UNITED STATES TAX COURT
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T.C. Memo. 1999-268
UNITED STATES TAX COURT
UNITED PARCEL SERVICE OF AMERICA, INC. ON BEHALF OF ITSELF AND
ITS CONSOLIDATED SUBSIDIARIES, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 15993-95.
Filed August 9, 1999.
Joel V. Williamson, J. Allen Dougherty, Maurice M. Agresta,
Joseph R. Goeke, Kim Marie Boylan, Roger J. Jones, William A.
Schmalzl, Daniel Dumezich, Thomas L. Kittle-Kamp, Clisson S.
Rexford, Scott M. Stewart, Thomas C. Durham, Gayle L. Elsner,
Michelle J. Kim, Richard T. Morrison, Mary Ellen Kiruit, and
Wayne S. Kaplan, for petitioner.
Theodore J. Kletnick, Suzanne Corbin, Curt M. Rubin, William
S. Garofalo, Maria T. Stabile, Elizabeth A. Maresca, Halvor Adams
III, Stephen C. Best, Paul S. Manning, Anthony J. Kim, and Ron J.
Mizrachi, for respondent.
- 2 -
MEMORANDUM FINDINGS OF FACT AND OPINION
RUWE, Judge:
Respondent determined deficiencies in
petitioner's Federal income taxes and additions to tax as
follows:
Year
Deficiency
1983
1984
$2,330,687
64,870,674
Additions to Tax
Sec. 6653(a)(1) Sec. 6653(a)(2)
-$3,243,534
-50% of the
interest due
on $45,122,925
Sec. 6661
-$11,280,731
Respondent also determined that petitioner is liable for
increased interest pursuant to section 6621(c)1 on the portion of
the 1984 deficiency attributable to respondent's determination
that excess value charges are includable in petitioner's income.
After concessions,2 the issues for decision are:
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
2
Respondent concedes that $8,855,121 of income earned on
funds invested by Overseas Partners, Ltd. (OPL), is not income to
petitioner pursuant to sec. 482. Respondent determined that if
petitioner must include excess value charges in gross income,
petitioner is entitled to a corresponding deduction of
$32,543,889 for shippers' claims.
Respondent concedes that $325,740 of the $1.2 million paid
Liberty Mutual Insurance Group (Liberty Mutual) for claims
adjustment services is deductible. Respondent further concedes
the deductibility of $50,000 paid by petitioner to Liberty Mutual
for the retained layer of liability for losses above $250,000.
These concessions reduce the amount of the deduction at issue
(continued...)
- 3 (1)
Whether amounts collected by petitioner as "excess
value charges" (EVC's)3 from its customers must be included in
gross income in 1984 pursuant to section 61.
We hold that EVC's
must be included in petitioner's income.4
(2)
Whether petitioner is entitled to deductions under
section 162 for any amounts paid to National Union Fire Insurance
Co. of Pittsburgh, Pennsylvania (NUF).
We hold that petitioner
is not entitled to those deductions.
(3)
Whether respondent properly disallowed petitioner's
deduction of $11,151,675 paid to Liberty Mutual Insurance Group
(Liberty Mutual) as California workers' compensation premiums.
We hold that the deduction is allowable.
(4)
Whether petitioner is liable for an addition to tax
pursuant to section 6653(a)(1) and (2) for negligence or
2
(...continued)
with respect to the Liberty Mutual policy to $11,151,675.
In the notice of deficiency, respondent disallowed sec. 38
investment tax credits of $1.6 million and $19,006,175 reported
by petitioner in 1983 and 1984, respectively. On Sept. 15, 1997,
the parties filed a Joint Motion to Sever, requesting that the
Court sever the investment tax credit issue. On Sept. 15, 1997,
the motion to sever the sec. 38 investment tax credit was
granted. The parties subsequently engaged in mediation and
settled this issue.
3
Throughout the opinion, "EVC" represents "excess value
charge" and "EVC's" represents "excess value charges".
4
As a result of our holding, we need not consider
respondent's alternative arguments under secs. 482 and 845(a).
- 4 intentional disregard of rules or regulations for the tax year
1984.
We hold that it is.
(5)
Whether petitioner is liable for an addition to tax
under section 6661 for a substantial understatement of tax for
1984.
We hold that it is.
(6)
Whether petitioner is liable for increased interest on
substantial underpayments attributable to tax-motivated
transactions under section 6621 for 1984.
We hold that it is.
Some of the facts have been stipulated and are so found.
The stipulations of facts are incorporated herein by this
reference.
At the time the petition was filed, petitioner was a
Delaware corporation with its principal office in Atlanta,
Georgia.
FINDINGS OF FACT
I.
General
A.
United Parcel Service
Petitioner is the largest motor carrier in the United States
with a principal business consisting of the pickup and delivery
of small packages and parcels.
During 1983 and 1984, petitioner
conducted its business through wholly owned subsidiaries in the
United States, Canada, and West Germany.
Petitioner, United
Parcel Service of America, Inc. (UPS), had several wholly owned
subsidiaries, including United Parcel Service, Inc.--New York
(UPS-New York), United Parcel Service, Inc.--Ohio (UPS-Ohio), and
- 5 United Parcel Service General Services Co. (UPS-General
Services).
UPS-General Services provides management services to
affiliates of UPS.
UPS-New York provides ground delivery
services in the eastern region of the United States.
UPS-Ohio
provides ground delivery services in the central and western
region of the United States.
Within the United States,
petitioner generally provided statewide intrastate service5 and
interstate service between all points in the States and the
District of Columbia.6
Another subsidiary, UPS-Air, provided air
delivery service for packages traveling partially by air.
Petitioner had 62 operating districts in the United States.
Each district had an operational and administrative staff and a
manager who was responsible for all district operations.
The
district manager reported to 1 of 11 regional managers, who, in
turn, reported to the corporate headquarters.
Generally, each package picked up by a UPS driver is
delivered to a package operating center.
At each center,
packages are unloaded from package cars and loaded onto trailers,
which haul the packages either directly to another center for
delivery or to a UPS sorting hub.
At the hub, packages are
5
Petitioner did not provide intrastate service within Texas.
6
There were limited exceptions pertaining to Texas, Hawaii,
and Alaska in which petitioner did not provide full services.
- 6 sorted by destination, loaded back onto trailers, and hauled to
the appropriate center, where they are loaded onto package cars
for delivery.
Packages traveling by air are sorted at an air hub
and transported to the center for delivery.
B.
Shipping Rates and Tariffs
As a domestic motor common carrier, petitioner was regulated
by the Interstate Commerce Commission (ICC).
Petitioner's
intrastate service was regulated by State transportation agencies
and public utility commissions.
As an air carrier, petitioner
was regulated by the Civil Aeronautics Board.
The ICC issued Certificates of Public Convenience and
Necessity as evidence of the carrier's authority to engage in
transportation as a common carrier by motor vehicle.
UPS-New
York and UPS-Ohio each filed tariffs7 and tariff supplements with
the ICC.8
The ICC tariffs and tariff supplements contained
provisions which governed the rates and services offered by
petitioner to its shippers.
The tariffs filed with the ICC by
7
A tariff is a "public document setting forth services of
common carrier being offered, rates and charges with respect to
services and governing rules, regulations and practices relating
to those services." Black's Law Dictionary 1457 (6th ed. 1990).
8
Generally, a motor common carrier must publish and file
with the ICC tariffs containing the rates for transportation it
may provide. See Trucking Industry Regulatory Reform Act of
1994, 49 U.S.C. sec. 10762(a)(1) (1994); see also Fabulous Fur
Corp. v. United Parcel Serv., 664 F. Supp. 694, 695 (E.D.N.Y.
1987).
- 7 UPS-New York and UPS-Ohio which were in effect during the years
in issue contained, among other things, provisions relating to
the scope of operations, damaged and unclaimed property, methods
of determining rates, and filing of claims.
With respect to the
scope of operations, the tariffs for both UPS-New York and UPSOhio provide:
"Rates and provisions named in this tariff, or as
amended, are limited in their application to the extent of the
operating rights set forth below."
The provisions of the tariffs
governed the rates and services offered by petitioner to its
shippers.
The ICC tariffs filed by UPS-Ohio and UPS-New York were
similarly filed with the State transportation commissions of most
of the States.9
Individual State filings were required in the
9
The tariffs filed by UPS-Ohio were filed with the State
transportation commissions of Alabama, Arkansas, Colorado,
Georgia, Idaho, Illinois, Indiana, Iowa, Kansas, Kentucky,
Louisiana, Michigan, Minnesota, Mississippi, Missouri, Montana,
New Mexico, North Carolina, North Dakota, Ohio, Oregon, South
Carolina, South Dakota, Tennessee, Utah, and Washington.
The tariffs filed by UPS-New York were similarly filed with
the State transportation commissions of Connecticut, Maryland,
Massachusetts, New Hampshire, New York, Pennsylvania, Rhode
Island, Vermont, and West Virginia.
In 1983 and 1984, the States of Arizona, Delaware, Florida,
Maine, New Jersey, and Wisconsin did not regulate intrastate
motor common carriers. In Wyoming, no regulatory filing was
required.
In Texas, intrastate service was limited to the
Dallas-Fort Worth, Houston, and San Antonio metropolitan areas.
In Hawaii, an intraisland service was commenced between all
islands of the State. Petitioner did not operate in Alaska
(continued...)
- 8 States of California, Hawaii, Nebraska, Oklahoma, and Virginia.
Whenever UPS-Ohio or UPS-New York made a change to its tariff, a
tariff supplement was filed with the ICC.
1.
Pre-1984
a.
Excess Value Charges
Petitioner refers to its customers as shippers.
Petitioner
charged its shippers a fee for the shipment of each package based
on the weight of the package, the distance that the package would
travel, the value of the package, and various accessorial
services offered by petitioner.
Petitioner's rates were governed
by the tariffs, which it submitted to the ICC and the various
States.
The tariffs10 submitted to the ICC provided, among other
things, for rates in cents per package and per pound as follows:
ITEM 1000
*
*
*
*
*
*
*
The rate for delivery of packages, released to value
not exceeding $100 per package, shall be 116.0¢ per
package plus the following rates per pound or fraction
thereof:
9
(...continued)
outside the regulatory-free zones.
10
The provisions of the tariffs were similar except that the
tariff provided by UPS-Ohio further included "item 1040", which
does not affect our decision, and we will not reproduce it in the
opinion.
- 9 Zone
Rate
2....................8.9¢
3...................11.8¢
4...................15.4¢
5...................19.5¢
6...................25.3¢
7...................31.5¢
8...................38.5¢
The rates published in item 1000 applied to all the packages
shipped by petitioner.
Petitioner provided its shippers with a rate card that
enabled shippers to determine what petitioner would charge for a
particular shipment.
The distance a package was to travel
determined the number of zones from the point of origin that the
package would cross.
A package shipped to zone 2, for example,
would travel approximately 150 miles.
3 would travel up to 300 miles.
A package shipped to zone
Zone 8 was the furthest zone and
distance a package would travel within the United States.
Zones
2 through 8 were represented as column headings at the top of the
rate card.
Weight categories also determined how much petitioner
charged shippers for transporting a particular package.
The rate
card listed weights down the left side of the table in 1-pound
increments from 1 pound to 50 pounds.
By cross-referencing the
zone and the weight, a shipper could determine the exact shipping
charge for a particular package whose released value did not
exceed $100.
There was an additional charge under the tariff
- 10 when a shipper declared the value of the package to be in excess
of $100.
Under the tariff, shippers could also elect to purchase
accessorial services that had additional charges.
Accessorial
services included, among other things, collection on delivery
(COD) and acknowledgment of delivery (AOD).
With respect to damaged and unclaimed property, the tariffs
provided the following:
DAMAGED AND UNCLAIMED PROPERTY
Whenever property is damaged by the carrier in the
course of transportation, the carrier will tender the
damaged property to the shipper and offer to pay for
the damage, not to exceed the actual or declared value
of the property, whichever is the lower. If the
shipper so elects, the carrier will pay the full actual
or declared value of the property, whichever is lower,
and title of the property shall thereupon pass to the
carrier.
Thus, petitioner was obligated to shippers under the tariffs to
pay up to the actual or declared value for loss or damages caused
by petitioner during the course of transporting the package.
Petitioner applied for and received from the ICC an order
generally allowing petitioner and its shippers to agree in
writing that petitioner's liability would be limited to a
released value not exceeding $100 per package.
With respect to
the released rate and EVC, the tariff provided as follows:
To determine rates in this tariff:
- 11 1.
Refer to governing rate basis tariff to
determine appropriate zone for use in
determining the poundage rate.
2.
Refer to Item 1000 or 1040 herein.
Released value of shipment:
The rates published in Item 1000 or 1040 are
applicable only when the value of the property
declared in writing by the shipper or agreed upon
in writing as the released value thereof is as
follows:
Released to a value
not exceeding $100
per package or
article not enclosed
in a package
Apply the rates as
published in Item
1000 or 1040.
Released to a value
exceeding $100 per
package or article
not enclosed in a
package
Apply the rates as
published in Item
1000 or 1040 as
base rates, plus a
value charge of 25
cents for each $100
or fraction thereof
of value in excess
of the valuation in
which the base rate
applies.
Under the provisions of the tariff, petitioner received from
its shippers 25 cents for each additional $100 of declared value
of a package shipped, and petitioner referred to the additional
amount as an "excess value charge" (EVC).
If a shipper paid the
EVC of 25 cents per $100 of value, part or all of the declared
value of the package would be paid to the shipper in the event
that the package was damaged, lost, or destroyed.
In the event
that a shipper did not declare the value of the package to be in
- 12 excess of $100, petitioner was liable to the shipper for the
value of the package up to $100.
In June 1983, petitioner filed supplements to its ICC
tariffs amending the provision related to the method of
determining rates for shippers under the original tariff.
The
supplements provided an additional clause with respect to the
method of determining rates:
Unless otherwise directed by the shipper, the carrier
may remit excess valuation charges to an insurance
company as a premium for excess valuation cargo
insurance for the shipper's account and on its behalf.
If the carrier does so, claims for loss of or damage to
the shipper's property will be filed with and settled
by the carrier on behalf of the insurance company. In
the event that the insurance company fails to pay any
claim for loss of or damage to the shipper's property
under the terms of its policy, the carrier will remain
liable for loss or damage within the limits declared
and paid for.[11]
Although the supplements were filed June 1983 and became
effective July 1983, petitioner did not remit EVC's to an
insurance company before 1984.
The declared value in excess of $100 is indicated on
petitioner's package pickup record.12
The package pickup record
11
Identical changes were made to petitioner's State tariffs.
12
Petitioner's pickup record states:
Unless a greater value is declared in writing on this
receipt, the shipper hereby declares and agrees that
the released value of each package or article not
enclosed in a package covered by this receipt is $100,
(continued...)
- 13 was used to enter billing information into petitioner's billing
system.
Billing information for regular customers and shippers
who shipped parcels from petitioner's customer counters was
entered into petitioner's computer system regularly by each
district, and petitioner billed its regular customers weekly.
The bills sent to petitioner's regular shippers reflected all
amounts to be collected from those shippers.
Included, and
itemized separately, on those bills were the EVC's and other
miscellaneous charges.
All amounts collected from shippers by
petitioner, including amounts for EVC's, were deposited into
petitioner's bank accounts.
For the taxable year ended December 31, 1983, EVC's billed
and/or collected from shippers were included in petitioner's
reported income for tax, financial accounting, ICC, State
regulatory, and Securities and Exchange Commission (SEC)
reporting purposes.
b.
Claims
Shippers' claims were governed by the tariffs submitted by
petitioner to the ICC and the various States.
12
Petitioner's
(...continued)
which is a reasonable value under the circumstances
surrounding the transportation. The entry of a C.O.D.
amount is not a declaration of value. In addition, the
maximum value for an air service package is $5,000 and
the maximum carrier liability is $5,000. Claims not
made to carrier within 9 months of shipment date are
waived. * * *
- 14 tariff 201-C effective January 31, 1983, included provision 510
relating to filing of claims, which provided:
All claims for loss or damage to property transported
or accepted for transportation in interstate or
intrastate commerce must be in writing and must include
reference to the pickup record number and date or
copies of other documents sufficient to identify the
shipment involved; must assert liability of the carrier
for alleged loss or damage; must make claim for payment
of a specified or determinable amount of money; and
must be accompanied with a copy of the original invoice
or, if no invoice was issued, other proof, certified to
in writing, as to the value of the property or extent
of the damage. * * *
Under tariff provision 510, a shipper was required to assert that
petitioner was liable for the alleged loss or damages.
Tariff
201-C also contained provision 520 limiting the time for filing
claims.
Provision 520 provided:
As a condition precedent to recovery, claims must be
filed in writing with the carrier within nine months
after delivery of the property or, in case of failure
to make delivery, then within nine months after a
reasonable time for delivery has elapsed; and suits
shall be instituted against the carrier only within two
years and one day from the day when notice in writing
is given by the carrier to the claimant that the
carrier has disallowed the claim or any part or parts
thereof specified in the notice. Where claims are not
filed or suits are not instituted thereon in accordance
with the foregoing provisions, the carrier hereunder
shall not be liable, and such claims will not be paid.
Under provision 525, petitioner was required to promptly
investigate "each claim filed against [petitioner]".
With
respect to disposition of claims, tariff 201-C provides:
"Carrier after receiving a written claim for loss or damage to
- 15 property transported will pay, decline, or make a firm compromise
settlement offer in writing to the claimant within 120 days after
receipt of the claim by the carrier".
