UIL: 163.00-00, 264.00-00 Control No. TAM-253952-96

199901005

UIL: 163.00-00, 264.00-00 Control No. TAM-253952-96

Internal Revenue Service

Technical Advice Memorandum SEP 99 4998

Name of Taxpayer:

Taxpayer's Address:

EIN:

Year(s) Involved:

Conferences of Right:

Legend:

Request Date

State A

Insurer

Carrier

Administrator

Number

Amount

Number

Number

Form F

Amounts G

Amount H

State I

Amount

Date K

Number

Amount

Amount

Year

Year

Year

Year

Year

Year

Month 1

Policy Date

endorsements

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Insurance Agent

Consultants

Date

Date

Date

Date

Date

noun u wit

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By memorandum dated Request Date, the District Director of

State A and Taxpayer requested technical advice with respect to

1999010095

-2-

the federal tax treatment of interest deductions claimed under

certain corporate owned life insurance (COLI) contracts.

Issues

The first issue is whether deductions of Amounts G in fiscal

years Year T, U and V, respectively, relating to Taxpayer's COLI

contracts should be disallowed because either (1) the amounts

claimed as deductions are not interest paid or accrued within the

taxable year on indebtedness as required for a deduction under

section 163 of the Internal Revenue Code (Code); or (2) the

relationship of the debt to the annual premiums due fails to

satisfy the "4 out of 7" test of section 264(c)(1) on interest

not otherwise disallowed under section 264(a) (4).' We conclude,

for the reasons described below, that these deductions should be

disallowed. Second, the Taxpayer has requested, under section

7805(b), that the Service limit the retroactive application of

any adverse conclusions drawn herein that limit Taxpayer's

deductions for the taxable years T, U and Vv.

Facts

Taxpayer is principally engaged in manufacturing and

marketing products for the health and funeral industries, both

directly and indirectly, through domestic and foreign

subsidiaries and affiliates. Taxpayer is an accrual basis

taxpayer with a tax year ending Date 2 and is subject to the

audit jurisdiction of the District Director of the State A

District. The taxable years at issue in this request are Years

T, U, and V. During Year T, Taxpayer employed a total of

approximately Number B individuals.

All of the issues presented involve Taxpayer's purchase of

COLI contracts covering a large group of its employees. In

general, COLI refers to life insurance purchased by non-natural

persons (generally corporate employers) insuring the life of any

officer, employee, director, or any person financially interested

in, any trade or business currently or formerly carried on by the

taxpayer. The advantage of broad-based COLI programs is the

ability to maximize the after-tax benefits while attempting to

meet the restrictions under the Code on borrowing secured by life

insurance contracts.

1 Section 264(a) (4) disallows any interest deduction paid

or accrued on any indebtedness with respect to one or more life

insurance policies owned by a taxpayer covering the life of any

individual who is an officer or employee of, or financially

interested in, any trade or business carried on by the taxpayer

to the extent that the aggregate amount of the indebtedness with

respect to policies covering such individual exceeds $50,000.

199901005

In Year S, the Insurance Agent and the Consultants made

proposals to Taxpayer under which a large group of life insurance

policies would be purchased pursuant to a program under which the

premiums for the first three policy years would be paid by loans

secured by the policies' cash surrender value. The next four

years' premiums would be paid through a combination of large

dividends’ paid concurrently with the due date of the premiums

together with policy surrenders. Projections of the after-tax

benefits of the proposed program were provided by the Insurance

Agent to the Taxpayer based on four different assumed corporate

income tax rates and two different level annual premium charges.

-~ 3 -

The Insurance Agent was in a position to reassure Taxpayer

as to the expectations that the performance would track the

proposals due to past correspondence with the Insurer on such

issues as the likelihood that dividends would be paid on the

scale described in the illustrations. One memorandum from the

Insurer to the Insurance Agent stated:

The premium expense charges are significantly higher than

anticipated expenses. During the first 14 policy years

[when investment-related dividends would first be available

the entire dividend is based on the difference between

expense charges and expenses. Because of the source of

these dividends, they are paid at the time premiums are paid

under current practice.... [Bly law, life insurance

dividends can't be guaranteed.... However, in my opinion

adequate provision has been made for commissions,

administrative expenses, and taxes under current laws, so I

believe the dividends illustrated have a high degree of

integrity.

A letter dated Date 3 to the Taxpayer's Board of Director's

Finance Committee succinctly described the contemplated

advantages of the proposed program:

[M]anagement [has] recommended a financial tax-leveraged

proposal which would significantly improve cash flow, net

income and would not materially compete for other uses of

capital. The concept is a corporate-owned life insurance

program ("COLI"). A corporate-owned life insurance program

involves buying life insurance policies on employees, with

their prior consent, naming the Taxpayer as beneficiary.

COLI programs provide unique tax advantages to the

corporation, such as, borrowing against cash values with the

* This expectation was borne out by the payment of

dividends on the first day of each policy year, starting on the

issue date, that have corresponded closely in amount and timing

to the pre-sale illustrations.

199901005

~ 4 -

interest being tax deductible and the eventual receipt of

the life insurance proceeds tax free.

At least two presentations were made to Taxpayer before a

decision to purchase was made by Taxpayer's Board on Date 4. The

presentation outline for one of them described COLI as "an

investment vehicle which provides substantial positive cash

flow.... With the build-up of the policies' cash values,

Taxpayer will be able to offset premium payments through nonrecourse policy loans and dividends." Another presentation's

materials described the program as "an investment in the

insurable values of Taxpayer employees to increase cash flows

through reduced taxes."

Other than the expected tax benefits, the materials for the

two presentations also noted that the COLI Plan could be used to

finance future health care and other employee benefits with any

excess benefits available for general corporate purposes. This

dual purpose -- but with an emphasis on the tax benefits -- for

the program was discussed in a letter dated Date 5 (shortly after

the issuance of the policies) from Taxpayer's President and Chief

Executive Officer to the Number D employees’ who were to be

insured under the COLI Plan:

During the last several years, we experienced tremendous

increases in our health care costs.... We continuously

explore effective ways to fund this growing responsibility

to our employees and at the same time, assure our company's

financial future and continued success. One program we have

been evaluating is a life insurance based investment

program.... The [COLI] program contemplated by the

Taxpayer, involves buying life insurance policies on

employees with the Taxpayer as the beneficiary....

While life insurance is the vehicle for this particular

investment, the program has nothing to do with employee

benefits as we normally view them. This is strictly an

investment strategy that permits the Taxpayer to receive

very favorable tax treatment.

Taxpayer's Board of Directors decide to purchase the COLI

Plan using Form F on Date 4. The Number D policies under the

COLI Plan were issued by Insurer with effective dates of Policy

Date, Year T.‘ The policies were governed by the State A laws.

> This group represents approximately 38 percent of

Taxpayer's domestic work force.

4 The COLI contracts were assumed by Carrier in Year V when

Insurer became insolvent. The term "Insurer," where used for

periods after that date, refers to Carrier rather than to the

199901005

- 5 -

A single application was filed for the Number D employees

that had given their written consent to Taxpayer's purchase of

insurance on their lives. No questions were asked relating to

individual characteristics of the insureds that might affect

their insurability such as occupation or health. Under the

"remarks, details, and special request" section of the

application, the following notations appear:

Policy loan interest payable in arrears.

Policy loans should be made in accordance with instructions

received from the client company or its agent from time to

time.

Policy loan interest rate adjustable.

Dividends should be paid in cash or credited to policy value

using the same principles and calculation formulas used in

the preparing the attached illustration.

Issue as Form F.

