying Apple is 100% allowed to perform whatever they can to lower their taxes while the political left has decried the practice as a deliberate evasion of taxes.  What both sides have failed to do is place the idea of offshore planning in the context of US anti-avoidance law in order to determine if the structure would indeed stand-up to scrutiny in the event it was challenged in court.  While the analysis that follows will hardly be an in-depth treatment, it should serve to highlight some of the legal issues involved with complex international tax planning of this nature.

By way of introduction, there are two core concepts of US anti-avoidance law, both of which are derived from the same case, Gregory v. Helvering.  The concept which is by far most cited is that taxpayers are allowed to structure their affairs to minimize taxation.  However, just as important -- but not cited with near the frequency -- is that all transactions must have substance; merely complying with the technical requirements of the code is insufficient.  In Gregory, the taxpayer performed a corporate formation and liquidation over a three day period.  The court ruled this short duration indicated the corporation was not meant to be used for a legitimate business purpose, but was instead a technical shell game used to minimize taxes.  In ruling against the taxpayer, the court forever added an additional layer to tax planning -- the need to demonstrate transactional "substance."

Further complicating our analysis are two issues.  The first is that "legal substance" is an ephemeral and ill-defined concept.  Little to no scholarship has been performed on the idea.  The vast majority of courts dealing with this issue gloss over it, usually stating the act of formation is sufficient in and of itself to demonstrate a legitimate enterprise.  However, this is exactly what the taxpayer did in Gregory only to have the court rule against her.  Perhaps the best list of factors for practitioners to use to demonstrate substance (or at lease corporate separateness) comes from veil piercing law, where many courts have a list of factors to determine if a company is in fact an "alter ego" of the person incorporating the company.  A strong argument could also be made that the material participation standards of 26 U.S.C. 469 could provide some much needed parameters for comparison.  However, no court decision that I'm aware of has formally applied these commonly used and understood concepts to the area of corporate substance. 

The best explanation I have found for "substance" is from a law review article titled "Business Purpose, Economic Substance and Corporate Tax Shelters" by Peter C. Canellos (54 SMU L. Rev. 47) where he notes that the vast majority of legitimate business transactions (which would therefore survive a substance over form challenge) have at their core one of three purposes: increasing profit, lowering expenses or acquiring/raising financing.  However it should be noted that only lowering a tax expense is insufficient.  Unfortunately from a practicing perspective, whether or not a transaction falls into one of the three categories usually falls under the, "I know it when I see it" column.

The second problem complicating an analysis of the transaction is that substance over form law is itself a conceptual briar patch.  Despite it's importance to tax law, no case law book has ever been written on this topic.  Shepherdizing the Gregory case returns over 1000 cases, law review articles, CLE materials and practitioner's guides.  Courts routinely use various substance over form terms interchangeably and incorrectly, and return conflicting decisions on the same or similar facts.  While five actual anti-avoidance law concepts have been cited and developed in the case law (substance over form, the sham transaction, business purpose, the economic substance doctrine and the step transaction doctrine), legitimate scholarly debate could support the contention that there is only one, or three, four and five doctrines.     

Going forward, I'm going to look at offshore  from three perspective: substance over form, economic substance and business purpose.  Substance over form will use the concepts outlined above ("material participation" and the factors in "alter ego" analysis will be used.  There will also be an explanation of legislative intent).  I will make the assumption that the economic substance doctrine is a latter day version of the sham transaction doctrine ("sham transaction" language was used primarily in the 1950s-1970s while "economic substance" language was used from the late 1980s/early 1990s onward; both contain an objective and subjective component).  The business purpose doctrine will use the factors outlined in the Frank Lyon case.  As the step transaction doctrine is most often used in corporate reorganizations or shorter duration transactions, it will not be used. 

Monday, May 27, 2013

Captives and Insurance Policies/Contracts

In my opinion, the ability to draft your own insurance policies is one of the largest advantages of a captive insurance company.  However, it's very difficult to explain to the non-lawyer why this is such a great benefit.  To the uninitiated, this is at best an advantage that barely gets past a "ho-hum."  Words are words, phrases are phrases, and the placement thereof is not important.  But as attorneys who draft documents on a regular basis,the choice of words, the nature of a phrase and all other manners of writing English is our milieu; the placement of a word of phrase can make or break a document.  Let me provide two examples, one from the captive world and one from the non-captive world. 

The parties in "Frigaliment Importing, Co, v. B.N.S. International Sales Corp. (190 F. Supp. 116, SDNY 1960) were engaged in the poultry business.   The defendant agreed to sell "chickens" to the plaintiff.  Simple transaction, right?  The problem arose when the plaintiff and the defendant disagreed on exactly what a "chicken" was.  Because both parties defined chicken differently, the product supplied by the defendant to the plaintiff was considered sub-standard by the plaintiff, leading to very expensive litigation.  This entire situation could have been avoided if both parties had agreed to define "chicken" in the contract.  In fact, a well-written contract will have an entire section devoted to definitions to avoid this very type of misunderstanding. 

In the captive world, consider the case of Beech Aircraft (Beech Aircraft v. U.S., 1984 WL 988 at 1) who had an insurance policy which gave the insurance company complete control of insurance counsel throughout the entire litigation process.  The company did not like insurance appointed counsel during a very expensive product liability case, and went so far as to file a motion to have the court remove counsel.  The court denied the motion and Beech eventually lost the case, facing an adverse judgment of over $17 million dollars.  Beech formed a captive to gain complete control of counsel in the event of a lawsuit.

Because an insurance transaction is viewed more as a sale then a contract negotiation, the parties pay remarkably little attention to the contents of the policy, nor do they consider how beneficial it would be to re-draft the document to their liking.  For example, suppose we define the terms of a cyber liability policy very broadly, so that a breach would occur in a wider variety of circumstances.  This would allow the parent company to have far broader coverage for its cyber exposures.  Or consider the addition of a clause in the claims section of a policy that stated minor mistakes in the claims submission process would not jeopardize the claim itself.  Both of these additions are very beneficial to the insured -- and would therefore not be included in the average policy.

Let me leave you with a most egregious example.  Over the last year, I reviewed a policy for a client.  I wrote a basic legal summation of the policy and returned it to him.  During the call where we reviewed the analysis, he asked for the "quick down and dirty."  I told him that there was literally no way the insurance company would ever pay on the policy -- the language was that restrictive.  And while the company might argue that the policy was an adhesion contract and would therefore be interpreted against them by a court, the reality is the adhesion contract concept is a great law school exam answer that has little effective application in the real world.  

As the examples above illustrate, writing your own policy gives you complete control of the transaction -- a benefit no third-party insurance company would ever allow you to have.