UPS-New York and UPS-Ohio,
through their respective district offices, processed all claims
for loss or damage to parcels, including any excess value portion
of a claim.
When a shipper was in need of a verification of the
status of a shipment, the shipper initiated an inquiry, by either
telephone or mail, which was referred to the delivery information
department of the district from which the shipment was made.
Tracing requests were initiated as a result of shippers'
inquiries.
After the tracing request was completed, it was
transmitted to the destination district via computer.
If the
record showed that the package was delivered and signed for, the
clerk made a copy of the delivery record.
If the tracing
procedure was unsuccessful, petitioner assigned a loss damage
investigation number to identify the shipper claim.
Petitioner remitted amounts for claims processed by UPS-New
York and UPS-Ohio from petitioner's central bank account.
Generally, a single check was issued to a shipper if the shipper
had declared excess value and a claim for loss or damage was
paid.
Before 1984, petitioner reported claims paid in excess of
$100 as an expense for tax, financial accounting, ICC, State
regulatory, and SEC reporting purposes.
- 16 Petitioner made efforts to reduce claims, including excess
value claims.
Petitioner advised its drivers to pay extra
attention to declared value packages.
Petitioner also incurred
added handling costs in connection with excess value packages.
In Metro New York, Long Island, New Jersey, and Metro
Chicago, petitioner took special precautions to avoid loss or
damage to high-value packages.
For instance, in New York, with
respect to jewelry and similar items, petitioner's driver would
segregate them in his load, and upon arrival at petitioner's
facility, a designated clerical person would meet the driver and
take the packages containing the jewelry or other items.
Under
certain circumstances, the packages would be specially bagged and
tagged.
Thereafter, the appropriate contact person at the next
destination of the package would be informed of the position of
the package on the trailer.
When the trailer reached its
destination, a person would be present to retrieve the bag.
Petitioner instituted and used special parcel handling
procedures, which involved segregating and protecting high-value
parcels in other districts as well.
Petitioner referred to the
special handling procedure as "controlled parcel handling".13
13
This procedure was not used in the Metro New York, Long
Island, New Jersey, and Metro Chicago districts. Controlled
parcel handling procedures that were stricter than the controls
set forth in the loss prevention manual were applied in Metro New
York, Long Island, New Jersey, and Metro Chicago.
- 17 Petitioner maintained a "Loss Prevention" manual that contained
written standards and procedures on prevention of loss associated
with the shipment of packages.
Controlled parcel handling was
addressed in a specific section of the loss prevention manual.
As part of the controlled handling procedures, petitioner
performed audits in its hub, transportation, and delivery
operations to ensure security of high-value packages.
Petitioner
considered these procedures to be expensive and time consuming.
c.
Negotiations To Change Petitioner's Method of
Handling Excess Value Charges
Mr. Kenneth Johnson was the head of petitioner's insurance
department.
After various discussions with Mr. Walter
Danielewski, petitioner's chief financial officer (CFO),
regarding the manner in which petitioner collected EVC's, Mr.
Johnson contacted the brokerage firm of Frank B. Hall (Hall).
(1)
Hall
Hall was one of the largest insurance brokerage firms in the
world.
in 1981.
Mr. Johnson had first worked with representatives at Hall
At that time, Mr. George Corde, an experienced vice
president of Hall, worked with Mr. Johnson in connection with
insurance for petitioner's aircraft and other matters.
Mr.
Thomas Garrity was a Hall vice president who worked for Mr.
Corde.
- 18 In 1982, Mr. Johnson met with representatives of Hall to
discuss petitioner's EVC's.
At their first meeting regarding
petitioner's EVC's, Mr. Corde advised Mr. Johnson of potential
alternatives that might be available to petitioner, including the
possibility of petitioner's forming its own insurance subsidiary.
Thereafter, Mr. Corde and Mr. Garrity attended meetings relating
to the planning, structuring, and implementation of petitioner's
subsidiary and petitioner's excess value activity.
In September 1982, at the request of petitioner, Hall
prepared a document titled "United Parcel Service--A Preliminary
Analysis of an Insurance Subsidiary" (preliminary analysis).
The
preliminary analysis indicated that Hall understood that
petitioner currently was liable to its shippers for the value of
any parcels lost or damaged up to $100.
The preliminary analysis
indicated that Hall understood that those parcels with values in
excess of $100 could be declared by the shipper, and the shipper
could secure protection at a cost of 25 cents per $100 of value
in excess of the first $100.
Hall further understood that while
the protection provided by the EVC was not considered to be
insurance, insurance could be provided by a UPS-owned insurance
company.
The preliminary analysis then proceeded to make the
following assumptions and conclusions:
We have been advised that the revenues generated by
this "declared value" protection for the 1981 year
approximated $67,000,000 and that the loss in excess of
- 19 $100 per claim approximated $20,000,000. In Exhibits
II-1A and II-2A we have attempted to set forth the
implications of this coverage to * * * [petitioner] on
a net after tax basis. In this Exhibit we have made
the following assumptions:
1.
Revenues are in equal amounts payable at mid
points of quarters;
2.
Expenses as percent of gross premium = 0%;
3.
Loss ratio = .299;
4.
2;
Duration (in years) to ultimate value of losses =
5.
Annual payout pattern - 70%, 30%;
6.
Plan reimburses gross paid losses for each month
at the end of the following month;
7.
Applicable Federal Income Tax rate as percentage =
46%; and,
8.
Effective rate of interest per annum as percent =
12%.
Based upon these assumptions review of Exhibits II-1A
and II-2A disclose that the contribution of this
program to * * * [petitioner's] after tax earnings is
$31,001,618 at the end of the second subsequent year
when all losses are closed.
On February 24, 1983, a meeting was held at Hall's offices
in Briarcliff Manor, New York, to discuss petitioner's excess
value activity.
In attendance at this meeting were:
Messrs.
Danielewski, Johnson, Pat Edmunds, Jerry Stein, and Jack
McGuinness representing petitioner; Mr. Allen Dougherty, as
petitioner's attorney; and Messrs. Corde, Garrity, and Roger Wade
representing Hall.
Mr. Corde prepared a memorandum dated March
- 20 1, 1983, that summarized the purpose and content of the February
24 meeting at Briarcliff Manor.
The memorandum states:
The purpose of this meeting was to consider Frank B.
Hall's proposal presented to * * * [petitioner] last
September 1982 which dealt with the feasibility of
creating a subsidiary insurance company. The subject
reviewed in the report dealt with declared value
insurance and the utilization of an insurance
subsidiary to handle customer risk of loss on property
in transit.
The topics discussed in our Thursday meeting focused
strictly on the declared value program and the
viability of converting this into an insured plan that
would produce, in the final analysis, an improved
economic result for * * * [petitioner]. The report
submitted by Hall dealt with the organization of a
United Parcel insurance subsidiary company. This new
insurance entity would assume reinsurance from a
licensed admitted US carrier who would underwrite the
declared value program.
During the February 24 meeting, petitioner's tax counsel,
Mr. Dougherty, expressed concern with the specifics of the Hall
proposal, and he believed that the proposal would not be viewed
favorably by the Internal Revenue Service (IRS).
Mr. Dougherty
suggested an alternative whereby petitioner would form an
insurance company in Bermuda to be owned by petitioner's
employees and, in this manner, such a company would be classified
as a noncontrolled foreign corporation.
Mr. Dougherty believed
that the Bermuda insurance company could accept reinsurance of a
licensed U.S. underwriter directly and not have U.S. tax
obligations on profits until risk funds were repatriated.
- 21 After all the alternatives were discussed, it was agreed
that petitioner would pursue the alternative to create an
insurance subsidiary to act as a reinsurer.
Further, the
insurance subsidiary would be owned by petitioner, and
ultimately, petitioner might adopt a long-range strategy of
transferring ownership in such a company to petitioner's
shareholders.
Finally, it was agreed that Mr. Danielewski and
other members of the UPS team would submit a proposal to senior
management based on the following financial projections, as
stated in Mr. Corde's March 1, 1983, memorandum:
UPS CURRENT POSITION
A:
Projected 1983 Declared Value Revenue
Estimated 1983 Losses
$69,900,000
$21,400,000
Pretax Profit
$48,500,000
Net After Tax Profit
$26,190,000
B-Alternative Program:
1.
2.
C:
Insured Declared Value Program (U.S. Front)
Estimated Annual Premium
*Estimated Expenses (6.5)
$69,900,000
$4,485,000
Net Underwriting Income
$65,415,000
UPS Insurance Subsidiary
Foreign Reinsurance Premium Income
Ceding Commission - 2-1/2%
$65,415,000
$1,747,500
Net Premium Income
Expected Losses
$63,667,500
$21,400,000
Underwriting Profit
$42,267,500
Projected Benefit to * * *
[Petitioner]
$16,077,500
- 22 *
Front Fee
Premium Tax
Federal Excise Tax
2.0
3.5%
1.0%
6.5%
The $16,077,500 projected benefit to petitioner is the amount of
Federal income tax petitioner would have otherwise paid and is
based on the assumption that the underwriting profit, which was
referred to as the "UPS Insurance Subsidiary" in Bermuda, would
not be subject to Federal income tax.
(2)
AIG/NUF
American International Group, Inc. (AIG), was a holding
company and the parent of over 500 subsidiary operating insurance
and subsidiary companies.
a subsidiary of AIG.
AIG Risk Management, Inc. (AIGRM), was
Mr. Joseph Smetana served as president and
CEO of AIGRM and senior vice president of NUF.
NUF was a wholly
owned subsidiary of AIG and operated as a domestic insurance
company.
On behalf of Hall, through a letter dated April 27, 1983,
Mr. Corde contacted Mr. Smetana.
In the letter, Mr. Corde
apprised Mr. Smetana of petitioner's plan regarding the EVC's.
Mr. Corde indicated in the letter that petitioner's plan
contemplated that the shippers' property handled by petitioner
would be insured under a master "Shippers Interest Policy".
Further, the letter indicated that the contract of insurance
would be issued to petitioner and would cover the property of the
owners, shippers, consignees, or other interested parties.
With
- 23 respect to the anticipated risk or exposure to AIG, the letter
stated:
The Shippers Interest Program is to be 100% reinsured
to Union International/Hamilton, Bermuda. Union will
then retrocede this risk to other insurers. This,
therefore, would leave the shippers interest issuing
carrier in a "fronting" capacity with essentially no
risk or exposure to loss under the program.
Finally, the letter requested that AIG submit a proposal on
petitioner's Shippers Interest Program setting forth:
a.
The fronting/administration fee it would require as the
issuing carrier.
b.
Estimated premium taxes applicable under this program.
c.
Its acceptance of Union International as the program
reinsurer.
d.
Acceptance and confirmation of * * * [petitioner] as
the authorized program administrator with total claim
settlement authority.
e.
The specific documentation required to be given to
shippers electing coverage under this program.
On April 27, 1983, Mr. Corde sent a letter to Mr. Robert
Sargent of Travelers Insurance Co. (Travelers) discussing
petitioner's excess value program and requested that Travelers
submit a proposal for the excess value program.
On May 20, 1983,
Mr. Sargent sent a letter to Mr. Corde outlining an alternative
for petitioner.
In a letter dated May 7, 1983, to Mr. Corde, Mr. Smetana
presented AIGRM's proposal for an excess value program.
In the
letter, AIGRM proposed that it would issue a single master
- 24 insurance contract that would cover the interests of petitioner's
shippers.
The proposal indicated that the documentation of
coverage under such a contract would be identified through a
"Service Instruction Agreement" and the declared value entry on
the bill of lading.
AIGRM's proposal was based upon insurance
coverage for values in excess of $100, at a premium charge of 25
cents per $100 of insured value in excess of $100.
things, AIGRM proposed that:
Among other
(a) Premiums be remitted by
petitioner to NUF on a monthly basis less any losses paid and
loss expense incurred; (b) petitioner administer all claims under
the policy on behalf of NUF; and (c) petitioner be responsible
for bad debts or uncollectible items since NUF had no control
over the payment of premiums by shippers.
Hall found the AIGRM
proposal to be more reflective of petitioner's requirements than
the Traveler's proposal and submitted the AIGRM proposal as its
recommendation for review by petitioner's management.
NUF prepared a "binder of insurance" under which it
described the insured as "United Parcel Service of America, Inc.
on behalf of its customers, shippers, consignees or other
interested parties, as Their Interest may Appear."
described the insurance as "Shippers Interest".
The binder
The rate or
premium under the binder was set at 25 cents per $100 of declared
value, and the insurance would become effective as of August 8,
1983.
- 25 However, on August 8, 1983, Mr. Corde sent a telex to Mr.
Smetana which stated:
[PETITIONER] HAS POSTPONED FINALIZATION OF SHIPPERS
INTEREST PROGRAM PENDING THEIR REVIEW AND EVALUATION OF
NEW TAX LEGISLATION CURRENTLY ON THE FLOOR OF THE HOUSE
OF REPRESENTATIVES WHICH WE UNDERSTAND CAME [sic] OF
COMMITTEE END OF LAST WEEK. WILL KEEP YOU COMPLETELY
APPRISED OF THE DEVELOPMENTS AS THEY OCCUR.
Petitioner and AIG continued to work together in planning
petitioner's Shippers Interest Program.
On October 25, 1983, Mr.
Corde of Hall sent Mr. Smetana of AIG a letter which, among other
things, proposed that changes be made to the wording of
petitioner's service explanation.
Petitioner's service explanation is a document regularly
provided by petitioner to its customers as part of a kit
containing other documents, upon commencement of the
relationship, upon request by customers, and upon other
occasions.
Service explanations were generally available to
petitioner's walkup customers upon request.
- 26 As of November 1983,14 petitioner's service explanation
stated:
Unless a greater value is declared in writing on the
pickup record, the shipper declares the released value
of each package or article not enclosed in a package,
to be $100. For each $100 or fraction thereof of value
per package or article not enclosed in a package, in
excess of $100, an additional charge, as stated on the
current rate chart, applies. Except if otherwise
directed by the shipper, the carrier will remit excess
valuation charges to National Union Fire Insurance
Company of Pittsburgh, PA as a premium for excess
valuation cargo insurance for the shipper's account and
on its behalf. When the carrier does so, claims for
loss of or damage to the shipper's property will be
filed with and settled by the carrier on behalf of the
insurance company. In the event that the insurance
company fails to pay any claim for loss of or damage to
the shipper's property under the terms of its policy,
the carrier will remain liable for loss or damage
within the limits declared and paid for. Shippers
Interest Policy IMB9310977 is available for inspection
at the office of the carrier. Claims not made within
nine months after receipt by the carrier of the
merchandise shall be deemed waived.
In December 1983, petitioner circulated to its shippers an
edition of its quarterly newsletter entitled "Roundups".
Within
the December Roundups, petitioner informed its shippers that
14
This service explanation was used throughout 1984.
Petitioner's service explanations, as revised in 1986 and 1988,
contained similar wording. These revisions both stated that
petitioner remained liable for loss or damage. However, the 1986
and 1988 revised service explanations state that petitioner "may"
remit EVC's to NUF as opposed to the "will remit" language in the
above excerpt. We note that the "may remit" language of the 1986
and 1988 revisions is the same language used in petitioner's
tariff. We also note that the "will remit" language in the
November 1983 service explanation could not have been effective
in 1983 since the NUF contract itself does not purport to apply
before January 1984.
- 27 petitioner intended to make permanent the practice of allowing
its drivers to leave packages at certain specified locations
without a signature.
With respect to the delivery of packages
without the normal signature, petitioner stated the following in
its newsletter:
[Petitioner] also will continue to assume liability for
lost and damaged packages up to $100, or the declared
value. It might seem that leaving packages even in
safe places risks theft, weather damage, denial of
delivery or other types of losses. Actually, claims
for lost and damaged packages declined in Indiana and
Iowa where we've had the most experience with the
program.
On December 28, 1983, representatives of AIG and NUF signed
an insurance policy, entitled "Shippers Insurance"15 and numbered
IMB 9310977, on behalf of NUF which listed the name and address
of the insured as follows:
NAME AND ADDRESS OF INSURED
Shippers, Consignees, Customers or other interested
parties, as their interest may appear with regard to
parcels shipped via United Parcel Service of America,
Inc. and/or its subsidiaries as now or hereafter
constituted (herein after referred to as UPS)
643 West 43rd Street
New York, New York
The address listed under the name and address of the insured
served as petitioner's world headquarters.
a term from January 1, 1984, until canceled.
The contract was for
15
NUF issued the
For reasons explained in our opinion, we will refer to the
agreement between petitioner and NUF as the Shippers Interest
contract.
- 28 contract in the State of New York with the understanding that it
was pursuant to the free trade zone legislation, article 63 of
the New York Insurance Law.
Clause 2 of the Shippers Interest contract states:
[Petitioner] will provide space on its "Pick-Up Record"
which will be labeled "Declared value if in excess of
$100.00". A declared value indicated by the Named
Insured in the space provided shall evidence the
existence and the amount of this insurance subject to
limits of liability provided herein. This insurance
shall not apply unless a declared value is indicated by
the Named Insured in the space provided in * * *
[petitioner's] "Pick-up Record".
Clause 6 of the Shippers Interest contract generally
provided that NUF was not liable for the first $100 of the value
of the property, and in no event did NUF's liability exceed the
declared value for surface shipments and a maximum of $25,000 per
package for air shipments.