Shortly thereafter, on Date 1, Taxpayer gave Insurer the

census data on the individuals to be insured. On that date,

Taxpayer also entered into a service agreement with the Insurance

Agent under which it was to perform a number of tasks, including

the provision of annual plan summaries. Insurance Agent prepares

the summaries from reports generated by its co-administrator of

the COLI Plan, Administrator. The two entities prepared issue

illustrations at or around the time of the purchase of the COLI

Plan, plus the following annual items: (a) periodic reports

summarizing the total annual activity for all of the policies,

(b) plan reviews prepared at the end of each policy year

reporting the current actual performance of the COLI Plan and

projecting the Plan's future performance, (c) minimum payment

schedules (included in the plan reviews) analyzing the annual

loan, premium, and other policy transactions occurring within the

age and sex groups in the policy population, and (d) summaries of

amounts due itemizing policy charges, payment offsets (such as

loans, dividends) and billing Taxpayer for any cash payments due.

The policy illustrations received by Taxpayer projected

positive cash flows and earnings in every policy year, predicated

on obtaining the full tax benefit from interest deductions

generated by non-recourse policy loans. Although illustrations

initial issuer. The administration of the contract, most notably

the timing and amount of the loading dividends and the continued

close correspondence of the COLI program to the pre-sale

illustrations, did not change upon substitution of insurance

companies.

199901005

are not guarantees, correspondence subsequent to the purchase

makes clear the importance of the plan operating as originally

contemplated. For instance, when the mortality costs to Insurer

ended up being lower than the mortality charges being paid by the

holders of Policy F, Insurer made adjustments and assured the

policyholders in writing of its intent to "maintain the integrity

of product performance and the profit levels of the original

pricing assumptions" and to "assure the integrity of Insurer's

illustrations."

- 6

In reply to these assurances, the Insurance Agent wrote:

Our clients relied on Insurer's illustrated mortality in

making financial decisions to acquire Insurer's COLI

products on a broad base of their employees. With actual

mortality significantly less than illustrated mortality,

many clients are experiencing a P&L and cash flow loss when

based upon the issue illustration they had expected and

budgeted for a P&L and cash flow gain. As you know, the

executives who made the decisions to acquire Insurer's COLI

product, based upon Insurer's original financial

illustrations, are concerned with and are measured on their

company's financial results over a short period of time....

These clients find some comfort in your written assurances

that the difference between actual mortality and the mortality illustrated by Insurer will be made up with interest

through a mortality dividend.... Equally important is the

amount of the contingency reserve and thus the amount of the

mortality dividend to be paid in Year V.

This exchange is yet one more indication of the intention of all

parties -- both prior to the purchase and after -- that the COLI

Plan produce, as closely as possible, the illustrated results.

The total life insurance in force under the COLI contracts

during Year T was approximately Amount M in potential death

benefits. Taxpayer has kept all of the COLI contracts in force

except those under which the insured has died. Through the sixth

policy year, Insurer has paid Taxpayer aggregate gross death

benefits of Amount C and net death benefits of approximately

Amount. N.°

The COLI contracts were issued on Form F, a life insurance

contract first filed with state insurance regulatory authorities

in Year P. Form F is an increasing death benefit, fixed premium,

whole life insurance contract form, subject to the terms of

> There is a minor difference in the calculation of this

amount between the Taxpayer and the Field that is not material to

the analysis in this memorandum.

199901005

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several endorsements, intended for use in the COLI market. The

paragraphs below describe the relevant provisions of Form F,

incorporating the terms of all endorsements included with the

contract.

Premiums -- Each of the Number D COLI contracts provides for

either of two level annual premiums: Amount H or Amount J. If

the premium is not paid when due, the policy automatically

becomes paid up on the basis of net single premium factors

applied to the policy value (after satisfaction of any policy

loans) although the policyholder can elect, within three months

of default, to receive extended term insurance instead.

Death Benefit -- The initial death benefit (also referred to

as the specified amount) for each of the Number D COLI contracts

is based upon the individual insured's sex and age (but no other

underwriting factors), assuming an annual | premium of either

Amount H or Amount J payable until death.® The death benefit is

contractually defined ag the greater of (a) the specified amount

shown on the specifications page, (b) the policy value on a given

date divided by the specified net single premium factors, and (c)

the amount required, for the policy to qualify as life insurance

under section 7702. The proceeds payable to the contract's

owner upon the death of the insured are the death benefit, any

dividend additions, any amount payable under an extra benefit

rider, and a refund of unearned premium, reduced by any loan

balance and unpaid premiums.

Policy Value -- The policy value under each COLI contract

is determined by accumulating the net premiums paid (gross

premiums reduced by any contractually specified loading charges),

6 The contract originally delivered to Taxpayer did not

include the endorsement that applies partial withdrawals in the

manner described. This memorandum assumes its inclusion as the

parties have consistently acted as if the endorsements were

included from the date of issue.

7 Of the Number D insurance policies, Number E (with an

annual premium of Amount J) covered the lives of employees who

were "exempt," as defined by the Fair Labor Standards Act, and

Number L (with an annual premium of Amount H) covered the lives

of employees who were non-exempt.

§ The illustrations assumed that the policies' benefits

would be "paid up" after nine years so that no further premiums

would be needed.

° Because of this formula, the COLI contracts will meet the

definition of life insurance contracts under section 7702 if the

applicable law requirement of section 7702(a) is satisfied.

_ 199901005

plus any dividends applied to the policy value, and less the cost

of insurance charges. The policy value is also reduced by any

partial withdrawals. Each policy contains a Table of Values with

minimum policy values based on the minimum guaranteed interest

rate of four percent, the maximum guaranteed cost of insurance

charges, and the policy's expense charges. This Table of Values

reflects the increase in death benefits that will eventually

occur if the annual premiums continue to be paid when due.

The policy value has several effects under Form F: (1) a

policy value above the minimum tabular values may force a death

benefit increase to assure compliance with the cash value

accumulation test of section 7702 (under the formula assuring

compliance of the contract with that section), (2) the policy

value is the cash surrender value (amount distributed to the

policyholder when a policy is surrendered prior to death) after

reduction for outstanding loans (with accrued interest) and

unpaid premiums, and (3) the policy value is the starting point

for fixing the policy's loan limit.

Interest Credited -- Interest is credited to policy value at

one of three different interest rates: the "Current Credited

Unlioaned Interest Rate" (the basic crediting rate) or one of two

"Current Credited Loaned Interest Rates" (the two rates

associated with borrowed policy value). The rate applied depends

upon whether the policy value is in use as collateral for a loan

from Insurer and, if so used, whether the loan carries a fixed or

adjustable loan interest rate.

The basic crediting rate applies only to the portion of the

policy value that is not used as collateral for a policy loan.

The basic crediting rate is defined as the greater of (i) a rate

that Insurer may declare or (ii) four percent per year. This

rate has little application if the policyholder elects to make

the maximum policy loans permissible within the limits of section

264.

The Current Credited Loaned Interest Rate credited to the

policy value that collateralizes a policy loan carrying an

adjustable rate (adjustable loan crediting rate) is the greater

of:

(a) the ratio of (i) Moody's Corporate Bond Yield

Average - Monthly Corporate Baa (the Baa rate)’ for the

calendar month two months before the date on which the rate

is determined, and (ii) 100% less the average Baa rate

defined in (i), and

10 The use of the Baa rate in Form F was considered to be a

feature "unique" to COLI policies by the outside actuarial firm

engaged by the Administrator to develop COLI products.

199901005

(bo) the basic crediting rate, defined as the greater

of (i) a rate that Insurer may declare, or (ii) four percent

per year.