The cancellation provision of the
contract stated:
This policy may be cancelled [sic] by the Named Insured
or * * * [petitioner] on behalf of the Named Insured by
mailing to the Company written notice stating when
thereafter such cancellation shall be effective. This
Policy may be cancelled [sic] by the Company by mailing
to the Named Insured or * * * [petitioner] at the
address shown in this Policy or last known address
notice stating when not less than thirty (30) days
thereafter such cancellation shall be effective. * * *
Under this provision, petitioner had the power to cancel the
Shippers Interest contract.
Clause 20 of the Shippers Interest contract addressed other
insurance and stated:
- 29 If there is any other insurance covering the
property insured hereunder, or * * * [petitioner's]
liability, if any, whether prior, subsequent to, or
simultaneous with this policy, which in the absence of
this insurance would cover the loss, damage or
liability hereby covered, then this Company shall not
be liable hereunder for more than the excess over and
above such other insurance. This clause, however,
shall not apply to insurance effected by a Named
Insured, and the existence of such insurance, or
payment of a loss thereunder, shall not constitute a
defense of any claim otherwise payable under this
Policy, nor shall such insurance be called on to
contribute to any loss payable hereunder.
Under clause 20, NUF was not liable in the event that
petitioner's liability for loss or damage to a shipper's package
was covered by another insurance policy unless the other policy
was "effected" by a shipper.
(3)
Affiliated FM Insurance
Policy
Petitioner maintained an insurance policy with Affiliated FM
Insurance Co. (AFM policy).
The AFM policy was issued on
December 27, 1982, and provided coverage from October 1, 1982 to
1985.
The AFM policy insured petitioner's property and liability
for, among other things, petitioner's interest in the "real and
personal property of others, including parcels held for delivery
and in transit for which petitioner may be liable or for which
the * * * [petitioner] may assume liability or agree to insure
prior to loss affected thereby."
The AFM policy contained a $100
million liability limitation with sublimits.
The AFM policy had
a $10 million limit "on Personal Property while in the course of
- 30 transportation as respects loss or damage arising out of any one
occurrence" and a deductible clause that excluded the first
$25,000 of claims arising out of any one occurrence from
coverage.
On December 28, 1983, an endorsement was added to the AFM
policy, which became effective January 1, 1984.
The endorsement
stated:
Permission is hereby granted to insure the deductible
amount (25,000.00) applicable to coverage 1B. Personal
Property while in the course of transportation. If
such property is also insured under policy #IMB-9310977
issued by the National Union Fire Insurance Company of
Pittsburgh, PA, and any renewals, or rewrites thereof,
it is agreed that any such insurance shall be ignored
in determining the amount of loss to which such
deductible amount applies. It is also agreed that
thirty (30) days advance notice of cancellation shall
be given to National Union Fire Insurance Company of
Pittsburgh, PA. Any claims presented that exceeds
$25,000.00 National Union agrees to abide with our
settlement of such claims.
Petitioner paid annual installment premiums of $356,945 for
coverage of all petitioner's real and personal property,
including parcels held for delivery and in transit.
The annual
premium was based on property values and stated rates.
The AFM
policy provided a calculation for the annual premium which
operated to apportion $86,820 of the total annual installment
premium to property value related to parcels in transit.16
16
The $86,820 premium attributable to parcels was computed
by multiplying the average daily value of parcels of $354,369,000
(continued...)
- 31 (4)
UPSINCO, Ltd./OPL
On June 9, 1983, pursuant to petitioner's plan, Hall,
through Parker & Co.-Interocean, Ltd. (Parker & Co.),17 prepared
a summary of a proposal to organize an insurance subsidiary
domiciled in Bermuda under the name UPSINCO, Ltd. (UPSINCO).
By
a memorandum dated June 13, 1983, Mr. Corde provided to Mr.
Johnson copies of the forms filed with the Registrar of Companies
in Bermuda relating to the incorporation of UPSINCO.
On June 23, 1983, a meeting was held which the following
persons attended:
Messrs. Danielewski, Johnson, and Jerome Stein
representing petitioner; Messrs. Garrity, Corde, and John Iacono
representing Hall; Messrs. Robin Spencer Arscott and Geoffrey
Hunt of Hall-Bermuda; and Messrs. Chet Butterfield and John
Ellison of the Bermuda law firm of Conyers, Dill & Pearman.
Among other things, the purpose of the meeting was to discuss
various aspects of the Shippers Interest program including the
contract form, documentation/ certification, service instruction
agreement, monthly bordereaux,18 and premium/loss reports.
16
(...continued)
times the rate of .0245 percent. The average daily value equaled
the average parcel value of $80 times the annual total parcels of
1,616,809,741 divided by 365.
17
18
Parker & Co. is a wholly owned subsidiary of Hall.
Petitioner's bordereau is a statement which summarizes, by
State, the units of excess value purchased by shippers and the
(continued...)
- 32 UPSINCO was incorporated in Bermuda as a wholly owned
subsidiary of petitioner on June 28, 1983.
UPSINCO was
registered as an exempted company pursuant to the provisions of
section 13 of the Companies Act of 1970, under the laws of
Bermuda.
On June 28, 1983, the first meeting of the provisional
board of directors of UPSINCO was held.
The provisional
directors of UPSINCO were listed as Messrs. John A. Ellison,
director, C.F.A. Cooper, and N.B. Dill, Jr.
UPSINCO was
incorporated with initial capital of $1.2 million and had 12
million shares of capital stock.
Initial ownership of the stock
of UPSINCO was as follows:
Name
United Parcel Service
of America, Inc.
Walter E. Danielewski
Kenneth L. Johnson
Jerome D. Stein
John Ellison
H.C. Butterfield
R.S.L. Pearman
No. of Shares
1,199,994
1
1
1
1
1
1
On July 14, 1983, the shareholders of UPSINCO held their
first general meeting in which they elected a board of directors.
The elected board of directors consisted of five people.
Three
of the five directors elected, Messrs. Danielewski, Johnson, and
Stein, were also employees of petitioner.
The remaining two
elected directors, Messrs. Ellison and Butterfield, were
18
(...continued)
claims in excess of $100 paid to petitioner's shippers.
- 33 representatives of the Bermuda law firm of Conyers, Dill &
Pearman.
The minutes of the first meeting indicate that Messrs.
Danielewski and Johnson were, respectively, elected to the
positions of president and vice president of UPSINCO.
The
minutes further indicate that Mr. Stein was appointed as
secretary and treasurer and that Mr. Danielewski was appointed as
assistant treasurer.19
Thus, the majority of UPSINCO's board of
directors and officers were all employees of petitioner.
During the July 14, 1983, meeting, the board of directors of
UPSINCO appointed Parker & Co. as manager of the company and
passed bylaws which it then submitted to the shareholders for
confirmation.20
Also on July 14, 1983, the shareholders of
UPSINCO confirmed and adopted the bylaws and approved all actions
taken by UPSINCO's provisional directors on June 28, 1983, and
its directors on July 14, 1983.
On August 1, 1983, UPSINCO was
certified as an insurer in Bermuda by the Minister of Finance.
By resolution dated October 31, 1983, the executive
committee of the board of directors of petitioner authorized a
capital contribution in the amount of $41,017,575 in cash to
UPSINCO.
In addition, the executive committee of the board of
19
The minutes also indicate that Mr. A.L. Vincent Ingham was
appointed assistant secretary.
20
As of Jan. 1, 1985, subject to the directions and
instructions of OPL, the administrative functions of OPL were
provided by Parker & Co., a Bermuda corporation.
- 34 directors of petitioner resolved to take all actions necessary to
effect a change of the name UPSINCO to Overseas Partners, Ltd.
(OPL).
By resolution on November 3, 1983, the board members of
UPSINCO increased the authorized share capital of the company by
$15,687,030, from $1.2 million to $16,887,030, through the
creation of an additional 156,870,300 shares of capital stock at
10 cents par value.
The members of UPSINCO further resolved that
the sum of $25,330,545 be accepted as contributed surplus,
resulting in an increase of $41,017,575 in UPSINCO's capital to
$42,217,575.
On November 14, 1983, petitioner made a capital contribution
of cash in the amount of $41,017,575 to UPSINCO.
On November 17
and 18, 1983, petitioner's board of directors declared a dividend
of 1 share of OPL (then known as UPSINCO) capital stock on each
outstanding share of petitioner's stock (excluding petitioner's
shares held in treasury) payable on December 31, 1983, to
shareholders of record on November 18, 1983.
On November 23, 1983, the board members of UPSINCO resolved
that the name of the company be changed to OPL.
By resolution
dated November 25, 1983, petitioner's board of directors changed
the name of UPSINCO to OPL.
On December 28, 1983, NUF and OPL entered into a Facultative
Reinsurance Agreement (agreement) under which NUF agreed to cede
- 35 its liability under the Shippers Interest contract to OPL as
reinsurer.
Under the terms of the agreement, NUF was required to
remit to OPL 100 percent of the gross amounts received from
petitioner under the Shippers Interest contract less:
(a) A
commission to NUF of 1.18 percent of the gross premiums not to
exceed $1 million; (b) an allowance of 3.1 percent of the gross
premiums written to cover NUF's premium tax and board and bureau
charges; and (c) 1 percent of the gross premiums for the purpose
of paying Federal excise taxes.
In addition, under article IX of
the agreement, NUF held as security an amount equal to the first
2 months of gross premiums written less commission, taxes, board
and bureau charges, losses paid, loss expenses paid, and Federal
excise taxes, if any.
The agreement became effective on January 1, 1984, and
remained in effect until canceled or terminated.
The termination
provision of the agreement stated:
Neither the Company nor Reinsurer may terminate this
Agreement while the Policy listed in Article I Item B
is in force; however, if the Policy listed in Article I
Item B[21] is in fact terminated then in that event and
that event only this Agreement shall be terminated
simultaneously therewith. * * *
Under this provision, neither NUF nor OPL could cancel the
agreement while the Shippers Interest contract remained in force.
21
Article I Item B lists only the Shippers Interest contract
between petitioner and NUF.
- 36 On December 31, 1983, petitioner made a distribution, which
it treated as a taxable dividend to its shareholders, of 1 share
of OPL stock for each share of petitioner's stock then
outstanding.
Petitioner distributed 164,477,491 shares of OPL
stock with a net asset value of 25 cents per share.
dividend was $41,119,372.75.
The total
The fair market value of the OPL
capital stock received by each of petitioner's shareholders was
considered by petitioner to be ordinary income to each of
petitioner's shareholders.
In 1983, petitioner was owned by its active employees and
former employees, as well as the families, estates, and trusts of
former employees.
shareholders.
In 1983, there were approximately 14,000
On December 31, 1983, as of the moment of
distribution of the OPL stock, the shareholders of OPL were
essentially the same as petitioner's shareholders.
The only
difference between the shareholders of OPL and petitioner's
shareholders was that petitioner's shareholders did not receive
the same proportionate interest in OPL that they owned in
petitioner because petitioner itself was a shareholder of OPL.
On December 31, 1984, there were 14,811 shareholders in OPL
holding an aggregate of 164,358,562 shares of common stock, not
including the 4,511,738 treasury shares of OPL owned by
petitioner.
The total shares in OPL equaled 168,870,300.
On
December 31, 1984, there were 16,297 shareholders in petitioner
- 37 holding an aggregate of 163,182,028 shares of common stock.
The
4,511,738 shares of OPL owned by petitioner represented 2.67
percent of the 168,870,300 shares in OPL on December 31, 1984.
During the years in issue, restrictions applied in the event
an OPL shareholder wanted to sell shares of OPL.
No outstanding
shares of OPL capital stock were transferable, except by gift or
inheritance, unless the shares were first offered for sale to
petitioner at the lower of the net book value of the OPL stock or
at the price and terms at which the OPL stock was offered to the
proposed transferee.
OPL shareholders were required to notify
petitioner's treasurer of the number of shares proposed to be
sold, the proposed price per share, the name and address of the
proposed transferee, and the terms of the proposed sale and
provide a statement of the proposed transferee that the
information contained in the notice was true and correct.
OPL
shareholders had the right to pledge OPL stock but were not
allowed to transfer the stock upon foreclosure without
petitioner's having first been offered the option to purchase the
stock.
2.
1984 and Years Following
a.
General
For the taxable year ending December 31, 1984, excess value
amounts billed to regular shippers and collected from other
shippers were not included in petitioner's reported taxable
- 38 income.
Petitioner did not include excess value amounts billed
to regular shippers in its filings with the SEC and the ICC for
the year ended December 31, 1984.
Otherwise, petitioner's
activities with respect to the excess value activity basically
remained the same as in prior years.
Petitioner continued to
bill customers for shipping charges on the basis of information
recorded by shippers on the package pickup records.
The bills
reflected all amounts to be collected from shippers, including
EVC's.
All amounts collected, including EVC's, from the shippers
were deposited in petitioner's bank accounts.
Petitioner
continued to process all claims for loss or damage to parcels,
including any excess value portions of the claims.
If a claim
for loss or damage was paid, petitioner continued to remit the
amount for the claim by check to the shipper.
Petitioner did not apply for, and did not hold, an insurance
license of any type.
During 1984, petitioner's employees who
processed shippers' claims were not licensed as claims adjusters
in the States in which they processed claims.
NUF did not
participate in the resolution of specific claims in 1984,
challenge the amounts of specific loss claims paid by petitioner,
or challenge the amounts of loss and damage claims that
petitioner subtracted from the amounts that it remitted to NUF
during 1984 in connection with NUF contract IMB 9310977.
- 39 b.
Accounting
For the taxable years ended December 31, 1983 and 1984, UPSNew York and UPS-Ohio were required to file annual reports with
the ICC and were required to follow the rules of accounting and
use the accounts established by the ICC in connection with ICC
accounting and reporting requirements.
Petitioner was also
required to follow Generally Accepted Accounting Principles.
For
financial accounting and managerial reporting purposes,
petitioner used a system of accounts that was generally the same
as the ICC system of account numbers.
However, petitioner's
expense accounts are much more detailed than ICC expense accounts
used for ICC accounting purposes.
With respect to a shipment made by a regular customer, there
was no change in the method in which journal entries were made in
1983 and 1984.
Petitioner generally debited accounts receivable
and credited an intercompany account.
When petitioner received
the EVC amounts from its shippers, the amounts were deposited in
petitioner's bank accounts.
Petitioner paid shippers' claims out
of corporate bank accounts.
Petitioner did make changes to its internal accounting
worksheets at its district level in 1984.
The worksheets
detailed the EVC's differently in 1984 than in 1983.
However,
petitioner's accounting journal entries were the same in 1984 as
they were in 1983 at the district level.
- 40 c.
Transactions Between Petitioner and NUF
Beginning in January 1984, petitioner transferred excess
value amounts billed to its regular shippers and collected from
other shippers, net of claims paid in excess of $100, to NUF on a
monthly basis.
Petitioner did not receive reimbursement or
compensation from NUF for generating, billing, and collecting
EVC's or for processing the excess value claims.
In 1984, petitioner began preparing a "bordereau" statement
which summarizes, by State, the units of excess value purchased
by shippers and the claims in excess of $100 paid to petitioner's
shippers.
The bordereau statement reflects total amounts
transferred by petitioner to NUF during 1984 as follows:
Month
Gross Premium
Claims Paid
Net Premium
Jan.
Feb.
Mar.
Apr.
May
June
July
Aug.
Sept.
Oct.
Nov.
Dec.
$6,441,266.73
8,872,879.29
8,204,394.80
7,543,896.37
7,564,372.78
9,287,618.30
6,999,418.50
9,998,146.19
8,034,914.33
8,522,263.90
10,600,501.16
7,725,117.32
$67,764.74
493,372.97
1,152,402.35
1,537,670.65
1,945,900.71
2,086,223.87
1,970,519.97
2,367,289.23
2,098,262.38
2,887,865.46
2,922,216.00
2,554,523.60
$6,373,501.99
8,379,506.32
7,051,992.45
6,006,225.72
5,618,472.07
7,201,394.43
5,028,898.53
7,630,856.96
5,936,651.95
5,634,398.44
7,678,285.16
5,170,593.72
99,794,789.67
22,084,011.93
77,710,777.74
Total
The category "Net Premium" represents EVC's billed to
petitioner's regular customers and collected from other shippers
from each of the States and the District of Columbia, less claims
- 41 over $100 remitted to petitioner's shippers during the month.
Generally, around the middle of the month following billing to
regular shippers or collection from walk-in shippers, the net
amounts were remitted by wire transfers from petitioner's account
to an NUF account.
No interest on excess value amounts that had
been collected before the excess value amounts were transferred
to NUF was paid to NUF.
During 1984, if a shipper did not pay a
bill that included declared excess value amounts, petitioner did
not reduce the amount transferred to NUF.
If collection
activities occurred, petitioner attempted to collect the entire
amount due from the shipper, including any EVC's included in the
bill.
Petitioner did not reduce the amount transferred to NUF by
any amount uncollected or any cost it incurred in collecting
delinquent EVC's.
d.
Transactions Between NUF and OPL
Beginning in January 1984, after receiving the amounts
remitted to NUF by petitioner, NUF prepared a bordereau and
remitted the net amounts shown on NUF's bordereau to OPL by wire
transfer.
The following table summarizes the amounts and dates
of transfers made by NUF to OPL relating to excess value amounts
during 1984:22
22
The amounts shown in the table were rounded, resulting in
minor discrepancies of a few dollars.
- 42 -
Month
Net1
Premiums
Underwriting
Expenses
Taxes
Boards &
Bureaus2
Funds
Withheld3
Interest on
Funds
Withheld
Net Payment
to OPL4
Jan.
$6,373,502
$76,007
$264,092
$6,033,403
-0-
-0-
Feb.
8,379,506
104,700
363,788
7,911,018
$45,453
$45,453
Mar.
7,051,992
96,812
336,380
-0-
113,879
6,732,679
Apr.
6,006,226
89,018
309,300
-0-
142,349
5,750,256
May
5,618,472
89,260
310,139
-0-
113,879
5,332,953
June
7,201,394
109,594
380,792
-0-
113,879
6,824,888
July
5,028,899
82,593
286,976
-0-
146,416
4,805,745
Aug.
7,630,857
117,978
409,924
-0-
109,812
7,212,767
Sept.
5,936,652
94,812
329,431
-0-
142,349
5,654,758
Oct.
5,634,399
100,563
349,413
-0-
113,879
5,298,302
Nov.
7,678,285
38,663
434,621
-0-
113,879
7,318,880
Dec.
5,170,594
-0-
316,730
-0-
126,081
4,979,945
Total
77,710,778
1,000,000
4,091,586
13,944,421
1,281,855
59,956,626
1
This column was arrived at by netting gross income and losses paid.
This column contains the total amounts included on the bordereau for
taxes, board and bureau charges, and Federal excise taxes.
3
In 1984, the net amounts to be remitted by NUF to OPL for January and
February were withheld in escrow by NUF.
4
The "Net Payment to OPL" is calculated by reducing the net premiums
shown in column one by expenses, taxes, board and bureau charges, and funds
withheld and by increasing that amount by interest on funds withheld.
2
NUF paid Hall $250,000 from the $1 million it received from
petitioner as fees.
OPL ultimately recorded the funds received
in its general ledger.
C.
FFIC/PIP
Fireman's Fund Insurance Co. (FFIC), through a policy sold
by Parcel Insurance Plan, Inc. (PIP), since 1966, offered excess
value protection for shipments sent via petitioner, the U.S.
Postal Service, and other carriers.
came from petitioner's shippers.
Most of FFIC/PIP's business
PIP tried to solicit business
from petitioner's shippers who spent at least $1,000 annually for
- 43 EVC's.
Generally, PIP charged 50 percent of the rate charged for
the excess value coverage offered by petitioner to its shippers.
This amounted to a price of $0.125 per $100 of coverage.
PIP declined to provide coverage to certain high-risk
shippers and also declined to provide coverage on certain types
of packages.
However, PIP's marketing materials indicate that
shippers in industries with serious theft problems could still
participate, but they were charged more than $0.125 per $100 of
coverage.
If such a shipper were accepted by PIP, PIP would
charge between $0.15 and $0.175 per $100 of coverage.
FFIC was responsible for payment of losses and reimbursed
PIP weekly for loss claims paid.
For the years 1983 and 1984,
PIP's profit margins equaled 36 percent and 34 percent,
respectively.
PIP paid approximately 64 percent and 66 percent
for 1983 and 1984, respectively, of the amounts collected to FFIC
for the parcel protection.
For 1983, FFIC's gross profit margin
equaled 27 percent of the premium written.23
II.
Liberty Mutual Insurance Policy
A.
Insurance Policy Between Petitioner and Liberty Mutual
Liberty Mutual is a group of mutual insurance companies.
Liberty Mutual are multiline property and casualty insurers based
in Boston, Massachusetts, which operate in all 50 States and the
23
The "profit margin" is equal to premiums minus claims paid
minus commissions.
- 44 District of Columbia, Canada, and the U.S. Virgin Islands.
Liberty Mutual Fire Insurance Co. (Liberty Mutual Fire) is a
member of Liberty Mutual.
Liberty Mutual wrote workers' compensation insurance in all
States except those that were "monopolistic".
In the eight
"monopolistic" States, only one State-affiliated company was
permitted to write workers' compensation policies.
In 1984,
workers' compensation policies accounted for 39.3 percent of
Liberty Mutual Fire's net premiums.
In 1984, Liberty Mutual Fire
wrote workers' compensation policies in California.
California
law prohibited insurance policies for California workers'
compensation risks from also insuring workers' compensation risks
for other States.
Thus, a California workers' compensation
policy was always a "stand-alone" policy.
The initial premium for a workers' compensation policy in
California was determined by a statutory formula which took
account of the estimated payroll for each job classification.
However, an employer's loss experience could also affect the
premium if the employer received an "experience modification"
from the State of California.
Generally, California law permits
the payment of dividends by a mutual insurance company but
prohibits any individual or insurance company from promising the
future payment of dividends under an unexpired workers'
compensation policy or misrepresenting the conditions for
- 45 dividend payment.
See Cal. Code Regs. tit. 10, sec. 2504 (1999).
From 1979 through 1983, petitioner self-insured its workers'
compensation risks in California.
R.L. Kautz, a company
unrelated to petitioner or Liberty Mutual, administered this
program.
Liberty Mutual wrote the workers' compensation
insurance for petitioner in all other States that were not
monopolistic during this period.
Any employer in California seeking to be self-insured for
workers' compensation must submit an application to the State and
obtain State approval.
Any employer seeking to change from a
self-insured to an insured program for workers' compensation must
also submit an application to California and obtain State
approval.
On October 3, 1983, Mr. Eugene Schoenleber of petitioner's
insurance department requested that Mr. Al Sharlun submit a
proposal for taking over the administration of petitioner's
California workers' compensation program from R.L. Kautz.
Mr.
Sharlun worked in Liberty Mutual's national sales department,
which handles large national accounts.
Subsequently, petitioner
and Liberty Mutual agreed that Liberty Mutual would write an
insurance policy for petitioner's 1984 California workers'
compensation liability.
On December 15, 1983, the State of California sent a letter
to petitioner reflecting its understanding that it was the
- 46 intention of petitioner to withdraw from workers' compensation
self-insurance status in California.
On December 28, 1983,
petitioner sent a letter to the State of California confirming
that Liberty Mutual Fire was taking over the management of all
open and closed self-insurance claims from 1979 through 1983.
The State of California granted petitioner's application to
terminate its self-insurance plan.
As of January 1, 1984,
petitioner and Liberty Mutual entered into an insurance policy
with respect to petitioner's 1984 California workers'
compensation liability.
Petitioner was listed as the insured.
The policy was issued by Liberty Mutual Fire and was a
permissible workers' compensation policy in the State of
California.
As part of the agreement, Liberty Mutual Fire was
required to investigate and adjust all claims made under the
policy.
The policy provides coverage for compensation and other
benefits required of petitioner by the workers' compensation laws
of California and provides coverage for all sums which petitioner
is legally obligated to pay as damages because of bodily injury
or accident or disease, including death arising out of the course
of employment.
Under the Participating Provision Endorsement of the
insurance policy, petitioner was designated a member of Liberty
Mutual, with a right to participate in the distribution of
dividends.
Dividends were determined by the board of directors
- 47 of Liberty Mutual.
nonassessable.
This endorsement provided that the policy was
As a nonassessable policyholder, petitioner could
not be assessed for Liberty Mutual's losses and expenses in
excess of the premiums paid for the 1984 California workers'
compensation policy.
The Participating Provision Endorsement
also reiterated the statutory provision in California which made
it unlawful for Liberty Mutual to promise the future payment of
dividends before the expiration of the 1984 policy period, and
the endorsement noted that dividends are payable only as
determined by the board of directors of Liberty Mutual following
the expiration.
The policy also contained a Redetermination Agreement
Endorsement which provided that an initial apportionment of
dividends may be made from a surplus accumulated from the
California workers' compensation insurance following termination
of the policy.
Further, the policy provided that if a subsequent
dividend is greater than the dividend previously paid to
petitioner, Liberty Mutual shall pay to petitioner the additional
dividend shown to be due.
However, if the subsequent dividend is
less than the dividend previously paid to petitioner, petitioner
shall refund the amount by which the previous dividend exceeds
the current dividend.
The audited premium for the policy is based upon actual
payroll amounts during the policy period for various job
- 48 classifications, multiplied by a standard rate set by the State
for each classification, and further multiplied by an experience
modification factor.
The estimated modified annual premium is
the amount initially paid to Liberty Mutual Fire, which is
determined based upon estimates of payroll amounts for the year.
After the end of the year, the audited modified premium is
determined based upon the final payroll figures for the year.
Under the policy, Helmsman Management, a subsidiary within
the Liberty Mutual group, would administer the runoff of the 1979
through 1983 workers' compensation self-insurance plan for
petitioner beginning in 1984 for a flat fee of $250,000.
Liberty
Mutual charged petitioner 12 percent of its workers' compensation
losses, subject to a maximum of $1.2 million, for the cost of
handling the workers' compensation claims.
Liberty Mutual
charged petitioner 1 percent of its audited premium for excise
tax and 1 percent for management fees.
Dividends were to be
declared and paid in accordance with California law and the
determinations of the board of directors of Liberty Mutual.
In 1984, petitioner made premium payments to Liberty Mutual
in connection with the California workers' compensation policy
and received a dividend payment in 1985.
During 1984, petitioner
also continued to insure its workers' compensation liability for
most other States with Liberty Mutual.
In April 1984, the
estimated premium for petitioner in California was calculated to
- 49 be $14,241,915.
The $14,241,915 estimated premium was paid to
Liberty Mutual by petitioner in monthly installments in 1984.
By
April 1, 1985, Liberty Mutual completed its audit of the hours
worked by various classes of petitioner's employees in California
and determined the audited premium.
After the audit, the
standard premium for petitioner was increased by $204,496 to
reflect the actual amounts of petitioner's California payroll for
the year 1984.
In October 1985, Liberty Mutual Fire sent petitioner a
statement showing the first dividend adjustment to the Liberty
Mutual policy.
Every year thereafter through 1994, an annual
dividend statement was sent to petitioner reflecting further
dividend readjustments to the policy.
B.
Liberty Mutual-OPL Reinsurance Treaty
Effective January 1, 1984, Liberty Mutual and OPL entered
into a reinsurance treaty for petitioner's 1984 California
workers' compensation liability, which was the subject of the
Liberty Mutual policy.
Liberty Mutual:
Pursuant to the agreement, in 1984
Paid OPL $12,228,077.62 in premiums in monthly
installments; retained a ceding commission of $1.2 million;
withheld and created an escrow of $480,000 to cover OPL's
liability for losses paid by Liberty Mutual; paid a Federal
excise tax of $141,919.15; and retained a management fee of
$141,918.23.
- 50 The agreement, with respect to OPL's reinsurance of Liberty
Mutual includes but is not limited to the following terms:
1.
OPL reinsured Liberty Mutual's UPS California workers'
compensation exposure for losses not exceeding $250,000 from any
one accident.
Liberty Mutual retained the exposure for losses
exceeding $250,000 from any one accident.
Liberty Mutual also
retained the risk of multiple accidents with losses in excess of
$250,000.
2.
Liberty Mutual Fire agreed to pay over to OPL an amount
equal to the premiums received on the California workers
compensation policy, less $50,000 for the retained layer of
liability for losses above $250,000, a management fee equal to 1
percent of the premium, 1 percent of the premium for excise tax,
and a ceding commission equal to 12 percent of the losses
incurred.
3.
The ceding commission was capped at $1.2 million.
Liberty Mutual retained the obligation to investigate
and adjust all claims for the UPS workers' compensation program
in California.
4.
Liberty Mutual paid a 1 percent excise tax on
reinsurance by a foreign insurer, pursuant to I.R.C. section
4371.
C.
Amount in Dispute
On its 1984 Federal income tax return, petitioner deducted
the estimated premium of $14,241,915 it paid to Liberty Mutual
- 51 for California workers' compensation coverage.
By December 31,
1984, petitioner had incurred workers' compensation losses in
California that had been paid by Liberty Mutual in the amount of
$2,714,500.
Respondent disallowed $11,527,41524 deducted on
petitioner's 1984 return.
After concessions, the amount in
dispute with respect to the Liberty Mutual policy has been
reduced to $11,151,675.25
OPINION
I.
Excess Value Charges
Respondent determined that EVC's in the amount of
$99,794,790 must be included in petitioner's 1984 income pursuant
to section 61.
Section 61(a) provides in part that "gross income
means all income from whatever source derived".
It is
fundamental to our system of taxation that income must be taxed
to the one who earns it.
See Commissioner v. Culbertson, 337
24
This amount represents the difference between the total of
$14,241,915 of deductions and the $2,714,500 actually paid out by
Liberty Mutual Fire in 1984 claims.
25
Respondent conceded a total of $375,740. See supra note
2. Thus, respondent's initial disallowance of $11,527,415 has
been reduced by $375,740 to $11,151,675. The $375,740 conceded
by respondent is made up of $325,740, representing a 12-percent
claim adjustment expense for losses paid in 1984 plus $50,000 in
premiums paid to Liberty Mutual for risk associated with claims
over $250,000.
The $325,740 conceded amount was calculated by respondent to
be an allocation of a portion of the total $1.2 million retained
by Liberty Mutual based on the ratio of 1984 claim payments to
total 1984 claims paid between 1984 and 1994.
- 52 U.S. 733, 739-740 (1949).
The incidents of taxation cannot be
avoided through an anticipatory assignment of income.
See United
States v. Basye, 410 U.S. 441, 447, 449-450 (1973); Lucas v.
Earl, 281 U.S. 111, 114, 115 (1930).
"the first principle of taxation".
supra at 739.
This has been described as
Commissioner v. Culbertson,
The question of who should be taxed depends on
which person or entity in fact controls the earning of the income
rather than who ultimately receives the income.
See Commissioner
v. Sunnen, 333 U.S. 591, 604-606 (1948); Corliss v. Bowers, 281
U.S. 376, 378 (1930); Vercio v. Commissioner, 73 T.C. 1246, 1253
(1980); see also Ronan State Bank v. Commissioner, 62 T.C. 27, 35
(1974); American Sav. Bank v. Commissioner, 56 T.C. 828 (1971);
Nat Harrison Associates, Inc. v. Commissioner, 42 T.C. 601
(1964).
A taxpayer realizes income if he controls the
disposition of that which he could have received himself but
diverts to another as a means of procuring the satisfaction of
his goals.
The receipt of income by the other party under such
circumstances is merely the fruition of the taxpayer's economic
gain.
See Commissioner v. Sunnen, supra at 605-606; Helvering v.
Horst, 311 U.S. 112, 116-117 (1940).
Respondent does not, and need not, challenge OPL's separate
existence as a valid corporate entity.
The classic assignment of
income cases involve persons and entities whose separate
existence was unquestioned.
See United States v. Basye, supra;
- 53 Lucas v. Earl, supra; Leavell v. Commissioner, 104 T.C. 140
(1995).
The Supreme Court's articulation of the assignment of
income doctrine requires no challenge to the separate existence
of the persons or entities to which the doctrine applies.
As the
Court stated:
The entity earning the income--whether a partnership or
an individual taxpayer--cannot avoid taxation by
entering into a contractual arrangement whereby that
income is diverted to some other person or entity.
Such arrangements, known to the tax law as
"anticipatory assignments of income," have frequently
been held ineffective as means of avoiding tax
liability. * * * [United States v. Basye, supra at
449-450.]
Therefore, the issue we must decide is whether petitioner, rather
than NUF and OPL, earned the EVC's.
During the years prior to 1984, petitioner properly reported
revenues from EVC's as income for Federal income tax purposes.
During those years petitioner performed the following EVC
functions and activities:
1.
Maintained and advertised the shipping activity,
which provided a customer base for petitioner's
excess value activity.
2.
Printed shipping forms with an excess value election.
3.
Published excess value rates in tariffs.
- 54 4.
Incurred liability for damage or loss to packages in
excess of $100 when the shipper declared such excess
value and paid an EVC.26
5.
Billed shippers for EVC's.
6.
Collected EVC's.
7.
Deposited EVC's into petitioner's bank accounts.
8.
Retained interest paid on EVC income held in
petitioner's accounts.
9.
Processed excess value claims.
10.
Investigated excess value claims.
11.
Traced lost parcels.
12.
Inspected damaged parcels.
13.
Paid excess value claims.
14.
Maintained a "loss prevention" manual and
personnel to audit and implement it.
15.
Defended against lawsuits brought by shippers whose
excess value claims had been denied.
16.
Incurred all costs associated with the administration
of its excess value activity.
17.
Obtained and paid for catastrophic insurance
to cover its liability for lost or damaged shipments.
26
Petitioner accepted liability for damage or loss to
packages up to $100 and made payment for such loss or damages.
- 55 After January 1, 1984, petitioner continued to perform all these
functions and activities.
This continuity in petitioner's EVC
activity after January 1, 1984, was consistent with a plan
petitioner had formulated during 1983.
During 1983 petitioner asked AIG to submit a proposal for
restructuring petitioner's excess value program.
AIG's proposal
contemplated that NUF would perform in a "fronting" capacity; a
capacity in which NUF would receive excess value income under the
Shippers Interest contract and reinsure its liability under the
Shippers Interest contract with OPL.
In his letter dated April
27, 1983, Mr. Corde, of Hall, stated that NUF would exist "in a
fronting capacity with essentially no risk or exposure to loss
under the program."
NUF retained an even $1 million in 1984 as a
fronting service fee for agreeing to reinsure the Shippers
Interest contract with OPL.27
Mr. Smetana of AIG proposed that petitioner would continue
to collect EVC's from shippers, administer and pay all valid
claims, and remit excess value amounts to NUF net of claims.
Mr.
Smetana also proposed that petitioner be responsible for
uncollectible EVC's.
27
Mr. Smetana reasoned that "since * * *
A front has been generally described as an arrangement
whereby an insurance company allows another company to use its
name for a fee. See Old Sec. Life Ins. Co. v. Continental Ill.