-9 -

Because the Baa rate has been (and generally will be) in

excess of both four percent and the basic crediting rate declared

by Insurer, paragraph (a) effectively determines the adjustable

loan crediting rate. This rate can be expressed in the formula:

Adjustable Baa

loan crediting SB teers

rate 1 - Baa

For example, if the Baa rate is 10 percent, the adjustable loan

crediting rate would be 11.1 percent (.10/(1-.10)).

Under a Form F endorsement attached to Taxpayer's COLI

contracts, a policyholder can elect, but only at issue, to have

the adjustable loan crediting rate increased through using a "T-

factor." Using a T-factor increases the adjustable loan

crediting rate (and thus the adjustable loan rate discussed

below) to a rate higher than the formula detailed above. State

I, where Insurer was domiciled, disapproved the use of this

endorsement, on the grounds that:

[I]t is inappropriate for a policyholder to determine within

a range what these two rates [the loan and crediting rates]

should be. The premise of the variable loan rate is to

charge a rate dependent on an outside index, and the

methodology used to determine the credited interest rate

should rely on company expectation, not policyholder

discretion.

Taxpayer did not, according to the material submitted, elect to

apply a T-factor to increase the adjustable loan rate.

If the policy value secures a fixed rate policy loan, the

interest credited to the policy value (the fixed loan crediting

rate) is the greater of (i) a rate that Insurer may declare, or

(ii) four percent per year. Although this definition is the same

as for the policy value not used as collateral, the two crediting

rates need not be the same. Further, although a basic crediting

rate has been applied to the policy value that is not used as

collateral from inception of the COLI contracts, no fixed loan

crediting rate was declared by Insurer until Date K.

Other policy forms offered by Insurer at the time that

Taxpayer purchased its COLI contracts also adjusted the crediting

rate on policy values to assure a fixed, minimum spread between

crediting and loan rates. In none of these other forms, did the

crediting rate go above a common index, such as Moody's Corporate

Bond Yield Average--Monthly Average Corporate rate (Moody's

1999010006

Average Corporate rate), when the policy value was used to

collateralize a policy loan.

- 10

Policy Charges -- There are no specified policy fees.

However, expense charges (the loading charges) are imposed during

the entire duration of each COLI contract. For a 31-year-old

female, the loading charges, as a percentage of the Amount H or

Amount J premium, are:

Policy Year Loading Charge

The loading charges differ for each policy based upon the age and

gender of the insured but are similar in pattern to the numbers

listed above. In general, the loading charges are less than the

numbers in the above table if the insured is older at issue.

Both Taxpayer and the Revenue Agent have asked us to assume that

the loading charges for a 31-year-old female are typical of the

COLI contracts.

Cost of Insurance Charges -- The cost of insurance charges,

i.e., the amount paid to Insurer as consideration for its risk

that the insured might die during the period covered by the

charge, are deducted from the policy value on each processing

date. The maximum monthly cost of insurance rates are the 1980

CSO(A) Mortality Table with monthly curtate functions.

Surrenders’! and Withdrawals -- All (or a portion) of the

policy value, including any paid-up additions, may be withdrawn

under the base policy. A withdrawal first reduces the loan

balance to the new loan limit (computed by reference to the new

lower policy value after the withdrawal), while the remainder is

paid to the policyholder in cash. Each withdrawal reduces the

death benefit on a dollar for dollar basis rather than reducing

it proportionally, as would occur with a partial surrender of a

policy. No adjustments to the premium are made upon withdrawals

accompanied by reductions in death benefit.

Policy Loans -- Policy loans, on the sole security of the

policy, are available under Form F as required by state law. The

loans need not be repaid until the death of the insured or the

surrender of the policy.

4 There is no specific provision permitting surrenders of

part or all of the death benefit under the COLI contracts.

199901005

- 1l1 -

The contractually defined loan limit is (1) the policy value

plus the dividend value (defined as the cash value for any

dividend additions, plus any other dividend credits), both

computed as of the next policy anniversary, less (2) all unpaid

premiums plus interest at the loan rate on each such premium to

the interest due date. Although the formula does not so state,

the loan limit presumably takes into account previously issued

loans.” Restated, the loan limit is the year-end unborrowed

cash value, assuming premiums are timely paid.

The interest rate on all loans secured by the policy value,

pre-existing or new, is chosen annually by the policyholder, who

can select either an adjustable or a fixed loan rate. The

adjustable loan rate (payable in arrears) is determined by

Insurer annually two months before the start of the policy year

and can be any rate that does not exceed the contractually

specified maximum, The maximum’? adjustable loan rate is the

greater of:

(a) Moody's Average Corporate rate, as published by Moody's

for the calendar month two months before the date on which

the rate is determined, and

(b) the adjustable loan crediting rate (the interest rate

credited on that portion of the policy value which is equal

to the loan balance) plus one percent.

The adjustable loan crediting rate that is the base for the

borrowing rate described by paragraph (b) is higher than the Baa

rate which, in turn, is higher than the Moody's Average Corporate

rate. Accordingly, the adjustable loan rate determined under

paragraph (b) is always higher than the rate determined under

paragraph (a). The adjustable loan rate under paragraph (b) can

be described in a fraction that is closely related to the formula

used for the underlying adjustable loan crediting rate:

Adjustable Loan Rate =) ------- + 1%

122 gection 264(a) (4) disallows the interest on loans under

any COLI contract that exceed $50,000 cumulatively, which serves

as a practical cap on borrowing that is often lower than the

contractual loan limit.

13° Although Form F only defines a maximum adjustable loan

rate, the rate declared by Insurer each year has never been less

than the maximum.

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If, using the earlier example, the Baa rate is 10 percent, the

adjustable loan crediting rate is 11.1 percent, and the

adjustable loan rate under paragraph (b) is 12.1 percent.

At any time, the policyholder can also elect a fixed loan

rate option of 8.0 percent (if charged in arrears) or 7.4 percent

(if charged in advance). If the fixed loan rate is selected by

the policyholder, the amount credited to the portion of the

policy value that is collateral for the loan (the fixed loan

crediting rate) is the greater of a rate declared by Insurer or

four percent (the minimum interest rate guarantee). As the fixed

loan rate has never been selected by Taxpayer, the fixed loan

crediting rate has never applied to the portion of the policy

value used as collateral for the COLI contract loans. **

Each year, the statements provided to Taxpayer assumed that

Taxpayer would select the higher adjustable loan rate. Although

Taxpayer could have opted for the fixed loan rate at any time,

the statements failed to specify the fixed loan crediting rate

that would have allowed Taxpayer to determine whether the same

one percent spread would apply. There is also no evidence that

Taxpayer inquired about the fixed loan crediting rate. As noted

earlier, Insurer did not declare a fixed loan crediting rate

until Date K.

Dividends -- Form F, as endorsed, states that Insurer "will

credit this policy with such dividends as we may apportion."

Dividends may be paid in cash (applied against the premium due),

applied to policy value, or used to purchase paid-up life

insurance or one-year term insurance, at the option of the

policyholder. Insurer credits dividends at the beginning of each

policy year under Form F, including upon the issue date of the

policy. The crediting of a dividend upon the issue date is not a

benefit under life insurance contracts generally, and is not

specified in the contract.

There are three components of the dividends paid under Form

F, only two of which applied during the taxable years at issue.

For example, the Year V Dividend Declaration provides that the

dividends credited in Year V would be the sum of three items: (a)

an excess interest dividend, (b) a mortality dividend, and (c) a

loading dividend, reduced by deferred acquisition cost (DAC)

reductions and increased by DAC amortization. The excess

interest component of the dividend is zero until the end of the

15th policy year and, therefore, can be ignored for purposes of

this memorandum.

“4 Since Issuer first informed policyholders of these rates

in Date K, the same one percent spread between borrowing and

crediting rates has occurred under both the fixed and adjustable

loan rate scenarios.