Natl. Bank & Trust, 740 F.2d 1384, 1387 n.2 (7th Cir. 1984); see
also Northwestern Natl. Ins. Co. v. Marsh & McLennan, Inc., 817
F. Supp. 1424, 1426 (E.D. Wis. 1993).
- 56 [AIG/NUF] would have no control over the payment of premium by
shippers, * * * [AIG/NUF] would not take on the responsibility
for any bad debt or uncollectables under the program."
These
proposals all became part of petitioner's method of operation on
January 1, 1984.
Under the Facultative Reinsurance Agreement between NUF and
OPL, article I, item B lists the Shippers Interest contract as
the policy to be reinsured.
Under article XVIII, subparagraph
(A), neither NUF nor OPL could terminate the reinsurance
agreement while the Shippers Interest policy remained in force.
Article XVIII further requires that only in the event that the
Shippers Interest contract is in fact terminated will the
reinsurance agreement between NUF and OPL be terminated
simultaneously therewith.
Either petitioner or the "Named
Insured" could cancel the Shipper's Interest contract under the
terms of that agreement.28
Beginning in January 1984, petitioner transferred excess
value amounts billed to its regular shippers and collected from
other shippers, net of claims paid in excess of $100, to NUF on a
monthly basis.
Petitioner did not reduce the amounts transferred
to NUF in order to compensate itself for sales and marketing
28
We note that it is unrealistic to conceive of a situation
in which a single shipper could cancel the whole Shipper's
Interest contract or that all the unrelated shippers in unison
could cancel the contract.
- 57 expenses that it incurred regarding the EVC's.
Petitioner did
not charge either NUF or OPL for providing the point of contact
with shippers who declared excess value and paid EVC's.
No
interest on excess value amounts that had been collected before
the excess value amounts were transferred to NUF was paid to NUF.
During 1984, if a shipper did not pay a bill that included excess
value amounts, petitioner attempted to collect the entire amount
due from the shipper, including any EVC's included in the bill.
Petitioner did not reduce the amount transferred to NUF by any
amount uncollected or any cost it incurred in collecting
delinquent EVC's.
Petitioner also adjusted and paid all claims
with respect to lost or damaged shipments.
Petitioner also
defended against shippers' claims that had been denied.
Petitioner did not reduce the amounts it transferred to NUF in
order to compensate itself for performing these activities and
did not otherwise charge NUF or OPL for performing any of these
activities.
Petitioner also continued to provide other services related
to EVC's.
Petitioner provided "controlled parcel handling"
procedures, which were expensive and time consuming.
Those
procedures included bagging, tagging, and tracking high value
packages that had declared values in excess of $100.
Petitioner
maintained a loss prevention department in which it employed
personnel to audit controlled parcel handling procedures.
Such
- 58 audits took place at petitioner's hub and delivery center
operations.
Petitioner's special controlled parcel handling
procedure with respect to high-value packages constituted extra
services for shipments whose declared value exceeded $100.
Petitioner did not reduce the amount transferred to NUF in return
for performing the controlled parcel handling procedures and did
not otherwise charge NUF or OPL for performing these activities.
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.
- 59 The only potentially relevant change that occurred on
January 1, 1984, was the introduction of the Shippers Interest
contract between petitioner and NUF and the Facultative
Reinsurance Agreement between NUF and OPL.
Petitioner attempts
to justify this arrangement on the ground that it was based on
bona fide business considerations and that the arrangement had
economic substance.
If on the other hand the arrangement with
NUF and OPL had neither business purpose nor economic substance,
other than tax avoidance, the entire arrangement has all the
earmarks of a classic assignment of income wherein petitioner was
attempting to assign EVC income that had been earned through its
own services and activities to OPL for the benefit of
petitioner's and OPL's common shareholders.
On brief, petitioner relies on Moline Properties, Inc. v.
Commissioner, 319 U.S. 436 (1943), for the proposition that it
may rearrange, change, and divide business activities among
business entities.
We agree that, normally, a choice to transact
business in corporate form will be recognized for tax purposes as
long as there is a business purpose or the corporation engages in
business activity.
See Northern Ind. Pub. Serv. Co. v.
Commissioner, 105 T.C. 341, 347-348 (1995) (citing Moline
Properties, Inc. v. Commissioner, supra at 438-439), affd. 115
F.3d 506 (7th Cir. 1997).
As previously noted, OPL's separate
corporate existence is not being questioned.
The issue then is
- 60 whether the restructuring of petitioner's EVC activity in 1984 by
inserting NUF and OPL as part of the EVC transactions had
substance.
If these transactions lack substance, then petitioner
engaged in an anticipatory assignment of income and cannot avoid
taxation "no matter how clever or subtle" the arrangement.
United States v. Basye, 410 U.S. at 450.
While a taxpayer may
structure a transaction to minimize tax liability, that
transaction must have economic substance if it is to be respected
for tax purposes.
See Kirchman v. Commissioner, 862 F.2d 1486
(11th Cir. 1989), affg. Glass v. Commissioner, 87 T.C. 1087
(1986).
The inquiry into whether transactions have sufficient
substance to be respected for tax purposes turns on both the
objective economic substance of the transactions and the
subjective business motivation behind them.
See Kirchman v.
Commissioner, supra at 1491-1492;29 see also ACM Partnership v.
29
In Kirchman v. Commissioner, 862 F.2d 1486, 1492 (11th
Cir. 1989), affg. Glass v. Commissioner, 87 T.C. 1087 (1986), the
court observed:
Courts have recognized two basic types of sham
transactions. Shams in fact are transactions that
never occur. In such shams, taxpayers claim deductions
for transactions that have been created on paper but
which never took place. Shams in substance are
transactions that actually occurred but which lack the
substance their form represents. * * *
Because all the transactions at issue in this case actually
(continued...)
- 61 Commissioner, 157 F.3d 231 (3d Cir. 1998), affg. in part and
revg. in part on another ground T.C. Memo. 1997-115; Lerman v.
Commissioner, 939 F.2d 44, 53-54 (3d Cir. 1991), affg. Fox v.
Commissioner, T.C. Memo. 1988-570; Casebeer v. Commissioner, 909
F.2d 1360, 1363 (9th Cir. 1990), affg. in part and revg. in part
on another ground Larsen v. Commissioner, 89 T.C. 1229 (1987).
The objective and subjective prongs of the inquiry are related
factors both of which form the analysis of whether the
transaction had sufficient substance apart from its tax
consequences.
See ACM Partnership v. Commissioner, supra at 247;
Casebeer v. Commissioner, supra at 1363.
In making our determination as to whether a transaction has
substance, we will first look to whether the taxpayer had a
business purpose for engaging in the transaction other than tax
avoidance.
See Frank Lyon Co. v. United States, 435 U.S. 561,
583-584 (1978); Kirchman v. Commissioner, supra at 1492; Bail
Bonds by Marvin Nelson, Inc. v. Commissioner, 820 F.2d 1543, 1549
(9th Cir. 1987), affg. T.C. Memo. 1986-23.
The determination of
whether the taxpayer had a legitimate business purpose in
entering into the transaction involves a subjective analysis of
29
(...continued)
occurred, we limit our inquiry to the question of whether their
substance corresponds to their form.
- 62 the taxpayer's intent.
See Kirchman v. Commissioner, supra at
1492.
Petitioner argues that it had legitimate business purposes
for entering into the arrangement with NUF and OPL, other than
tax avoidance.
Petitioner specifically alleges that during 1983
it was seriously concerned that its continued receipt of the
excess value income was potentially illegal under various State
insurance laws and that it was this concern that motivated it to
rearrange its method of handling its EVC activity.
Therefore,
petitioner argues, the EVC income cannot properly be considered
to belong to petitioner.
Petitioner cites Bank of Coushatta v.
United States, 650 F.2d 75 (5th Cir. 1981), as authority.
In Bank of Coushatta v. United States, supra, the taxpayer
bank was contesting the imposition of Federal income tax on
credit life insurance commissions, which the bank contended were
actually earned by one of its executives.
See id. at 76.
The
bank had transferred the credit life insurance business to the
executive because the bank believed that it would have been
illegal for it to continue to earn and receive insurance
commissions.
The District Court reasoned that because there was
no showing of any kind that the bank ever received the
commissions as income under section 61, the bank had not "earned"
the income.
See id. at 77.
The Court of Appeals for the Fifth
Circuit affirmed on the basis of the District Court's opinion.
- 63 However, the Court of Appeals limited its holding to the
situation where the bank's decision to transfer the insurance
business to the executive was motivated by the good faith belief
that it would be illegal for the bank to continue to earn and
receive insurance commission income.
See id. at 76.
Therefore,
petitioner's ability to rely on Bank of Coushatta depends on
whether petitioner's decision to transfer the excess value income
to OPL through NUF was motivated by a good faith concern that it
was illegal for petitioner to continue to receive the excess
value income.
We do not believe that this was petitioner's
purpose.
Mr. Kenneth Johnson, head of petitioner's insurance
department, testified that in the early 1980's he learned that
the collision damage waivers offered by the Hertz and Avis rental
car companies were being challenged by State insurance regulators
as an illegal insurance business and that this caused him to
become concerned that petitioner's excess value activity could be
viewed by State insurance regulators as engaging in an unlicensed
insurance activity.
No State insurance regulators had ever
questioned the legality of petitioner's EVC activity, and Mr.
Johnson was not aware that any such questions had ever been
raised with other carriers.
Mr. Johnson testified that, because
of his concerns, he had a casual conversation with an
- 64 acquaintance, Ms. Yudain, who was an insurance broker who told
him that his concerns might have substance.
Both Mr. Johnson and Mr. Corde testified that they met in
1982 and had some discussion regarding the possibility that
petitioner's EVC activities might run afoul of State insurance
regulations.
After Mr. Johnson met with Mr. Corde in 1982, Mr.
Corde sent Mr. Johnson a report on September 7, 1982, discussing
the feasibility of creating a subsidiary to reinsure declared
value risks.
The report stated:
It is our understanding that * * * [petitioner]
currently provides its customers with coverage for any
parcels lost or damaged up to $100. Those parcels with
values in excess of $100 can be declared by the shipper
and protection secured at a cost of $.25 per $100 of
value. While this protection is not considered to be
insurance, it could be converted to insurance and that
insurance could be provided by a * * * [petitioner]
owned insurance company.
The report contains figures regarding petitioner's EVC revenues,
claims, and gross profits and discusses the potential for
increasing profits.
The report does not discuss problems with
State insurance laws.
Mr. Johnson's conversation with Mr. Corde in 1982 appears to
be his and petitioner's last inquiry regarding problems with
State insurance regulation.
Neither Mr. Johnson nor petitioner
sought legal advice regarding these alleged concerns.
In
addition, neither Mr. Johnson nor anyone else on petitioner's
staff appears to have made an inquiry as to whether the EVC
- 65 program, as proposed to be restructured, might violate State
insurance regulations.
No contemporaneously prepared documentary
evidence was presented to indicate that petitioner had such
concerns or to indicate that petitioner analyzed the alleged
problem and considered the steps necessary to deal with its
alleged concerns.30
Mr. Johnson's testimony on cross-examination
is revealing:
Q.
Your concern about possible state regulation, you
never discussed this with the [sic] anybody at the ICC, did
you?
A.
I did not.
No.
Q.
And you're not aware of anybody at UPS ever
discussing it with anybody at the ICC.
A.
I'm not aware of it.
30
During 1983, Mr. Corde of Frank B. Hall inquired about how
other Hall clients handled cargo coverage in connection with
analyzing the proposed UPS declared value program. Mr. Doug
Brown of Hall prepared an internal memorandum to Mr. Corde dated
Mar. 2, 1983, outlining the arrangements of other companies which
were Hall clients. The concluding paragraph of Mr. Brown's
memorandum states:
In my discussions with Frank B. Hall people and
underwriters, the opinion with regard to the legality
of selling shippers interest when in fact neither
client is a licensed insurance agent was that provided
the carrier is simply requesting an acceptance or
declination from the shipper for the insurance does not
put them in a brokerage or agency position. I find
this questionable especially since both clients that I
reviewed are doing very little domestic Shippers
Interest coverage, consequently, the problem may not
have arisen.
- 66 Q.
You're not aware -- you did not discuss it with
any state regulators.
A.
No, I didn't.
Q.
Either insurance or transportation.
A.
That's correct.
Q.
And you're not aware of anybody at UPS discussing
it with any state regulators, insurance or transportation.
A.
No, I'm not.
Q.
Throughout the entire time that UPS was
considering revising the excess value program, it never
obtained a legal -- a written legal opinion relating to
whether the excess value activity could be construed as
insurance.
A.
I did not.
Q.
And you're not aware of UPS doing it.
A.
No, I'm not.
Q.
And you never -- UPS never prepared an opinion of
even in-house counsel relating to whether the activity -its excess value activity could be construed as insurance.
A.
Not that I'm aware of.
Q.
Pardon me?
I didn't hear you.
A.
I said -- I'm sorry -- not that I'm aware of.
did not request one.
I
Q.
Even after you became concerned and started with
the negotiations, you didn't ask for an opinion, a legal
opinion.
A.
No.
Q.
Okay. You indicated yesterday you were concerned
about the Avis and Hertz collision damage waiver cases.
A.
And liability insurance.
- 67 Q.
And liability insurance cases. Did you ever
request a legal opinion as to whether UPS's activity was
similar or distinguishable?
A.
No.
Q.
During the negotiations, did you ever request an
opinion regarding whether federal transportation law
preempted state regulation?
A.
No, I didn't.
Q.
Okay. At some point in late 1984, UPS decided to
go forward with the transaction. Correct?
A.
1983.
Q.
1983.
A.
1983, yes.
Q.
And it --
A.
I don't know if it was late in 1983.
I'm sorry.
Q.
It's not my intention to quibble about the date.
Sometime in 1983, UPS decided to go forward.
A.
Yes.
Q.
And at some point, the structure was fairly known
to you. National Union would be involved, and OPL would be
the reinsurer. Is that correct?
A.
Yes.
Q.
At that point in time, did you request a legal
opinion as to whether that satisfactorily alleviated your
concerns about state regulation?
A.
No.
Q.
Did UPS?
A.
Not that I'm aware of.
Q.
Now, was --
- 68 THE COURT:
little bit.
THE WITNESS:
Mr. Johnson, could you speak up just a
I'm sorry, sir.
BY MR. KLETNICK:
Q.
Was one of the aspects of your concern that UPS
employees were selling excess value units in 1983?
A.
That was one of my -- my concerns were that it was
offered to our customers and they were accepting it in
1983.
Q.
And who was it offered by?
A.
It was in -- I guess, in our explanation of
service, and I assume the customer service people were
talking to our customers about it.
Q.
So they would, in effect, be selling excess value
units, wouldn't they?
A.
I think it would certainly look like that.
Q.
And so was that part of your concern?
A.
Yes, it was.
Q.
And they're not licensed as brokers.
A.
No, they're not.
Q.
They're not licensed as agents.
A.
No, they're not.
Yes.
Q.
And then if there's a claim, UPS customer service
personnel would on occasion settle the claim.
Yes.
A.
We had a claims department --
Q.
Right.
A.
-- yes, in the company that would settle claims.
- 69 Q.
All right.
various states?
A.
No.
Q.
Okay.
A.
Yes.
And those people weren't licensed in
So was that part of your concern?
Q.
Okay. So now after NUF comes into the picture,
the same UPS employees are still meeting with the
customers. Correct? The shippers?
A.
Q.
Right?
Yes.
They're still selling the excess value units.
A.
I wouldn't characterize it as -- well, call it
selling if you want, but I don't -Q.
Well, what would you call it?
A.
I don't know. I don't know what I would call it.
I don't really know how they did it is my problem.
Q.
They were going out and meeting with the
customers, telling them about UPS's excess value -- the
excess value charges.
A.
Yes.
I'm sure they were.
Q.
So -- and -- but you did not take the next step
and obtain an opinion as to whether that would be
permissible under state insurance laws?
A.
No, I did not.
With nothing more than the sketchy testimony about vague
concerns by Mr. Johnson, petitioner would have us conclude that
it divested itself of a very profitable $100 million per year
revenue source that was based on a decades-old system for setting
shipping rates that had consistently received approval of the
- 70 Federal and State Governments.
We do not believe that petitioner
would have restructured a significant portion of its business in
order to avoid a potential State law problem without having
thoroughly analyzed and considered the matter and the
ramifications that any proposed change might have.
Had petitioner been seriously concerned with State insurance
regulation, a logical question would have been whether
petitioner's EVC activity regarding interstate transportation was
preempted by Federal law.
The liability of an interstate carrier
for damage to a shipment is a matter of Federal law controlled by
Federal statutes and decisions.
See Missouri Pac. R.R. v. Elmore
& Stahl, 377 U.S. 134, 137 (1964); A.T. Clayton & Co. v.
Missouri-Kan.-Tex. R.R., 901 F.2d 833, 834 (10th Cir. 1990) ("The
Carmack Amendment codifies an initial carrier's liability for
goods lost or damaged in shipment.").
Generally, carriers are
liable for loss or damage caused by them to property they
transport.
See id.; see also Shippers Natl. Freight Claim
Council, Inc. v. ICC, 712 F.2d 740, 745 (2d Cir. 1983).
During the years in issue, pursuant to the Carmack Amendment
to the Interstate Commerce Act,31 a motor common carrier could
31
Although the substance of the Carmack Amendment
(originally 49 U.S.C. sec. 20(11) (1906)) was recodified into 49
U.S.C. secs. 11707, 10730, and 10103, these sections were
commonly termed the Carmack Amendment. See Hughes v. United Van
Lines, Inc., 829 F.2d 1407, 1412 n.6 (7th Cir. 1987). Effective
(continued...)
- 71 establish rates for the transportation of property under which
the liability of the carrier was limited to a value established
31
(...continued)
Jan. 1, 1996, the Carmack Amendment was again recodified at 49
U.S.C. secs. 11706, 14706, and 15906. See Accura Sys., Inc. v.
Watkins Motor Lines, Inc., 98 F.3d 874, 876 n.2 (5th Cir. 1996).
49 U.S.C. sec. 11707 (1994) provides in pertinent part:
(a)(1) A common carrier providing transportation
or service subject to the jurisdiction of the
Interstate Commerce Commission * * * shall issue a
receipt or bill of lading for property it receives for
transportation * * *. That carrier or freight
forwarder and any other common carrier that delivers
the property and is providing transportation or service
* * * are liable to the person entitled to recover
under the receipt or bill of lading. The liability
imposed under this paragraph is for the actual loss or
injury to the property caused by [the carrier] * * *
*
*
*
*
*
*
*
(c)(4) A common carrier may limit its liability
for loss or injury of property transported under
section 10730 of this title.
49 U.S.C. sec. 10730(b)(1) (1994) provides:
[A] motor common carrier * * * may * * * establish
rates for the transportation of property (other than
household goods) under which the liability of the
carrier * * * for such property is limited to a value
established by written declaration of the shipper or by
written agreement between the carrier * * * and shipper
if that value would be reasonable under the
circumstances surrounding the transportation.
49 U.S.C. sec. 10103 (1994) provides:
Except as otherwise provided in this subtitle, the
remedies provided under this subtitle are in addition
to remedies existing under another law or at common
law.
- 72 by written declaration of the shipper or by written agreement
between the carrier and the shipper if that value would be
reasonable under the circumstances surrounding the
transportation.
See 49 U.S.C. sec. 11707(a)(1) (1994); see also
Fabulous Fur Corp. v. United Parcel Serv., 664 F. Supp. 694, 696
(E.D.N.Y. 1987); Art Masters Associates, Ltd. v. United Parcel
Serv., 567 N.E.2d 226, 227-228 (N.Y. 1990).
A motor common
carrier must publish and file with the ICC tariffs containing the
rates for transportation it may provide.
See 49 U.S.C. sec.
10762(a)(1) (1994); Fabulous Fur Corp. v. United Parcel Serv.,
supra at 696.
Petitioner offered its interstate shippers "released rates"
authorized by a series of ICC Released Rate Orders (RRO).32
Petitioner filed tariffs and tariff supplements during the years
in issue which determined released value rates authorized by the
ICC by Released Rates Decision MC-978.
Under the "Damaged and
Unclaimed Property" provision 535 of the tariffs, if the package
was damaged by petitioner, petitioner was liable to the shipper
to pay the full actual or declared value of the property,
whichever was lower.
Under the "Method of Determining Rates"
provision of the tariffs, if a shipper did not declare value in
excess of $100, petitioner collected its base rate and its
32
Similar orders were issued by each State relating to
intrastate orders.
- 73 liability was limited to $100.
If a shipper declared value in
excess of $100, petitioner collected its base rate plus an EVC of
25 cents per $100 of additional declared value and its liability
equaled the amount of value declared.
Thus, the EVC was part of
the rate charged by petitioner, and the rates, including the EVC,
were determined under the tariff.
Under both Federal law and the
provisions of the tariff, petitioner was liable for damage to
shippers' packages up to the declared value or $100 if no value
was declared.
Even if petitioner's excess value activity could be
characterized as some form of "insurance" under the various State
laws, Federal law appears to preempt State law with regard to the
liabilities of interstate carriers.
The Supreme Court addressed
the preemptive scope of the Carmack Amendment, relating to State
regulation of carrier liability, in Adams Express Co. v.
Croninger, 226 U.S. 491 (1913).
There, the Court held:
Almost every detail of the subject is covered so
completely that there can be no rational doubt but that
Congress intended to take possession of the subject and
supersede all state regulation with reference to it.
* * * [Id. at 505-506.]
Later, in Moffit v. Bekins Van Lines Co., 6 F.3d 305 (5th Cir.
1993), the Court of Appeals for the Fifth Circuit addressed the
Carmack Amendment and stated:
a purpose of the Carmack Amendment was to "substitute a
paramount and national law as to the rights and
liabilities of interstate carriers subject to the
- 74 Amendment." This Court, furthermore, adopted the
Supreme Court's language in Adams Express Co.:
That the legislation supersedes all the
regulations and policies of a particular
state upon the same subject results from its
general character. It embraces the subject
of the liability of the carrier under a bill
of lading which he must issue, and limits his
power to exempt himself by rule, regulation,
or contract.
To hold that the liability therein
declared may be increased or diminished by
local regulation or local views of public
policy will either make the provision less
than supreme, or indicate that Congress has
not shown a purpose to take possession of the
subject. The first would be unthinkable, and
the latter would be to revert to the
uncertainties and diversities of rulings
which led to the amendment. [Id. at 306-307
(citing Air Prods. & Chems. v. Illinois Cent.
Gulf R.R., 721 F.2d 483, 486 (5th Cir. 1983)
(quoting Adams Express Co. v. Croninger,
supra at 505-506)).]
Petitioner has successfully asserted that the Carmack
Amendment preempted State law which might otherwise govern a
shipper's claim for damage to packages.
See Plaid Giraffe, Inc.
v. United Parcel Serv., Inc., No. 94-1002-PFK (D. Kan., Sept. 26,
1994); Art Masters Associates, Ltd. v. United Parcel Serv., supra
at 228-229.
Petitioner similarly defended itself in other
actions by shippers for recovery of lost or damaged shipments.33
33
In United Parcel Serv., Inc. v. Smith, 645 N.E.2d 1 (Ind.
Ct. App. 1994), petitioner appealed from an action in which Glenn
Smith, the shipper, filed suit against petitioner regarding an
allegedly lost shipment. Mr. Smith sought to recover $995, the
(continued...)
- 75 While we need not specifically decide whether Federal law
preempts State insurance laws with respect to petitioner's excess
value activity, we believe that petitioner was well aware of the
preemption position and had good reason to believe that it
33
(...continued)
value of the lost package, from petitioner.
petitioner advanced the position that
On appeal,
Congress clearly intended the Carmack Amendment to
preempt all state regulation of claims against common
carriers for interstate ground shipments, and the
Supreme Court has specifically so held * * *
[Appellant's Opening Brief at 14, United Parcel Serv.,
Inc. v. Smith, supra.]
The Indiana Court of Appeals concluded that "49 U.S.C. § 10101 et
seq., the Interstate Commerce Act, and specifically those
portions known as the Carmack Amendment, preempt all state
regulation of interstate ground shipments." Id. at 3 (fn. ref.
omitted).
In Simmons v. United Parcel Serv., 924 F. Supp. 65 (W.D.
Tex., 1996), Mr. James W. Simmons filed suit in the State
District Court of Bexar County, Texas against petitioner
regarding two 1994 excess value shipments. Mr. Simmons sought to
recover $49,000 in damages. On motion by Mr. Simmons to remand
to the State Court, petitioner alleged that the Carmack Amendment
completely preempted all State law claims. The court stated:
Under the "complete pre-emption doctrine," once an area
of state law has been completely pre-empted, any claim
purportedly based on that pre-empted state law is
considered, from its inception, a federal claim, and
therefore arises under federal law. * * * Both the
Supreme Court and the Fifth Circuit have held that the
Carmack Amendment preempts all state law claims against
a common carrier. * * * [Id. at 67 (citing Adams
Express Co. v. Croninger, 226 U.S. 491 (1913); Moffit
v. Bekins Van Lines, Co., 6 F.3d 305 (5th Cir. 1993)).]
The court held that the "complete pre-emption" doctrine applied
and that removal from State court was proper. See id.
- 76 applied.34
Nevertheless, petitioner made no attempt to analyze
the issue or obtain legal advice before deciding to restructure
the EVC part of its business.
This leads us to believe that
petitioner's interjection of NUF and OPL into its excess value
activities in 1984 was not done in order to avoid running afoul
of State insurance laws and regulations.35
34
Petitioner has not attempted to draw a distinction between
concerns about interstate versus intrastate matters. According
to the testimony of petitioner's former chairman and C.E.O., in
excess of 75 percent of petitioner's volume in 1984 consisted of
interstate shipments and 98 percent of petitioner's volume in
1984 consisted of ground transportation. As previously
indicated, petitioner obtained authorization for its pre-1984 EVC
activities from the required State transportation authorities,
and no State had asserted that petitioner was not in compliance
with State insurance law.
35
As stated by Dr. Shapiro in his expert report:
Assuming the risk of state regulation was real,
abandoning a profitable business because of this risk
is equivalent to burning down the barn to get rid of
the rats. Even if you solved the problem, the price
was too high.
*
*
*
*
*
*
*
Based on my business experience, it is my
strongly-held opinion that a company would not walk
away from such a valuable business on a mere suspicion
that it might be subject to an added risk of
regulation. Rather, in such a situation, the company
would first meet with legal counsel to get an opinion
as to the likelihood and business consequences of such
regulation. Next, it would analyze the financial
impact of such regulation and explore how it might be
able to legally avoid, minimize, or delay the impact of
any potential regulation. * * * [Fn. ref. omitted.]
- 77 Assuming that petitioner's excess value activity might have
been considered "insurance" subject to regulation under various
State laws, petitioner's "restructured" method of handling EVC's
would also seem to violate State laws.
For example, in some
States the sale or solicitation of insurance without
authorization is a violation of State statutes.
See, e.g., Cal.
Ins. Code sec. 700 (West 1993);36 N.Y. Ins. Law sec. 109(a)
36
Cal. Ins. Code sec. 700 (West 1993) provides:
§700.
Admittance required; penalties; compliance; hearings;
issuance of certificate
(a) A person shall not transact any class of
insurance business in this state without first being
admitted for that class. Admission is secured by
procuring a certificate of authority from the
commissioner. The certificate shall not be granted
until the applicant conforms to the requirements of
this code and of the laws of this state prerequisite to
its issue.
(b) The unlawful transaction of insurance business
in this state in willful violation of the requirement
for a certificate of authority is a public offense
punishable by imprisonment in the state prison, or in a
county jail not exceeding one year, or by fine not
exceeding one hundred thousand dollars ($100,000), or
by both, and shall be enjoined by a court of competent
jurisdiction on petition of the commissioner.
Cal. Ins. Code sec. 35 (West 1993) provides:
§35.
Transact
"Transact" as applied to insurance includes any of
the following:
(a) Solicitation.
(continued...)
- 78 (McKinney 1985).37
36
During 1984, petitioner provided its shippers
(...continued)
(b) Negotiations preliminary to execution.
(c) Execution of a contract of insurance.
(d) Transaction of matters subsequent to execution
of the contract and arising out of it.
37
N.Y. Ins. Law sec. 1102 (McKinney 1985) provides:
§1102.
Insurer's license required; issuance
(a) No person, firm, association, corporation or
joint-stock company shall do an insurance business in
this state unless authorized by a license in force
pursuant to the provisions of this chapter, or exempted
by the provisions of this chapter from such
requirement. Any person, firm, association,
corporation or joint-stock company which transacts any
insurance business in this state while not authorized
to do so by a license issued and in force pursuant to
this chapter, or exempted by this chapter from the
requirement of having such license, shall, in addition
to any other penalty provided by law, forfeit to the
people of this state the sum of one thousand dollars
for the first violation and two thousand five hundred
dollars for each subsequent violation.
N.Y. Ins. Law sec. 1101(b)(1) (McKinney 1985) provides:
§ 1101. Definitions; doing an insurance business
(b)(1) Except as provided in paragraph two hereof,
any of the following acts in this state, effected by
mail from outside this state or otherwise, by any
person, firm, association, corporation or joint-stock
company shall constitute doing an insurance business in
this state and shall constitute doing business in the
state within the meaning of section three hundred two
of the civil practice law and rules:
*
*
*
*
*
*
*
(continued...)
- 79 with the necessary forms upon which the shippers could declare
excess value.
The package pickup record was used by petitioner
to bill shippers for the EVC's sold.
Petitioner received and
deposited EVC income in its corporate accounts.
Thus, assuming
that the Shippers Interest Program was insurance, petitioner sold
or solicited the putative insurance in 1984.
received, reviewed, defended, and paid claims.
Petitioner also
By selling the
Shippers Interest policy, collecting the premiums, and adjusting
claims without the appropriate licenses, petitioner would
seemingly have been in violation of State statutes prohibiting
the sale, collection of premium, and adjustment of claims related
to the NUF insurance policy.
It strains credulity to believe
that petitioner attempted to avoid the requirements of State
statutes by restructuring its excess value activity in a manner
that arguably caused petitioner to remain in violation of State
statutes.38
Had such a restructuring occurred to avoid violating
State law, we believe that a large successful corporation such as
37
(...continued)
(C) collecting any premium, membership fee,
assessment or other consideration for any policy or
contract of insurance;
38
Indeed, on the question of whether petitioner's EVC
activity constitutes "insurance", petitioner fails to make any
meaningful distinction between the promise to "insure" the first
$100 of value in return for a shipping fee, which petitioner
continued after Jan. 1, 1984, and the excess value activity.
- 80 petitioner would have thoroughly analyzed the legal and business
ramifications.
That was not done.
Petitioner also argues that one of its business purposes for
restructuring the EVC activity was to leverage the excess value
profits into the creation of a new reinsurance company, which
over time could become a full-line insurer.
We have no doubt
that transferring the profits from the EVC activity, tax free,
could provide OPL with the capital to become a full-line insurer
of other risks.
But any investment of money into OPL could
accomplish this purpose.
The question here is whether petitioner
earned, and must pay tax on, the funds ultimately transferred to
OPL or whether the EVC profits were earned by NUF and OPL.
The
purpose for which the profits were ultimately used, or intended
to be used, does not answer the question before us.
Petitioner alleges that another business purpose for
restructuring its EVC activity was to enable it to increase its
rates.
Petitioner argues that by removing the excess value
revenue from its operating ratio computation, it could obtain
larger rate increases than would have otherwise been possible.
Petitioner historically targeted a 90-percent operating ratio on
its ground transportation business.39
39
Petitioner alleges that
Petitioner's operating ratio was computed as a ratio of
operating expenses to operating revenue. An operating margin is
the inverse of an operating ratio. Thus, a 90-percent operating
(continued...)
- 81 its operating ratios played an important role in obtaining rate
increases.
We do not believe that petitioner shifted EVC income to OPL
in order to justify raising its rates.
The 90-percent operating
ratio was a standard set by petitioner rather than a Federal or
State regulatory mandate.
The Motor Carrier Act of 1980 (MCA),
Pub. L. 96-296, 94 Stat. 793, provided for a Zone of Rate Freedom
(ZORF) for motor common carriers and freight forwarders.
ZORF
allowed for the filing of rate increases up to 10 percent above
the rate in effect 1 year before the effective date of the
proposed increase or a decrease of as much as 10 percent below
the lesser of the rate in effect on July 1, 1980, or the rate in
effect 1 year before the effective date of the proposed rate.
See MCA sec. 11, 94 Stat. 801.40
Petitioner did not offer any
39
(...continued)
ratio is equal to a 10-percent operating margin.
40
The pertinent portion of the Motor Carrier Act of 1980,
Pub. L. 96-296, sec. 11, 94 Stat. 801, provided:
ZONE OF RATE FREEDOM FOR MOTOR CARRIERS OF PROPERTY AND
FREIGHT FORWARDERS
Sec. 11. Section 10708 of title 49, United States
Code, is amended by adding at the end thereof the
following new subsection:
(d)(1) Notwithstanding any other provision of this
title, the Commission may not investigate, suspend,
revise, or revoke any rate proposed by a motor common
carrier of property or freight forwarder on the grounds
(continued...)
- 82 credible evidence that the various Federal and State regulatory
agencies would have denied a rate increase had it retained the
EVC income.
Petitioner's primary consideration in setting rates
was fairness and competition, according to its former executives.
Indeed, the testimony of petitioner's former executives indicates
that they could have sought greater rate increases under ZORF
than what was requested and that they were not concerned about
maximizing rates.
In November 1984, petitioner sought and
obtained from the ICC and various State regulatory bodies a 5.45percent rate increase effective January 1, 1985.
Petitioner's
rate increase of 5.45 percent was 4.55 percent less than the
maximum increase allowed by ZORF.
40
(...continued)
that such rate is unreasonable on the basis that it is
too high or too low if--,
(A) the carrier notifies the Commission that it
wishes to have the rate considered pursuant to this
subsection; and
(B) the aggregate of increases and decreases in
any such rate is not more than 10 percent above the
rate in effect one year prior to the effective date of
the proposed rate, nor more than 10 percent below the
lesser of the rate in effect on July 1, 1980 (or, in
the case of any rate which a carrier first establishes
after July 1, 1980, for a service not provided by such
carrier on such date, such rate on the date such rate
first becomes effective), or the rate in effect one
year prior to the effective date of the proposed rate.
- 83 Mr. Kent C. Nelson who, during the years in issue, was a
member of petitioner's board of directors and was petitioner's
chief financial officer, testified as follows:
Q.
Mr. Nelson, I believe you mentioned earlier
you were familiar with the rate increase in January
1985?
A.
Yes.
Q.
Was that rate increase higher or lower
because of the spinoff of the [excess value] business?
A.