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The second component was a mortality dividend that shifted

any profit due to favorable mortality from Insurer to the

purchasers of large COLI programs. The correspondence and

memoranda contemporaneous to the issuance of the COLI contracts

anticipated that Insurer's profit on Taxpayer's COLI program

would be derived principally from the one percent interest spread

between the crediting and borrowing rates related to the policy

loans, rather than from excess mortality charges. However, the

insureds covered under Form F contracts lived longer than

anticipated. In Year V, Insurer enhanced the mortality element

to the dividend calculation for Form F contracts at the behest of

Form F policyholders, Taxpayer and others, who detailed concerns

that they would not be obtaining the benefit of the original

bargain if Insurer retained the full cost of insurance charges.

The third and most significant factor in the amount of the

declared dividend was the loading dividend, which was derived

from the excess of the loading charges specified in the contract

over the actual expenses of administering the program. Through

the application of seven different factors used in the

determination of the portion of the loading charge to be

returned, a major portion of the contractually specified loading

charge is made available to the policyholder at the beginning of

each policy year. For example, in the fourth year of Taxpayer's

COLI program beginning on Policy Date, Year X, approximately 86

percent of the premium paid for that policy year was returned to

Taxpayer as paid, or approximately 94 percent of the aggregate

loading charges specified in the contracts. The dividends

calculated under the COLI contracts corresponded closely to the

original illustrations, with the exception of the modification of

the mortality dividend.

Both Insurer and Taxpayer have treated the Number D COLI

contracts as a unified program, and the Form F terms of the COLI

contracts, including all endorsements, have been applied on an

aggregate basis. All transactions, while taking into account

variances implicit in having age and sex groupings of insureds,

are accounted for on an aggregate basis.

The gross premiums due, in the aggregate for all outstanding

COLI contracts at the beginning of each policy year, beginning on

Policy Date, Year T, through the premiums due for the policy year

beginning Policy Date, Year Z, were:

19990109005

- 14 ~

Policy Year Premium’®

The cost of insurance charges for the policy years beginning

on Policy Date of each year were:

Policy Year Cost of Insurance

The interest rates disclosed to Taxpayer for the first six

policy years were as follows:

Policy Basic Crediting Adjustable Loan Adjustable

Year Rate* Crediting Rate Loan Rate

*Applies only to the unborrowed portion of policy value.

The corresponding Baa and Moody's Average Corporate rates

from Month 1 of the previous calendar year (the months and rates

used as the starting point for the interest rate calculations

under the COLI contracts) ,*® and the adjustable loan rates for

each policy year were:

© The periodic reports on the COLI contracts are

inconsistent on whether gross premiums are reduced by deaths that

have occurred but which have not been reported as of the date the

premiums are due. The differences are not material and can be

resolved between Taxpayer and the Revenue Agent.

‘© The use of the prior Month 1's Baa rate is not in

accordance with the terms of Form F as Month 1 is four months,

rather than cwo months, prior to the COLI program anniversary.

This discrepancy is unexplained.

199901005

- 15 -

Moody's Average Adjustable

Policy Year Baa Rate Corporates Loan Rate

The amount borrowed by Taxpayer during the first three

policy years, using the COLI contracts' policy values as

security, and the interest at the adjustable loan rate for those

and succeeding years, are as follows:

Policy Year New Borrowing Interest Accrued

Dividends made available to Taxpayer on the first day of

each policy year were:

Dividends as

Loading Mortality Percentage of

Year Dividend Dividend Gross Premiums Due

The relationships of the loading charges, the loading

dividends, and the aggregate premiums are as follows:”’

1 The aggregate numbers in this table are slightly less

than would occur if all insureds were the same age and sex as

under the representative policy used by Taxpayer and the Revenue

Agent. This slight decrease in loading charges and loading

dividends as percentages of the premiums occurs because some

members of the group of insureds under the Taxpayer COLI program

are male and/or older than the insured under the representative

policy.

199901005

- 16 -

Loading Charge Loading Dividend Loading Dividend

Policy as Percent as a Percent as a Percent

Year of Premium of Loading Charge of Premium Paid

Withdrawals of policy value began in the fourth policy year.

The withdrawals, which Taxpayer represents were on a roughly pro

rata basis among the COLI contracts, were in the following

aggregate amounts:

Policy Year Withdrawal

The components described above operated in a unified manner

as contemplated in the illustrations prepared by the Insurance

Agent during the study period prior to the purchase of the COLI

contracts. The program also operated in accordance with the

ongoing reports of the manner in which the COLI Plan operated,

which showed substantial similarity to the illustrations.

Taxpayer notes that there were deviations from the originally

contemplated plan as to the interest rates (which were expected

to fluctuate), the manner in which the dividends were applied

under the contract, and the amounts withdrawn from each COLI

contract's policy values. Nonetheless, the COLI program operated

with only immaterial variations from the anticipated program --

Taxpayer borrowed in the first three years and used loading

charge-derived dividends and withdrawals to minimize its costs in

subsequent years.

With the assistance of the Administrator, the Insurance

Agent sent periodic reports to Taxpayer detailing the results of

the COLI program, providing a summary of amounts due for the

upcoming year and an annual plan review. Specifically, Taxpayer

was informed of the amount due, and (by age and gender groups)

the prior loans, loan interest due, premiums due, amount of

premiums borrowed (if any), net amount of premiums due, loans in

excess of premiums (if any), and total loans as of the payment

due date.

In the first three years, the statements set forth the total

stated premiums for all COLI contracts still in force: (1)

reduced by loans made against the policy values, (2) reduced by

the loading dividends that were treated as paid to Taxpayer

(rather than credited to policy values), and (3) increased

(beginning at the end of the first policy year) by one year's

accrued loan interest. The final net figure was the amount to be

19 99 0 1 0 05

remitted to Insurer. During the first two policy years, all of

the loading dividend was credited to policy value which maximized

the amount that could be borrowed under the COLI contracts'

terms. Beginning in the third policy year, the loading dividend

credited at the beginning of the policy year was divided between

application to the policy value and payment of the premium due.

The remaining loading dividend and the revised mortality

dividend” credited at the beginning of the third policy year

were applied to pay the premium.

-17 -

In the fourth through sixth policy years, Taxpayer withdrew

large sums from the COLI contracts' policy values, and all

dividends (loading and mortality) were credited against premiums

due rather than applied to policy value. Accordingly, the

statements detailed the gross premium due, increased by the

accrued loan interest due, and reduced by dividends and partial

withdrawals from the COLI contracts.

The following summarizes the amounts (with three zeros

omitted) that were taken into account to determine the net amount

to be remitted from Taxpayer to Insurer:

Policy Gross+ Dividends Policy Interest Partial Net Amount

Year Premium Applied* Loans. Due Withdrawals Remitted

+ The number of COLI contracts dropped each year because of

contracts that terminated when the individual insured died.

* These amounts are only the dividends treated as paid in cash

to Taxpayer and do not include dividends credited to policy

values.

After taking into account the dividends, the loan interest

accrued, the policy values, and the partial withdrawals, the

aggregate net cash surrender values remaining in the contracts

were, at all times throughout the taxable years at issue, less

than one percent of year end policy value, as shown below:”?

18 The enhancement of the mortality component of the

dividend in response to the favorable experience is one of the

few differences between the contracts as administered and as

illustrated before issuance.

8 Although the policy values (and death benefits) would

have increased over time had Taxpayer continued to pay premiums

beyond the first seven to ten years of the policy, the

199901005

~ 18 -

Accrued Net

Unpaid Year End

Year End Policy Interest Policy

Policy Policy Loan On Policy Surrender

Year Value* Balance* Loans* Value*

*All values are actual dollar values; no zeros are omitted.