It's hard to tell, because the projection
process projects increased volume, projected labor
costs, and the revenue that we had from growing
businesses that are profitable. And it all comes
together the way it comes together. I don't know if it
would have had any effect on it at the time. It would
be conjecture on my part.
*
*
*
*
*
*
*
Q.
Assuming that all other factors were equal,
did the rate increase in 1985 increase or decrease
because of the transfer of the excess value business.
A.
I don't think it made any difference.
Like petitioner's other alleged business justifications for
restructuring its EVC activity, there is no contemporaneous
documentation that petitioner investigated or considered the
impact that restructuring its EVC activity would have on its
shipping rates.
Petitioner also argues that by restructuring the EVC
activity, it enhanced protection of the assets of its core
transportation activity from the risks associated with assuming
- 84 liability for declared value in excess of $100.
In order to
evaluate this alleged business purpose, we will look to whether
petitioner actually transferred or reduced its liability to
shippers in any meaningful sense.
In other words, did the
rearranged EVC activity have any real economic impact on
petitioner?
In 1983, petitioner supplemented tariffs filed with the ICC
on behalf of UPS-New York and UPS-Ohio.
Supplement provision
540-A to the tariffs provided that petitioner "may" remit excess
valuation charges to an insurance company as a premium for excess
valuation cargo insurance on the shipper's behalf.
However,
supplement provision 540-A also stated that in the event that the
insurance company failed to pay any claim for loss or damage to
the shipper's property under the policy, petitioner would remain
liable for any loss or damage within the limits declared and paid
for.41
41
Petitioner's service explanation also states that if NUF
fails to pay any claim for loss of or damage to the shipper's
property, petitioner will remain liable for loss or damage within
the declared limits of the Shippers Interest contract.
The Shippers Interest contract document specifically lists
the shippers under the "name and address of insured". However,
the contract document also lists the address of the insured to be
that of petitioner's world headquarters. Under the cancellation
provision of the Shippers Interest contract, either petitioner or
the "Named Insured" could terminate the contract. Thus,
petitioner had the power to cancel the insurance policy that
petitioner alleges was between its shippers and NUF. Of course,
(continued...)
- 85 Pursuant to tariff provision 510, filing of claims, shippers
were required to allege in writing, among other things, that
petitioner was liable for the loss or damage.
Pursuant to tariff
provision 520, time limit for filing claims, petitioner was
relieved of liability under its tariff if the shipper did not
file a claim with petitioner or institute a lawsuit against
petitioner within 2 years and 1 day from when petitioner notified
the shipper that the claim had been disallowed by petitioner.
Under this provision, shippers were required to bring an action
against petitioner in order to pursue their claims for damage or
loss of packages.
Each of the above-mentioned provisions existed
in petitioner's tariffs before and during 1984.
On the basis of
Federal law and the provisions that remained in petitioner's
tariffs, liability continued to arise under such tariffs in 1984.
Petitioner treated liability for loss or damages associated
with EVC's as arising from petitioner's tariffs in accordance
with Federal law.
Upon commencement of a relationship with its
shippers, petitioner provided most shippers with a copy of
petitioner's service explanation.
While the service explanation
referred to NUF and the Shippers Interest contract, petitioner
did not generally provide a copy of the Shippers Interest
41
(...continued)
petitioner would in any event have remained liable to its
shippers for damage claims.
- 86 contract to each of its shippers.
As a result of tariff
requirements 510 and 520, rather than filing claims with NUF
under the Shippers Interest contract, shippers were required to
file a claim only "against" petitioner within a specific time in
order to be compensated for loss or damage.
Even at the point
when petitioner adjusted shippers' claims, petitioner does not
appear to have informed the shippers that NUF was the insurer of
the claim or that the shippers had any recourse against NUF.
Thus, shippers' claims were presented to and resolved by
petitioner in accordance with the provisions of the tariff.
Petitioner represented to its customers in its quarterly
publications that petitioner was liable for lost or damaged
packages.
In December 1983, petitioner's Roundups newsletter
informed its customers that petitioner's drivers would leave
packages without signatures at certain delivery locations.
In
the newsletter, petitioner assured its shippers that UPS would
continue to assume liability for lost and damaged packages up to
$100 or the declared value.
On the basis of the foregoing facts,
we find that after January 1, 1984, petitioner remained liable to
shippers who had declared a value in excess of $100.
There still remains the question of whether the arrangement
with NUF and OPL sufficiently reduced petitioner's financial
exposure to be recognized as having economic substance.
The
Shippers Interest contract provided that NUF was not liable for
- 87 the first $100 of value, and in no event did NUF's liability
exceed the declared value of a shipper's package.
The Shippers
Interest contract also provided that if petitioner's liability
for loss or damage to a shipper's package was covered by another
insurance policy, then NUF would not be liable for the amount
covered by petitioner's other insurance policy.
Other insurance
did exist.
Throughout 1984, petitioner maintained an insurance policy
with Affiliated FM Insurance Co. (AFM policy) that covered
petitioner's liability for loss or damage to shipper's
packages.42
Petitioner paid annual installment premiums of
$356,945 of which $86,820 was allocated to property value related
to parcels in transit.
Under the policy, $86,820 of annual
premium provided coverage for an average daily parcel value of
$354,369,000.
The AFM policy provided for a $25,000 deductible
to all loss claims arising out of a loss occurrence.
To the extent that other insurance did not exist, the
Shippers Interest contract generally did not limit claims to any
maximum amount per loss occurrence.43
The AFM policy covered
42
Petitioner's purchase of the AFM policy and its operation
effect of covering "petitioner's liability" for packages shipped
during 1984 is inconsistent with petitioner's argument that it
had no such liability to shippers after Jan. 1, 1984.
43
With respect to packages sent "UPS 2nd day Air" or "UPS
next day air", the Shippers Interest contract limited NUF's
(continued...)
- 88 petitioner's liability for package losses related to any single
occurrence to the extent the liabilities were greater than
$25,000 but did not exceed $10 million.
Thus, there was a
theoretical exposure for NUF and OPL, to the extent that one or
more loss occurrences resulted in more than $10 million in loss
per occurrence.
For example, if petitioner incurred liability to
shippers as a result of a single occurrence of three times the
$10 million limit that petitioner was insured for under the AFM
policy in 1984, NUF/OPL would have been liable for approximately
$20 million.44
(Twenty million dollars in additional claims
would have reduced the gross profit percentage from EVC's in 1984
from 78 percent to 58 percent.)
Even in this unlikely event,
excess value revenue in 1984 would have exceeded over two times
the amount of claims paid.
Considering the extreme magnitude of
a catastrophe that would have to occur before claims exceeded
excess value revenue in a given year, we again find it
unrealistic that petitioner or NUF/OPL would realize a loss in
its excess value activity.45
43
(...continued)
liability to $25,000 per package.
44
Disregarding the $25,000 deductible, petitioner would have
coverage of $10 million under the AFM policy, and NUF/OPL would
be liable for claims in excess of that.
45
The only potential financial benefit that petitioner could
realize from its arrangement with NUF and OPL was if liabilities
(continued...)
- 89 Petitioner must have drawn the same conclusion.
Through the
AFM policy, petitioner was able to cover its liability for up to
$10 million for any single occurrence in return for premiums of
$86,820.46
This amount of premium is less than one-tenth the
amount petitioner agreed to pay NUF to be a "front" in the
restructuring of the excess value activity.
NUF and OPL were not
liable for losses attributable to a single occurrence, to the
extent such losses were between $25,000 and $10 million.
Petitioner, in turn, was not dependent upon NUF and OPL for
single-occurrence catastrophic losses above the deductible of
$25,000 and under $10 million but would have been able to procure
coverage for such liability in excess of $10 million for a
relatively nominal premium.
Petitioner had a conservative, risk-averse insurance
philosophy and sought to have sufficient coverage to protect its
assets from a catastrophe.
In 1983, petitioner considered
raising the $10 million AFM policy limit to $20 million.
In a
letter dated May 26, 1983, sent by Mr. Edmund Mihich, of Hall, to
Mr. Johnson and Mr. Eugene Schoenleber of petitioner's insurance
department, Mr. Mihich wrote:
45
(...continued)
for lost and damaged shipments were to exceed EVC revenue that it
had given up.
46
This AFM coverage excludes liabilities of up to $25,000
per occurrence.
- 90 Please allow this letter to confirm our telephone
discussion of May 25, 1983 with regard to the * * *
[AFM policy].
*
*
*
*
*
*
*
With regard to your interest in increasing the unnamed
location and transit sub-limits from $10,000,000 to
$20,000,000, Allendale has requested to be provided
with the exposure data which creates this request.
Gene, as I indicated to you on the telephone, it was
Allendale's understanding that the present $10,000,000
limit provided was far more than sufficient. * * *
With regard to the transit limit, Allendale was under
the impression that there was no situation in which the
exposure approached anywhere near the $10,000,000 mark.
Both Allendale (AFM's parent) and Hall considered petitioner's
AFM policy limit of $10 million to be substantially more coverage
than necessary to insure against losses that petitioner's transit
operation exposed petitioner to.
Petitioner chose not to
increase the limits on the AFM policy to $20 million, further
indicating to us that there was no realistic possibility that
petitioner or NUF/OPL would realize a loss in its excess value
activity.
Because the AFM policy was in effect before, during,
and after the time when petitioner restructured its excess value
activity, we do not find any relationship between petitioner's
goal of protecting against catastrophic loss and the
restructuring of petitioner's excess value activity.47
47
An endorsement was added to the Affiliated FM policy
effective Jan. 1, 1984, which referred to the Shippers Interest
contract. However, petitioner maintained the same level of
coverage and deductible of the Affiliated FM policy that existed
(continued...)
- 91 The AFM policy did not provide benefits for damage to
packages below the $25,000 single occurrence deductible.
Such
losses could also theoretically have exceeded EVC revenue.
However, petitioner's excess value losses were part of a very
large universe of shipments, and the ratio of losses to EVC's
remained consistent over many years and was therefore
predictable.48
The following schedule reveals the consistency of
claims paid by petitioner for damages in excess of $100:
47
(...continued)
before the execution of the Shippers Interest contract.
48
Petitioner had been engaged in a declared value program
since the 1950's.
- 92 -
Year
EVC's
Claims Over
$100 Paid1
EVC's less
Claims Paid
Ratio2
1979
$49,200,000
$13,800,000
$35,400,000
72.0%
1980
57,900,000
16,200,000
41,700,000
72.0
1981
70,512,000
20,007,000
50,505,000
71.6
1982
73,816,000
21,372,000
52,444,000
71.0
1983
78,000,000
23,000,000
55,000,000
70.5
1984
99,794,790
22,084,012
77,710,778
77.9
1985
119,077,863
36,236,469
82,841,394
69.6
1986
140,255,469
43,499,702
96,755,767
69.0
1987
161,098,590
52,509,376
108,589,214
67.4
1988
187,106,344
67,230,962
119,875,382
64.1
1989
208,596,033
77,214,084
131,378,949
63.0
1
Amounts in this column for 1979 and 1980 are estimated
amounts.
2
This column represents the ratio of excess value income
less claims paid divided by total excess value income.
Petitioner's excess value claims payments over 11 years never
exceeded 40 percent of the total excess value income.
Considering the consistency of the ratio of loss claims payments
to EVC revenue from year to year, we find that the possibility
that total cumulative annual payments for shipping losses from
single occurrences involving less than $25,000 might exceed EVC
revenue was so remote, that for all practical purposes, it was
- 93 nonexistent.49
As a result, the level of risk, if any, that was
shifted from petitioner to NUF and OPL was insignificant.
The possibility that cumulative catastrophic losses in
excess of the $10 million per-occurrence limit on the AFM policy
would occur, and that claims for occurrences involving less than
$25,000 would increase dramatically, and that, either
individually or in combination, they would exceed total EVC's,
was improbable, unrealistic, and insignificant.
We find that
these theoretical possibilities had nothing to do with
petitioner's motivation for transferring the EVC profits, less
fronting costs, to OPL and that the insertion of NUF and OPL into
petitioner's EVC activity provided no significant nontax benefit
to either petitioner or its shippers.
49
We agree with respondent's expert Mr. Edward T. Kelley,
who concluded as follows:
As a general rule, the firm would prudently retain
exposures which could be expected to generate
reasonably predictable numbers of claims and relatively
stable and consistent amounts of total loss, and seek
to transfer exposures with substantially lower
predictability and greater volatility to an insurer
willing to assume liability for such exposures at terms
acceptable to the firm. Since * * * [petitioner], by
the nature of its operations, generates a very large
number of relatively homogeneous units of exposure, the
predictability of expected losses related to shippers'
property in its custody is very high and year to year
variability is relatively limited. Its self-insurance
program for handling claims for loss of or damage to
shippers' property produced consistently profitable
results during the years 1979 through 1982 * * *.
- 94 Another factor in determining whether a particular
transaction was a sham is the presence or absence of arm's-length
price negotiations and the relationship between the price and
fair market value.
See Helba v. Commissioner, 87 T.C. 983, 1005
(1986), supplemented by T.C. Memo. 1987-529, affd. 860 F.2d 1075
(3d Cir. 1988); see also Karme v. Commissioner, 73 T.C. 1163,
1186-1190 (1980), affd. 673 F.2d 1062 (9th Cir. 1982).
In
deciding such issues, courts often look to expert opinions.
The
Court is not bound by the opinion of any expert, and we may
accept or reject in full or in part experts' opinions proffered
by the parties.
See Helvering v. National Grocery Co., 304 U.S.
282, 294-295 (1938); Seagate Tech., Inc., & Consol. Subs. v.
Commissioner, 102 T.C. 149, 186 (1994); Parker v. Commissioner,
86 T.C. 547, 562 (1986).
Both petitioner and respondent offered
the reports and testimony of various expert witnesses in an
effort to establish an arm's-length price that petitioner could
have obtained for the coverage provided by NUF and OPL.
Respondent offered the expert report of Mr. Kelley for the
purpose of proving that, within the insurance industry, the
arm's-length price that petitioner could have obtained for
coverage associated with petitioner's excess value activity would
have been substantially less than 25 cents per $100 of excess
value.
Mr. Kelley has in excess of 30 years of experience buying
- 95 and providing insurance and reinsurance products.
In his report,
Mr. Kelley stated:
The .25 per $100 of declared value charges used on the
NUF policy was apparently derived directly from * * *
[petitioner's] tariff filing, and bore no reasonable
relationship to the rate that would have been developed
in a competitive marketplace for a comparable insurance
arrangement transacted on an "arm's length" basis.
* * * For the period 1984 through 1989 total premium
received and losses paid on the NUF policy amounted to
approximately $845,000,000 and $281,000,000,
respectively, for an overall loss ratio of 33% * * *.
There was little or no potential for late reported
claims or significant adverse reserve development on
business of this kind, so the numbers reflected on
NUF's premium and loss bordereaux may be treated as
final for the years involved.
In a competitive marketplace such results could never
be achieved. * * * it should be noted that the U.S.
property-casualty insurance industry has achieved a
combined ratio (the sum of the loss ratio (incurred
losses ÷ earned premium) plus the expense ratio
(expenses ÷ written premium) of less than 100%, i.e.,
produced an underwriting profit) in only three of the
past twenty years * * *.
It is also extremely unlikely that any insurance broker
that permitted an insurer to generate such profits at
the expense of its client could expect to retain that
client for very long. In this instance, of course, the
profits were not retained by NUF, but flowed, as
intended, as ceded reinsurance premiums back to OPL.
Mr. Kelley logically concluded that the 25-cent price per $100 of
excess value set on the NUF policy was not an arm's-length price
that would have been agreed upon in a competitive market.50
50
Similarly, respondent's expert Mr. Michael Cohen, an
insurance expert with extensive brokerage experience, agreed that
the 25 cents per $100 of excess value was too high. Referring to
(continued...)
- 96 This conclusion is also supported by comparing the 25-cent
price paid to NUF with the price that was offered by FFIC and
PIP.
For more than 15 years before 1983, FFIC, through a policy
sold by PIP, solicited and sold excess value coverage to
petitioner's shippers.
Generally, PIP sold the excess value
coverage at a price of $0.125 per $100 of coverage.
PIP retained
approximately 36 percent of the premium in 1983 and 34 percent in
1984.
Thus, of the $0.125 per $100 of coverage, PIP retained
approximately $0.045 and $0.0425 in 1983 and 1984,
respectively.51
On the other hand, FFIC underwrote the coverage
for approximately 8 cents52 per $100 of coverage in 1983 and
$0.082553 in 1984.
FFIC was able to realize a gross profit
margin of 27 percent in 1983, based on an approximate price of 8
cents per $100 of excess value coverage.54
The FFIC/PIP program
50
(...continued)
petitioner's loss ratios and declared revenues for 1981 through
1983, Mr. Cohen stated in his expert report:
In my experience spanning more than thirty years I
cannot recall one case where the broker would offer the
insurer on behalf of his client a piece of business at
such an advantageous rate. * * *
51
The $0.125 price times 36 percent and 34 percent equals
$0.045 and $0.0425, respectively.
52
$0.125 less $0.045 equals $0.08.
53
$0.125 less $0.425 equals ($0.0825).
54
Gross profit margin in this instance is defined as
(continued...)
- 97 did not offer coverage to certain high-risk shippers.
Nevertheless, the coverage underwritten by FFIC was very similar
to that which was purported to be provided by NUF and OPL and is
an indication that the price of the excess value coverage
provided by NUF and OPL was substantially more than the price
petitioner could have obtained in arm's-length negotiations.55
Respondent's expert, Prof. Alan Shapiro, Ph.D., professor of
finance and business economics, estimated that $0.092 per $100 of
declared value in excess of $100 would have been an arm's-length
price for insurance covering petitioner's excess value activity.