Taxpayer expected the COLI program to improve Taxpayer's

profit and loss for financial reporting purposes, taking into

account the tax effects of the borrowing. Although the results

have not been exactly as anticipated, Taxpayer represents that

the effects were generally as predicted by the illustrations.

Taxpayer claims that the COLI program had a positive effect on

its financial statement because the death benefits received and

interest and dividends credited are treated as profit and policy

values (net of policy loans) are treated as an asset, although

interest on the policy loans and premiums paid largely offset

these benefits. The policy loans are not listed as liabilities

on Taxpayer's financial statements.

For federal tax purposes, the annual increases in the policy

values under the policies that are reported as income in the

financial statements are eliminated from taxable income on

Schedule M of Taxpayer's income tax return. Death benefits are

also eliminated from taxable income on Schedule M. Similarly,

premiums charged on the policies were recorded as expenses on

Taxpayer's financial statements but reversed on Schedule M and

not claimed as deductions from taxable income. Finally, the

interest amounts charged to Taxpayer on policy loans were treated

as expenses for financial statement purposes and claimed as

deductions against taxable income on Taxpayer's return.

Applicable Law and Rationale

(L) Whether the amounts claimed by Taxpayer as deductions are

interest paid or accrued during the taxable year on indebtedness

within the meaning of section 163.

illustrations anticipated that Taxpayer would elect paid-up

status and stop paying premiums before the policy values grew to

any appreciable extent.

1 999 01 0 05

-~ 19 -

Section 163 allows as a deduction all interest paid or

accrued within the taxable year on indebtedness. However, a

prerequisite to the allowance of any interest deduction is that

the underlying transaction must have economic substance apart

from its tax benefits. In Knetsch v. United States, 364 U.S. 361

(1960), the Supreme Court applied the economic substance doctrine

to disallow an interest deduction where it found that "there was

nothing of substance to be realized ... from [the] transaction

beyond a tax deduction." 364 U.S. at 366. The Court held that,

because the taxpayer's financing arrangement with an insurance

company lacked non-tax substance, the transaction did not create

a valid indebtedness for purposes of Federal tax law.

(a) Whether Taxpayer, in substance, incurred an "indebtedness"

for Federal tax purposes.

The Field contends that Taxpayer's financing transaction

with Insurer is not valid "indebtedness" for tax purposes because

Taxpayer did not, in substance, acquire the use of funds it

otherwise would not have had, and Insurer did not part with the

use of funds from which it otherwise would have derived a

benefit. See Golsen v. Commissioner, 54 T.C. 742 (1970), aff'd,

445 F.2d 985 (10th Cir. 1971), cert. denied, 404 U.S. 940 (1971)

(collectively Golsen I). See also Goldman v. United States, 403

F.2d 776 (10th Cir. 1968). Although Taxpayer, in form, obtained

the use of money from Insurer to pay premiums on the COLI

policies, the totality of the facts and circumstances indicate

that Insurer did not part with any funds through loans and did

not acquire the use of any funds through receipt of premiums.

While Taxpayer and Insurer arranged for an appearance of cash

transfers that flowed in both directions, a substantial portion

of the amounts paid were returned concurrently with their

payment, creating a circular cash flow.

The Field further contends that the circular cash flow was

facilitated and enhanced by the COLI policies' high premiums.

According to the Field, an analysis of the premiums paid for the

policies, and the insurance benefits and cash surrender values

produced thereby, demonstrates that the premiums were intended to

pay neither for current insurance coverage nor future benefits.

Rather, a substantial portion of the premiums were paid for the

purpose of either being borrowed or funding simultaneous

dividends and partial withdrawals.

During the first three years of the COLI policies, purported

policy loans were the primary mechanism used to produce the

circular cash flow. After policy year three, the loading charges

stipulated in the COLI policies increased substantially, thereby

providing a source from which Insurer could "pay" loading

dividends that effectively offset a major part of the premiums

"que" under the COLI contracts. This relationship is

199901005

~ 20 -

demonstrated in the earlier table showing the relationship each

year between contractually specified loading charge, loading

dividend, and premiums due.

Insurer informed Taxpayer each year of the amount of the

loading dividend payable at the beginning of that year when the

premium also was due. The loading dividend had the effect of

returning to Taxpayer a substantial portion of the premium

simultaneously with its payment. For example, in the fifth

policy year, 92 percent of the loading charge (which was 94

percent of the premium for that year) was returned to Taxpayer as

a loading dividend that "paid" approximately 86 percent of the

premium. In addition, beginning in policy year four, amounts

previously credited to Taxpayer's policy value account were

withdrawn by Taxpayer from policy value and credited against

premiums and interest payments due.

The Field contends that the loading dividends were not true

dividends because they were dependent neither upon the experience

of the Insurer nor upon the Insurer's discretion. The Field

argues that the guaranteed aspect of the loading dividends is

demonstrated by the total improbability of their not being

declared. If substantial dividends were not declared in advance

of the policies' anniversary date when the premiums became due,

Taxpayer simply could refuse to pay the premium and elect to have

the policy lapse or convert to reduced paid-up status (in either

event the outstanding debt could be paid off without further cash

outlay by Taxpayer).

The Field also points to correspondence and memoranda in the

possession of Taxpayer and the Insurance Agent making clear that

the loading dividend was an important part of the COLI program.

With the assurances previously given by Insurer, the Insurance

Agent would be in a position to reassure Taxpayer as to any

concerns about this issue.

With regard to the partial withdrawals from the COLI

policies, the ability to make partial withdrawals of policy value

is not usual on a fixed premium life insurance contract.

Ordinarily, a withdrawal would be treated as a partial surrender

that would reduce the death benefit proportionally. Further, a

withdrawal of cash value that does not affect the future premiums

due is also unusual with a fixed annual premium contract.

Taxpayer contests the contention that the premiums for its

COLI policies were artificially high. Taxpayer argues that any

inquiry into the size and structure of the premiums must begin

and end with the testing of the contracts under sections 7702

(defining "life insurance contract" for federal tax purposes) and

7702A {establishing a specific limitation on the level of life

insurance premiums in relation to death benefits). Taxpayer

contends that, since the COLI policies are life insurance

199901005

- 21 -

contracts under section 7702 and the premiums for the policies do

not exceed the limits imposed by section 7702A, the premiums on

its COLI policies cannot, by definition, be artificially high

under the standards established by Congress for life insurance.

Taxpayer states that Insurer designed the COLI policy form,

secured regulatory approval by multiple states, and offered it on

a non-negotiable basis to Taxpayer as well as to other

prospective corporate purchasers. Taxpayer contends that the

COLI policies! loading charges provided Insurer with a cushion

against expenses of administration. In addition, Taxpayer argues

that using a loading dividend has certain unspecified advantages

over using net premiums for State premium tax purposes. Taxpayer

also does not agree that the loading dividends were contractually

guaranteed or virtually assured. Rather, Taxpayer contends that

Insurer's Board of Directors independently determined each year

whether to pay dividends after taking into account the

characteristics of the COLI programs, including the large

premiums being paid in the aggregate by the purchasers of the

COLI policies and the inequity to those policyholders of holding

large surplus generated by those premiums for a full year before

distributing it.

Taxpayer argues its situation is distinguishable from the

facts of Knetsch, which involved borrowing nearly all the cash

value of an annuity contract. Borrowing an annuity contract's

entire cash value defeats the purpose of the contract -- that is,

the eventual production of annuity payments. Knetsch's

transaction with the insurance company, therefore, did not

appreciably affect his beneficial interest except to reduce his

tax; that is, Knetsch realized nothing from the transaction

beyond a tax deduction. See 364 U.S. at 366. In contrast,

Taxpayer claims that its COLI policies always provide a

substantial amount of death benefit protection in excess of

policy loans. Taxpayer argues that Knetsch does not apply to its

leveraged COLI policies because the substantial life insurance

protection provided by those policies ensures that the policies

have economic substance appreciably affecting Taxpayer's

beneficial interest beyond the realization of a tax deduction.

Taxpayer also contends that the "four out of seven" test in

section 264(c) (1) explicitly permits the first three premiums of

a life insurance contract to be paid by means of policy loans,

provided the next four premiums for the contract are paid by

other means (for example, policyholder dividends or partial

withdrawals). Taxpayer argues that the Field's circular cash

flow argument is not consistent with either the statute or

published Service position. See Rev. Rul. 71-309, 1971-2 C.B.

168 (section 264(c) satisfied where corporate purchaser and

transferee trust cumulatively borrowed in no more than three of

first seven years); Rev. Rul. 72-609, 1972-2 C.B. 199 (borrowing

199901005

- 22 -

as to more than three of first seven years violates section

264 (a) (3)).

With regard to the Golsen I case, which disallowed a

deduction for interest on indebtedness incurred to purchase a

life insurance contract, Taxpayer points out that in Woodson-

Tenent Laboratories, Inc. v. United States, 454 F.2d 637 (6th

Cir. 1972), the Court of Appeals rejected the Government's

contention that Woodson-Tenent's leveraged life insurance program

on key employees lacked economic substance, expressed its

disagreement with the Golsen I decision, and allowed a deduction

for interest on policy loans used to purchase the life insurance

coverage. See also Campbell v. Cen-Tex, Inc., 377 F2d 688 (5th

Cir. 1967) (hereafter Cen-Tex) and Priester Machinery Co. V.

United States, 296 F. Supp. 604 (W.D. Tenn. 1969).

Taxpayer also contends that its situation is factually

distinguishable from Golsen I and other cases that have

disallowed deductions for interest on life insurance policy loans

used to pay premiums. Those cases involved borrowing to prepay

premiums. In contrast, Taxpayer limited its borrowing to the

amount needed to pay each of the first three level annual

premiums as each premium became due.*° See Golsen v United

States, 1980-2 U.S.T.C. para. 9741 (Ct. Cl. 1980) (upholding

deduction for interest on indebtedness incurred to pay currently

due premiums) (referred to hereafter as Golsen It) .*

Taxpayer notes that both Treasury testimony and Treasury

Reports have discussed broad-based leveraged COLI programs and

acknowledged the tax benefit flowing from the interest deductions

under those programs. Statement of Dennis E. Ross, Deputy

Assistant Secretary (Tax Policy), Department of the Treasury,

Hearings Before the Subcommittee on Select Revenue Measures,

Committee on Ways and Means, U.S. House of Representatives 32-33

(Mar. 15, 1988); Statement of Kenneth W. Gideon, Assistant

Secretary (Tax Policy), Department of the Treasury, Hearings

Before the Subcommittee on Select Revenue Measures, Committee on

Ways and Means, U.S. House of Representatives 42-43 (Feb. 21,

1990); Department of Treasury, Report to The Congress on the

Taxation of Life Insurance Products (Mar. 1990).

20 See discussion below of the definition of "annual

premiums due" in comparison to the stated premiums.

71 This case involved the same taxpayer and life insurance

policies as Golsen I, but different tax years. The Claims Court

in Golsen II did not view the earlier decision as controlling

with respect to interest on loans made after Golsen had

eliminated the prepaid premium fund.

199901005

- 23 -

Taxpayer also points out that section 264(a) (3) was amended

in 1996 by section 501 of the Health Insurance Portability and

Accountability Act of 1996 (HIPAA), 1996-43 I.R.B. 7, 60, to deny

interest deductions generated by broad-based leveraged COLI

programs. In enacting the 1996 changes to section 264, however,

Congress granted transition relief whereby the deduction for

otherwise allowable interest incurred under then existing COLI

programs is phased out over several years. Taxpayer argues that

the transition relief manifests Congressional recognition that

the broad-based leveraged COLI programs involved valid

indebtedness for tax purposes for years prior to 1996 (including

the years at issue), and further contends that its leveraged COLI

program is eligible for the transition relief.

We agree with the Field. Even if Taxpayer's COLI policies

are life insurance contracts other than modified endowment

contracts under sections 7702 and 7702A, such qualification does

not preclude a finding that the premiums are artificially high in

the context of determining whether Taxpayer's financing

arrangement has economic substance. Taxpayer claims that it

borrowed from Insurer to finance the payment of insurance

premiums. Contrary to Taxpayer's stated purpose for borrowing,

however, a substantial portion of the premiums paid for these

contracts did not pay for insurance benefits; instead, they were

paid for the purpose of either being borrowed or funding

simultaneous dividends or partial withdrawals. The policies'

high loading charges and loading dividends were specifically

designed for the large employer COLI market where the loading

costs were de minimis. Thus, the high premium structure together

with loading dividend and partial withdrawal mechanisms served no

economic purpose other than to provide the circular flow of cash

necessary to produce the expected tax benefits with a minimum

cash outlay by Taxpayer.

Furthermore, compliance with the literal requirements of

section 264 does not preclude the Service from looking below the

surface to examine whether there is real indebtedness for federal

tax purposes. Settled law makes clear that section 264 only

concerns actual interest on real indebtedness, i.e., interest on

policy loans that have economic substance for tax purposes. In

Knetsch, supra, the Supreme Court rejected the taxpayer's

argument that Congress, by amending section 264 effective for

transactions occurring after the taxpayer's, implicitly approved

the taxpayer's claimed interest deductions. The Court held that

the 1954 amendment was intended to further Congress' policy to

disallow interest incurred to produce partially exempt income and

was not intended to address sham transactions. The Court held

that the taxpayer's problem was caused by his noncompliance with

section 163 and not section 264, which is directed at

transactions involving interest payments on actual indebtedness.

In Golsen I, supra, the Tax Court rejected an argument similar to

that made by Taxpayer here, stating that "[section 264] simply

199901005

- 24 -

denies, or disallows, or prohibits deductions that might

otherwise be allowable ... [and] does not confer the right to any

deduction ...." 54 T.C. at 755-756. The Tenth Circuit affirmed

the Tax Court in Golsen I, finding "(t]he fact that Congress

considered it expedient to remedy an avoidance device which had

at least some court recognition does not bind us in dealing with

a specific fact situation." 445 F.2d at 990.

We do not interpret the cases and rulings cited by Taxpayer

to hold that all purported policy loans used to pay currently due

premiums are per se indebtedness for purposes of section 163 or

that interest on such policy loans is deductible so long as

section 264 parameters are satisfied. The legislative history

for the most recent modification to section 264 in 1996 makes

clear that the opposite is true:

Provided the transaction gives rise to debt for Federal

income tax purposes, and provided the 4-out-of-7 rule is

met,” a company may borrow up to $50,000 per employee,

officer, or financially interested person, and is not

precluded under section 264 from deducting the interest on

the debt, even though the earnings inside the life insurance

contract (inside buildup) are tax-free, and in fact the

taxpayer has full use of the borrowed funds.

H.R. Conf. Rep. 736, 104th Cong., 2d Sess. 319-320 (1996) (1996

Conference Report). In addition, Congress stated that no

inference was intended as to the treatment of interest paid or

accrued under prior law. Id. at 322. The transaction must give

rise to indebtedness under general tax law principles, taking

into account the facts and circumstances.