Professor Shapiro based his analysis on the proposition that an
arm's-length price for OPL's excess value coverage would be one
that over time provided OPL with a fair return on its necessary
equity investment.
In coming to his conclusion, Professor Shapiro compared what
OPL's return on equity would have been had it been reinsuring the
EVC activity during the years 1979 through 1983 with that of
54
(...continued)
premiums minus claims paid minus commissions.
55
Had petitioner's customers paid $0.125 per $100 of
declared value (the same as PIP charged), EVC revenues would have
been cut in half, but the gross profit percentage (one-half of
EVC's, less all claims paid, divided by one-half of EVC's) for
the years 1979 through 1989 would have been 37 percent. One-half
of EVC revenue for 1979 through 1989 is $622,678,544 less actual
claims paid of $393,153,605 equals gross profit of $229,524,939.
Gross profit of $229,524,939 divided by $622,678,544 equals a
gross profit percentage of 37 percent.
- 98 other members of the insurance sector OPL would have operated in.
Professor Shapiro's report contained the following chart, which
includes Value Line56 statistics regarding return on equity in
each year for 22 property/casualty insurers and diversified
insurance companies:
1979
1980
1981
1982
1983
Mean
Mean Value Line ROE
23.5%
20.4%
20.5%
13.8%
11.8%
18.0%
Estimated Value
Line ke1
18.5
20.0
22.5
19.2
17.1
19.5
Minimum Value Line
ROE
12.4
8.3
9.7
0.1
0.1
6.1
Maximum Value Line
ROE
39.6
40.0
42.3
26.6
27.1
35.1
OPL's estimated ROE
($0.25 charge)
172.9
170.1
182.3
174.1
168.6
173.6
OPL's estimated ROE
($0.092 charge)
15.7
15.8
15.2
13.5
12.8
14.6
Estimated OPL ke
13.7
15.2
17.7
14.3
12.3
14.6
Value Line sample
size
22.0
22.0
22.0
22.0
22.0
1
"ke" is the estimated year-by-year cost of equity capital.
Professor Shapiro concluded that had OPL been in existence during
the periods preceding 1984 and had it charged a fee of 25 cents
(instead of $0.092) per $100 in excess value coverage, it would
have earned huge persistent returns and that "OPL's ROE would
56
Value Line is a publication widely used as a source of
financial data.
- 99 have been over four times as large as the highest return earned
by any of the Value Line companies in any year, and its average
ROE of 173.6 percent would have been almost 10 times the average
ROE of 18.0 percent earned by the Value Line companies."
Respondent also offered the expert report of Mr. Frederick
Kilbourne, an actuary, for his opinion regarding an arm's-length
premium for the coverage associated with petitioner's excess
value activity.
In computing the premium rate, Mr. Kilbourne
analyzed the following premium elements:
1.
Losses (payments to claimants)
2.
Claim expenses
3.
Other expenses (commissions, taxes, etc)
4.
Investment income
5.
Risk charge (provision for profit and catastrophes)
Mr. Kilbourne determined on an actuarial basis the following
rates per premium element (in cents per $100 of coverage):
1.
Losses
7.5¢
2.
Claims expenses
0.0
3.
Other expenses
0.4
4.
Risk charge
0.4
5.
Investment income
-.2
Total
8.1¢
Additionally, Mr. Kilbourne concluded that if claim expenses were
to be covered within the premium rate, as is customary in the
- 100 industry, the needed rate would increase from 8.1 cents to about
8.6 cents.
Respondent's expert Dr. Blaine Nye, an insurance economist,
explained in his expert report that an insurance company would
price a policy by calculating the expected losses and expenses
and adding an underwriting profit margin.
Dr. Nye used the
capital asset pricing model to derive an underwriting profit for
petitioner's excess value activity.
Dr. Nye concluded that the
arm's-length price of an insurance arrangement providing coverage
on the liability to shippers declaring values in excess of $100
to be 32 percent of declared value revenues.
Thus, according to
Dr. Nye, petitioner would have paid a price of approximately 8
cents (32 percent of 25 cents) per $100 of coverage to insure its
excess value activity liability.
One of the experts presented by petitioner at trial
implicitly acknowledged that petitioner could have negotiated a
lower arm's-length price for the coverage provided by NUF and
OPL.
Petitioner presented Dr. Neil Doherty as an expert in the
economics of insurance.
On cross-examination, Dr. Doherty
responded as follows:
Q.
From purely insurance pricing perspective,
would you agree that if Overseas Partners, Limited, was
entirely unrelated to UPS, had no common shareholders,
no common officers, no common board of directors, that
this transaction would have made little sense from
UPS's perspective?
- 101 A.
Everything else in the transaction was the
same except that the ownership of OPL was different, it
was totally unrelated?
Q.
And from an insurance pricing perspective,
the question is whether that -- the transaction would
make sense from UPS's perspective.
A.
That's a little difficult to answer. It
would be very strange to think if UPS had the
opportunity to sell insurance, either directly or
indirectly, at the prices which were prevailing in that
marketplace at that time, it would be a rather strange
business decision to basically give off that profit to
an outsider.
As previously explained, in 1984 the EVC's billed by
petitioner were $99,794,789.67 and claims paid were
$22,084,011.93.
Thus, claims paid in 1984 represented
approximately 22 percent of the total EVC's billed.57
Claims
paid during the years 1979 through 1983 represented approximately
28.6 percent of the total EVC's billed during those years.
After
carefully considering the entire record, including the expert
reports offered by both petitioner and respondent, we are
persuaded that the price of 25 cents per $100 of excess value
liability paid to NUF pursuant to the Shippers Interest contract
that petitioner and NUF agreed to was not a result of arm's-
57
$22,084,011.93 divided by $99,794,789.67 equals
approximately 22 percent. When claims are added to fronting
expenses of $1,000,000 and taxes and board and bureau charges of
$4,091,586 for 1984, the claims and fees increase to
$27,175,597.93, and the ratio increases from 22 percent to
approximately 27 percent. $22,084,011.93 plus $1,000,000 plus
$4,091,586 equals $27,175,597.93.
- 102 length negotiations and that the price of 25 cents per $100 was
far in excess of the price that could have been negotiated by
petitioner.
This is another indication to us that petitioner's
arrangement with NUF and OPL was a sham.
Finally, unlike petitioner's purported business reasons for
its arrangement with NUF and OPL, there is contemporaneous
documentation to establish that petitioner seriously considered
and was motivated by the reduction of Federal income tax that
would occur by transferring excess value income to OPL.
In July
1982, petitioner's tax manager and another employee prepared a
memorandum to Mr. Danielewski concerning tax and other
implications of the insurance business.
The memorandum was
prompted by a meeting at which petitioner's EVC program was
discussed.
In September 1982, Hall prepared a memorandum
regarding the feasibility of creating a United Parcel Service
Insurance Subsidiary.
Throughout the memorandum, Hall noted that
there were a number of tax benefits if an offshore insurance
company were to be created.
The tax benefits were stated to be
approximately $24 million.
In summary, the report states:
It has been the purpose of this brief preliminary
report to consider in some detail the immediate
potential available to [petitioner] in maximizing the
profit potential in the declared value protection which
you are currently providing shippers and also to
acquaint you with some of the basic issues involved in
a captive operating in either a traditional role or
- 103 within the context of the declared value program as an
insurance subsidiary.
It appears obvious to us that the conversion of the
declared value program to an insured basis utilizing an
offshore insurer and F.I.R.S.T. will increase the
profits generated by this program by approximately
$24,000,000. It is also obvious that there are many
complex issues involved in this conversion which should
be considered by counsel.
The potential increase in after-tax profits appears to be totally
dependent on projected savings in Federal income tax.
In March 1983, Hall prepared a memorandum that contained a
description of the tax benefits if petitioner used the
alternative structure for the excess value program.
The
memorandum indicated that the projected tax benefit to petitioner
was $16,077,500 for the first year.
Hall arrived at this amount
by calculating the benefit to petitioner to be equal to the
elimination of income tax on petitioner's expected EVC income,
less the fronting fees, premium taxes, Federal excise taxes, and
ceding commission.
Thus, the documents generated by Hall portray
the tax results of creating a Bermuda insurance company as the
focus for improving the economic result of the transaction.
The
memorandum stated that the projection of tax savings prepared by
Hall was to be submitted to petitioner's senior management by Mr.
Danielewski.
Petitioner subsequently postponed its decision to go forward
with the proposed EVC activity structure because of tax
- 104 considerations.
NUF had prepared a binder for the Shippers
Interest contract to become effective as of August 8, 1983.
On
the same day the contract was to become effective, Mr. Corde sent
a telex to Mr. Smetana indicating that petitioner postponed the
finalization of the Shippers Interest program to allow for
petitioner's review and evaluation of pending tax legislation.
In April 1984, after restructuring its EVC activities, petitioner
released a report to shareholders in which petitioner indicated
that because OPL was organized as a Bermuda corporation doing no
business in the United States, OPL's earnings were not expected
to be subject to U.S. Federal or State taxes on income.
The contemporaneous documentation prepared by petitioner and
Hall regarding the plan to restructure the excess value activity
emphasized the resulting tax benefits to petitioner.
Petitioner
produced no documentation, such as corporate minutes, that was
prepared during the period in which petitioner was considering or
executing its EVC restructuring that indicates that petitioner
had motives other than tax reduction.
Petitioner has failed to prove that the restructuring of its
EVC activity was motivated by nontax business reasons or that the
restructuring had economic substance.
Rather, we find that the
restructuring was done for the purpose of avoiding taxes and that
the arrangement between petitioner, NUF, and OPL had no economic
- 105 substance or business purpose.58
Petitioner controlled and
performed all activities and functions that resulted in EVC
revenue.
The EVC profits that were transferred to OPL for the
benefit of petitioner's and OPL's shareholders were the fruition
of petitioner's EVC activity.
petitioner.
OPL provided nothing of value to
The purpose of the arrangement with NUF and OPL was
to confer tax-free benefits on petitioner's and OPL's
shareholders.
Obviously, petitioner is not entitled to any
deductions for profits transferred to OPL.
As a result,
petitioner must include EVC revenue in income for 1984 and is
liable for tax on the resulting profits.59
58
In arriving at our finding, we recognize that some of
petitioner's witnesses testified that they considered State
insurance regulation and other nontax considerations to be
reasons for restructuring petitioner's EVC program. We have
fully considered that testimony, the demeanor of the witnesses,
and the statements they made before trial (in both
contemporaneous documents and interviews) in addition to the
aforementioned matters discussed in the text. In the final
analysis, we do not believe that nontax business considerations
were the reasons that motivated petitioner.
59
Because we have held that petitioner's arrangement with
NUF and OPL was an assignment of income and a sham, we do not
reach the issue of whether an allocation must be made under sec.
482 or 845. Petitioner makes no argument that a sec. 482
analysis should be preferred over an assignment of income
analysis. Nevertheless, we are aware that several court opinions
appear to have expressed a general preference for application of
a sec. 482 analysis over the assignment of income analysis. We
believe those opinions are distinguishable because the facts in
the instant case are both "more extreme" and "heavily freighted
with tax motives". Cf. Foglesong v. Commissioner, 621 F.2d 865
(7th Cir. 1980), revg. and remanding T.C. Memo. 1976-294; Rubin
(continued...)
- 106 II.
Section 162 Deductions
Having held that petitioner's restructuring of its excess
value activity constituted a sham transaction that had no
economic effect, we are presented with the question of whether
petitioner is entitled to deduct the amounts retained by NUF.
The amounts retained consisted of NUF's "commission" of $1
million plus allowances for various costs.
Section 162 allows as a deduction all ordinary and necessary
expenses paid or incurred during the taxable year in carrying on
any trade or business.
See sec. 162(a).
However, expenses
incurred in furtherance of a sham transaction are not deductible.
As stated by the Court of Appeals for the Eleventh Circuit in
Kirchman v. Commissioner, 862 F.2d at 1490:
The sham transaction doctrine requires courts and
the Commissioner to look beyond the form of a
transaction and to determine whether its substance is
of such a nature that expenses or losses incurred in
connection with it are deductible under an applicable
section of the Internal Revenue Code. If a
transaction's form complies with the Code's
requirements for deductibility, but the transaction
lacks the factual or economic substance that form
represents, then expenses or losses incurred in
connection with the transaction are not deductible.
The Court of Appeals for the Second Circuit recently addressed a
similar issue with respect to interest deductions under section
59
(...continued)
v. Commissioner, 429 F.2d 650 (2d Cir. 1970), revg. and remanding
51 T.C. 251 (1968).
- 107 163.
In Lee v. Commissioner, 155 F.3d 584 (2d Cir. 1998), affg.
in part and remanding in part on another ground T.C. Memo. 1997172, the taxpayers had entered into a sham investment transaction
solely for the purpose of claiming tax deductions.
586.
See id. at
The taxpayers argued that interest arising from
economically empty transactions may still be deducted so long as
the debt itself has economic substance.
The Court of Appeals for
the Second Circuit declined to accept the taxpayers' argument and
held that in order for an interest deduction to be valid under
section 163, the underlying transaction must have economic
substance.
See id. at 587.
In Brown v. Commissioner, 85 T.C.
968 (1985), affd. sub nom. Sochin v. Commissioner, 843 F.2d 351
(9th Cir. 1988), we held that deductions claimed by the taxpayers
were not allowable because they were connected to sham
transactions.
We have found that petitioner's restructuring of its EVC
activity was a sham set up to reduce tax.
Following the
reasoning in cases such as Kirchman v. Commissioner, supra; Lee
v. Commissioner, supra; and Brown v. Commissioner, supra, we hold
that the amounts retained by NUF are not deductible.
III. Liberty Transaction
Respondent disallowed deductions taken by petitioner for
premiums paid to Liberty Mutual Fire for California workers'
compensation and employers' liability insurance coverage.
- 108 In 1983, petitioner notified the State of California of its
intention to terminate its self-insurance program for workers'
compensation, and the State acknowledged petitioner's intention.
Petitioner complied with State regulations and received State
approval to terminate its self-insurance activity.
Petitioner's
future obligations for 1984 under California's workers'
compensation were covered by the Liberty Mutual policy.
Liberty
Mutual entered into a reinsurance agreement with OPL wherein OPL
reinsured Liberty Mutual's exposure for claims not exceeding
$250,000 for any one accident.
There is no question that the
Liberty Mutual policy was a valid policy that satisfied
petitioner's workers' compensation responsibilities.
In calculating taxable income, section 162(a) permits the
deduction from gross income of all ordinary and necessary
expenses incurred in carrying on a business.
Premiums for
insurance, including those for workers' compensation coverage,
are deductible business expenses.
Tax Regs.
See sec. 1.162-1(a), Income
The insuring taxpayer deducts the amounts paid as
premiums but, of course, cannot deduct covered claims because the
source of the payments is the insurance carrier.
See Clougherty
Packing Co. v. Commissioner, 811 F.2d 1297, 1300 (9th Cir. 1987),
affg. 84 T.C. 948 (1985).
In lieu of purchasing insurance, one may elect to selfinsure, paying off claims as they arise or setting aside fixed
- 109 sums into a reserve account to pay off intermittent losses.
id.
See
While insurance premiums are deductible, amounts placed into
self-insurance reserves are not.
See id.; Steere Tank Lines,
Inc. v. United States, 577 F.2d 279, 280 (5th Cir. 1978); Spring
Canyon Coal Co. v. Commissioner, 43 F.2d 78, 80 (10th Cir. 1930),
affg. 13 B.T.A. 189 (1928).
Instead, the self-insuring taxpayer
must wait until losses actually occur, at which time the reserve
funds actually paid out may be expensed and deducted from gross
income.
See Clougherty Packing Co. v. Commissioner, supra.
Neither the Code nor the regulations provides a definition
of insurance.
The accepted definition for purposes of Federal
income taxation dates back to Helvering v. Le Gierse, 312 U.S.
531, 539 (1941), in which the Supreme Court stated that
"Historically and commonly insurance involves risk-shifting and
risk-distributing."
Shifting risk entails the transfer of the
impact of a potential loss from the insured to the insurer.
See
Clougherty Packing Co. v. Commissioner, supra.
Respondent concedes that the Liberty Mutual policy is a
valid insurance contract which operates to shift the insurance
risk from petitioner to Liberty Mutual with respect to losses in
excess of $250,000.
Respondent seeks to segregate the "premiums"
related to the liability in excess of $250,000 from the amounts
paid to Liberty Mutual for liability below $250,000.
Respondent
argues that amounts paid to Liberty Mutual under the workers'
- 110 compensation insurance policy related to liability for claims
below $250,000 are not deductible as premiums.60
Respondent does not argue that the terms of the controlling
documents are insufficient to constitute insurance or that the
contractual terms of Liberty Mutual's reinsurance with OPL negate
the existence of insurance.
Rather, respondent argues that
although petitioner had a formal insurance agreement with Liberty
Mutual, "in practice" petitioner and Liberty Mutual disregarded
the transactional documents in subsequent years and allowed OPL,
through Liberty Mutual, to collect an increased premium when
losses increased in subsequent years.
There is no evidence that
this alleged "practice" in later years was part of any agreement
in 1984.
Pursuant to the workers' compensation arrangement, Liberty
Mutual accepted a measurable degree of risk in entering the
insurance contract with petitioner.61
Apparently, respondent's
only complaint is that in the 10 years after the year in issue,
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