The effect of the transition rule provided in connection

with the 1996 amendment to section 264 is that interest under

some broad-based leveraged COLI programs, if previously

deductible under general tax law principles, continues to be

partially deductible during the phaseout of the deduction.

However, there is no statement, direct or indirect, that suggests

that all broad-based leveraged COLI programs involved genuine

indebtedness.

In this case, the loading dividend mechanism, partial

withdrawals, and artificial premium structure of Taxpayer's COLI

22 [footnote 23 in Conference Report] Interest deductions

are disallowed if any of the disallowance rules of section

264(a)(2)-(4) apply. The disallowance rule of section 264 (a) (3)

is not applicable if one of the exceptions of section 264(c),

such as the 4-out-of-7 rule (sec. 264(c)(1)) is satisfied. In

addition to the specific disallowance rules of section 264,

generally applicable principles of tax law apply.

199901005

~ 25 -

policies served no economic purpose other than to provide the

circular flow of cash necessary to produce the expected tax

benefits with a minimum cash outlay by Taxpayer. These features

distinguish Taxpayer's leveraged COLI from cases and rulings

cited by Taxpayer. Accordingly, those cases and rulings are not

dispositive of the issue of whether Taxpayer's transaction

produced genuine indebtedness.

"Indebtedness" has been defined as "an unconditional and

legally enforceable obligation for the payment of money."

Autenreith v. Commissioner, 115 F.2d 856, 858 (3d Cir. 1940). In

order to be deductible, interest must be paid on genuine

indebtedness, that is, indebtedness in substance and not merely

in form. Knetsch, 364 U.S. at 365. For an indebtedness to exist

in substance, the borrower must obtain the use of funds which he

would not otherwise have enjoyed, and the lender must part with

the use of funds from which it would have otherwise derived a

benefit. See Golsen I; see also Rev. Rul 54-94, 1954-1 C.B. 53.

Enforceability of a debt under state law does not necessarily

mean that it is an "indebtedness" for Federal tax purposes.

Peerless Industries v. United States, 94-1 U.S.T.C. | 50,043

(E.D. Pa. 1994), aff'd in an unpublished opinion, 37 F.3d 1488

(3d Cir. 1994).

As Taxpayer did not acquire, and Insurer did not forgo, the

use of any funds as a result of the loans, the Field correctly

determined that the purported policy loans in this case did not

produce "indebtedness" for tax purposes.

(b) Whether Taxpayer, in substance, paid or accrued "interest" for

Federal tax purposes.

The Field also contends that the amounts paid by Taxpayer

and denominated as "interest" by the parties do not, in

substance, represent compensation for the use or forbearance of

money. A number of arguments are made to support this

conclusion.

The first is that, as discussed above, Taxpayer did not

obtain and Insurer did not forgo the use of funds so that there

is no "indebtedness."

In addition, the Field contends that the parties'

characterization of certain amounts as "interest" disregards both

the manner in which the amounts are determined and the person

with the power to determine the rate to be paid. The amounts do

not represent a charge determined by Insurer (as lender), based

upon its judgment about overall market interest rates and the

particular characteristics of a policy loan secured by policy

value. Instead, the "interest" rate is effectively controlled by

Taxpayer and unrelated to the underlying risk.

199901005

- 26 -

To support its contention, the Field points out that the

formula used to derive the adjustable loan rate under Form F,

designed for large corporate purchasers, produces a rate

substantially higher than the interest rates under other life

insurance policies available to less creditworthy purchasers.

Further, unlike a typical insurance policy loan, the policy loan

rate is changeable annually at the option of the policyholder.

Although the borrowing rate on a policy loan and the

crediting rate for policy value securing that loan are often

linked (a process called "direct reflection"), the rate chosen as

the base generally bears some relationship to the insurance

company's investment practices by being keyed to a general

commercial rate -- in most cases, the Moody's Average Corporate

rate. Because the structure of Form F's borrowing and crediting

rates produced a one percent profit spread regardless of the rate

chosen, Insurer was indifferent to the level of the adjustable

loan interest rate charged, a factor not present in most lending

transactions, although common with policy loans.

The Field contends that the lack of an "interest" character

is further demonstrated by Taxpayer's choice of the higher of the

two available loan interest rates for each year of the program.

Taxpayer had the option, exercisable annually, to borrow at a

fixed or adjustable loan interest rate that would apply to all

outstanding loans, as well as to that year's loans, for all

future policy years until changed by Taxpayer. Taxpayer knew

both the fixed and adjustable borrowing rates before making its

annual decision about which interest rate would apply. For each

year of the program, the adjustable loan rate was substantially

greater than the fixed loan rate. Although choosing the fixed

loan rate would allow Taxpayer to borrow at a significantly

reduced cost, Taxpayer nonetheless always chose the higher

adjustable loan rate.

Taxpayer contends that choosing the higher adjustable loan

rate made economic sense because this choice guaranteed that its

borrowing costs were capped at the one percent spread between the

adjustable loan and crediting rates. Taxpayer also claims that

the interest rates on its COLI policy loans were well within the

range of commercial market rates for loans and that the policy

loan rates correlate reasonably well to its average interest

expense for short-term borrowing. Taxpayer points out that the

policy loan interest rate, in some years, is less than the

interest rate applicable to large taxpayers' tax underpayments

under section 6621(c). Taxpayer further claims that the policy

loan interest rates were in the range of the short-term rate

under section 482 for respecting loans between related parties.

In rebuttal, the Field argues that both Taxpayer and Insurer

understood that the fixed loan rate would not be elected

regardless of net cost. There is no evidence that Taxpayer

- 27 - 199901005

inquired about the fixed loan crediting rate in any year. In

later years, when Insurer did declare a crediting rate applicable

to policies with fixed rate loans, the spread between the

crediting rate and the interest rate for fixed rate loans was the

same one percent charged on adjustable rate loans. Nevertheless,

Taxpayer chose the higher rate because it improved the after-tax

returns on the program by increasing the claimed interest

deduction and the amount credited to the COLI policies' tax

deferred inside buildup.

"Interest" is compensation paid for the use or forbearance

of money. See, e.g., Old Colony R.R. Co. v. Commissioner, 284

U.S. 552 (1932); Deputy v. DuPont, 308 U.S. 488 (1940). Interest

is the charge per unit of time for the use of borrowed money.

Thompson v. Commissioner, 73 T.C. 878, 887 (1980). In short,

interest is the equivalent of "rent" for the use of funds.

Dickman v. Commissioner, 465 U.S. 330, 337 (1984). This isa

defining feature of interest.”

No deduction for interest is allowed where a taxpayer does

not, in substance, pay an amount for the use of borrowed money.

Knetsch, supra, 364 U.S. at 365; Golsen I, 54 T.C. at 753; Rev.

Rul. 54-94, supra. In determining whether a payment constitutes

interest on indebtedness, economic realities govern over the form

in which a transaction is cast; labels are not determinative.

Amounts that are compensation for the use or forbearance of money

are treated as interest regardless of how the parties designate

the amounts. See, ¢.g., Rev. Rul. 69-188, 1969-1 C.B. 54 (loan

processing fee (points)); Rev. Rul. 69-290, 1969-1 C.B. 55

(amount paid for privilege of being granted a loan); L-R Heat

Treating Co. v. Commissioner, 28 T.C. 894, 897 (1957) (bonus or

premium paid by borrower to obtain loan). Conversely, amounts

that are not compensation for the use or forbearance of money are

not treated as interest even if the amounts are designated as

"interest" by the parties. See, e.g., LaCroix v. Commissioner,

61 T.C. 471 (1974) (purported interest payment treated as a

deposit or down payment on principal due); Rev. Rul. 69-189,

1969-1 C.B. 55 (statement by lender that entire loan charge is

interest not sufficient if facts indicate that a portion of the

charge is attributable to services performed in connection with

the borrower's account).

We conclude that, based on the facts and circumstances

described, the amounts denominated as "interest" by Taxpayer and

Insurer did not, in substance, represent compensation for the use

or forbearance of money. Instead, the amounts denominated as

23 A second defining feature of interest, i.e., the need to

compensate the creditor for the risk of nonpayment associated

with the debtor, is generally not present in an insurance policy

loan context because the loan is fully secured by policy value.

199901005

- 28 -

"interest" were paid to support an interdependent and circular

structure of charges and credits, the purpose of which was to

increase Taxpayer's tax deductions (while simultaneously

increasing the amounts credited to the COLI policies' tax

deferred inside buildup).

(c) Whether Taxpayer possessed a non-tax, business purpose for

the financing transaction used to acquire the COLI contracts.

Taxpayer contends that it had several non-tax business

reasons for engaging in the COLI program. First, Taxpayer

contends that the economics of the COLI policies per se imbues

the purchaser with a legitimate business justification for their

purchase. That is, Taxpayer claims that it is inherently a

legitimate transaction for a business to purchase life insurance

policies that provide appreciable net death benefits or that can

be reasonably expected to produce a pre-tax gain over the

duration of the insurance program. Taxpayer claims that its COLI

policies have these characteristics.

In addition, Taxpayer claims that it entered into the COLI

program to finance unfunded employee benefit obligations.

Taxpayer argues that in Cen-Tex, 377 F.2d at 692, the Fifth

Circuit explicitly endorsed the leveraged purchase of life

insurance to finance deferred compensation, and that the Sixth

Circuit in Woodson-Tenent Laboratories adopted that conclusion.

The Field contends that Taxpayer's COLI financing

arrangement did not have a non-tax purpose but rather was

motivated by the tax benefits to be derived from deductions for

interest paired with tax-deferred inside buildup under the COLI

policies. Several arguments are made to support this contention.

The Field contends that documents prepared contemporaneously

with Taxpayer's COLI transaction, and correspondence between the

Insurance Agent and Insurer as to policies issued on Form F

generally, demonstrate that Taxpayer's overriding motivation in

entering into the financing arrangement was its desire to obtain

the maximum tax benefit from the deductibility of interest and

accompanying tax-deferred inside buildup, and hence the highest

possible after-tax return. The documents fail to link Taxpayer's

stated purpose for purchasing the plan (that is, to finance

employee benefits) and the benefits anticipated from the COLI

program. Although Taxpayer was aware of its large liabilities

for employee benefits, no specific health care commitments are

identified nor is any explanation made as to how any health care

commitments would be "funded" by the program.

The Field also argues that no rational relationship exists

between the financing of unfunded employee benefits and

Taxpayer's COLI program. Absent tax benefits due to interest

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- 29 -

deductions, the "additional profits" that Taxpayer claims its

COLI program produced are illusory. The "profits" exist only if

the costs associated with producing those amounts, primarily the

COLI loans, are disregarded. Taxpayer's contemporaneous

financial projections indicate that Taxpayer would transfer more

cash to Insurer yearly than it would receive from Insurer.

Taxpayer also knew that if it chose to cancel the COLI Plan, the

policy value payable to Taxpayer after repayment of its COLI

loans would always be significantly less than the actual cash

paid to Insurer. Accordingly, the Field contends that Taxpayer

could not have reasonably expected the cash flowing to it, even

including death benefits, to correspond to employee benefits

costs incurred at the time of the employee's death. Nor could

Taxpayer have reasonably expected the policy values (including

dividends and interest credited thereto), after taking into

account the loans and the cost of the policy loans, to produce

positive financial results.

In addition, the Field points out that the proceeds from the

COLI program were not earmarked in any way for the provision of

employee benefits. There is also nothing to indicate how the

apparently arbitrary Amount H or Amount J premium used for each

insured employee relates to, or was established to account for,

Taxpayer's purported need to secure death benefits sufficient to

finance employee benefits. Other features, such as large early

year policy values, are discussed as desirable for their

improvement on COLI policies' rates of return, but without

explanation as to how these values would better match the COLI

program gains to the costs of anticipated employee benefits.

Instead, Taxpayer's Assistant Treasurer summed up the operation

of the program as follows: "The economics of the program are

essentially generated by the fact that we get tax relief on the

interest expense associated with borrowing against the cash value

of the policies, while the investment return built up within the

policies and paid out to [Taxpayer] as death benefits are

received as tax-free income."

The Field also contends that Taxpayer did not need to borrow

from Insurer to accomplish the purchase of insurance benefits.

For the first five years of the plan, Insurer charged Taxpayer

total premiums of $143 million, which amount was approximately 25

times Insurer's cost of providing insurance (the mortality

charge). Despite the magnitude of the stated premiums due,

Insurer required Taxpayer to pay only slightly less than $18

million in cash annually in the first five years towards these

charges; the balance of the premiums due was satisfied by the

circular flows related to loans, dividends, and withdrawals.

Similarly, although Insurer charged Taxpayer $150 million in

interest during the first five years of the program, Taxpayer

paid only $77 million in cash toward these charges. The Field

contends that the parties anticipated from the beginning that

Taxpayer would never be required to pay the bulk of the purported

199901005

premium and interest charges other than by means of the circular

cash flow devices. As Insurer was never going to require any

more cash to support the insurance benefits than the net amounts

from Taxpayer as originally illustrated, Taxpayer's borrowing

served no non-tax purpose. In fact, the cash Taxpayer paid to

Insurer approximated Insurer's cost of insurance, expenses, and

profit; this is indicative of the true substance of the

transaction, i.e., the payment of nondeductible premiums. See

Golsen I, supra, 54 T.C. at 753 (holding that the net cash that

the insured paid to the insurance company was the true cost of

the insurance purchased) .

-~ 30 -

The Field also points to Taxpayer's indifference to the

program's projected pre-tax losses. The Insurance Agent provided

Taxpayer with several projections of the anticipated performance

of the COLI program Taxpayer was considering for purchase. All

of the projections showed that the COLI program would generate

pre-tax losses and after-tax gains for at least the first forty

years of the program. There is no indication in Taxpayer's

correspondence with Insurance Agent, nor in Taxpayer's internal

memoranda, that Taxpayer was concerned about the pre-tax loss

aspect of the projections.

In rebuttal, Taxpayer argues that the Field's approach

effectively requires the purchase of term insurance rather than

whole life insurance coverage. Taxpayer argues that its

borrowing made possible the many benefits associated with whole

life coverage.

Additionally, Taxpayer contends that the Field's focus on

the tax effects of the borrowing component of the overall

transaction is misguided. Specifically, Taxpayer believes that a

leveraged purchaser should be in the same economic position after

tax as a purchaser who uses working capital. A taxpayer who

purchases a life insurance contract using working capital reduces

its taxable income by the income that would otherwise have been

earned on the assets consumed in the purchase. In contrast, a

taxpayer that uses borrowed funds to purchase a life insurance

contract continues to receive the income generated by its working

capital but incurs an interest expense with regard to the

borrowed funds. Taxpayer argues that, absent a statutory

disallowance provision, a leveraged purchaser of a life insurance

contract should receive a tax benefit from the reduction of its

taxable income by the amount of interest paid. Otherwise, the

taxpayer who borrows is taxed more heavily than the taxpayer that

uses its working capital.

We agree with the Field that the interest is not deductible

under section 163. A transaction is recognized for tax purposes

only if there is some non-tax purpose for the entire transaction.

See Sheldon v. Commissioner, 94 T.C. 738, 759 (1990). The key to

this determination is ascertaining whether the transaction is

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