UPS v. Comr. of IRS , 254 F.3d 1014 ( 2001 )

[PUBLISH]
IN THE UNITED STATES COURT OF APPEALS
FOR THE ELEVENTH CIRCUIT
________________________
FILED
No. 00-12720 U.S. COURT OF APPEALS
ELEVENTH CIRCUIT
________________________ JUNE 20, 2001
THOMAS K. KAHN
T. C. Docket No. 15993-95 CLERK
UNITED PARCEL SERVICE OF AMERICA, INC.,
Petitioner-Appellant,
versus
COMMISSIONER OF INTERNAL REVENUE,
Respondent-Appellee.
________________________
Appeal from a Decision of the United States Tax Court
_________________________
(June 20, 2001)
Before WILSON and COX, Circuit Judges, and RYSKAMP *, District Judge.
COX, Circuit Judge:
*
Honorable Kenneth L. Ryskamp, U.S. District Judge for the Southern District of
Florida, sitting by designation.
The tax court held United Parcel Service of America, Inc. (UPS) liable for
additional taxes and penalties for the tax year 1984. UPS appeals, and we reverse and
remand.
I. Background
UPS, whose main business is shipping packages, had a practice in the early
1980s of reimbursing customers for lost or damaged parcels up to $100 in declared
value.1 Above that level, UPS would assume liability up to the parcel’s declared value
if the customer paid 25¢ per additional $100 in declared value, the “excess-value
charge.” If a parcel were lost or damaged, UPS would process and pay the resulting
claim. UPS turned a large profit on excess-value charges because it never came close
to paying as much in claims as it collected in charges, in part because of efforts it
made to safeguard and track excess-value shipments. This profit was taxed; UPS
declared its revenue from excess-value charges as income on its 1983 return, and it
deducted as expenses the claims paid on damaged or lost excess-value parcels.
UPS’s insurance broker suggested that UPS could avoid paying taxes on the
lucrative excess-value business if it restructured the program as insurance provided
by an overseas affiliate. UPS implemented this plan in 1983 by first forming and
1
These facts synopsize the high points of the tax court’s long opinion, which is
published at 78 T.C.M. (CCH) 262.
2
capitalizing a Bermuda subsidiary, Overseas Partners, Ltd. (OPL), almost all of whose
shares were distributed as a taxable dividend to UPS shareholders (most of whom
were employees; UPS stock was not publicly traded). UPS then purchased an
insurance policy, for the benefit of UPS customers, from National Union Fire
Insurance Company. By this policy, National Union assumed the risk of damage to
or loss of excess-value shipments. The premiums for the policy were the excess-value
charges that UPS collected. UPS, not National Union, was responsible for
administering claims brought under the policy. National Union in turn entered a
reinsurance treaty with OPL. Under the treaty, OPL assumed risk commensurate with
National Union’s, in exchange for premiums that equal the excess-value payments
National Union got from UPS, less commissions, fees, and excise taxes.
Under this plan, UPS thus continued to collect 25¢ per $100 of excess value
from its customers, process and pay claims, and take special measures to safeguard
valuable packages. But UPS now remitted monthly the excess-value payments, less
claims paid, to National Union as premiums on the policy. National Union then
collected its commission, excise taxes, and fees from the charges before sending the
rest on to OPL as payments under the reinsurance contract. UPS reported neither
revenue from excess-value charges nor claim expenses on its 1984 return, although
it did deduct the fees and commissions that National Union charged.
3
The IRS determined a deficiency in the amount of the excess-value charges
collected in 1984, concluding that the excess-value payment remitted ultimately to
OPL had to be treated as gross income to UPS. UPS petitioned for a redetermination.
Following a hearing, the tax court agreed with the IRS.
It is not perfectly clear on what judicial doctrine the holding rests. The court
started its analysis by expounding on the assignment-of-income doctrine, a source rule
that ensures that income is attributed to the person who earned it regardless of efforts
to deflect it elsewhere. See United States v. Basye, 410 U.S. 441, 450, 93 S. Ct. 1080,
1086 (1973). The court did not, however, discuss at all the touchstone of an
ineffective assignment of income, which would be UPS’s control over the excess-
value charges once UPS had turned them over as premiums to National Union. See
Comm’r v. Sunnen, 333 U.S. 591, 604, 68 S. Ct. 715, 722 (1948). The court’s analysis
proceeded rather under the substantive-sham or economic-substance doctrines, the
assignment-of-income doctrine’s kissing cousins. See United States v. Krall, 835 F.2d
711, 714 (8th Cir. 1987) (treating the assignment-of-income doctrine as a subtheory
of the sham-transaction doctrine). The conclusion was that UPS’s redesign of its
excess-value business warranted no respect. Three core reasons support this result,
according to the court: the plan had no defensible business purpose, as the business
realities were identical before and after; the premiums paid for the National Union
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policy were well above industry norms; and contemporary memoranda and documents
show that UPS’s sole motivation was tax avoidance. The revenue from the excess-
value program was thus properly deemed to be income to UPS rather than to OPL or
National Union. The court also imposed penalties.
UPS now appeals, attacking the tax court’s economic-substance analysis and
its imposition of penalties. The refrain of UPS’s lead argument is that the excess-
value plan had economic substance, and thus was not a sham, because it comprised
genuine exchanges of reciprocal obligations among real, independent entities. The
IRS answers with a before-and-after analysis, pointing out that whatever the reality
and enforceability of the contracts that composed the excess-value plan, UPS’s
postplan practice equated to its preplan, in that it collected excess-value charges,
administered claims, and generated substantial profits. The issue presented to this
court, therefore, is whether the excess-value plan had the kind of economic substance
that removes it from “shamhood,” even if the business continued as it had before. The
question of the effect of a transaction on tax liability, to the extent it does not concern
the accuracy of the tax court’s fact-finding, is subject to de novo review. Kirchman
v. Comm’r, 862 F.2d 1486, 1490 (11th Cir. 1989); see Karr v. Comm’r, 924 F.2d
1018, 1023 (11th Cir. 1991). We agree with UPS that this was not a sham transaction,
and we therefore do not reach UPS’s challenges to the tax penalties.
5
II. Discussion
I.R.C. §§ 11, 61, and 63 together provide the Code’s foundation by identifying
income as the basis of taxation. Even apart from the narrower assignment-of-income
doctrine — which we do not address here — these sections come with the gloss,
analogous to that on other Code sections, that economic substance determines what
is income to a taxpayer and what is not. See Caruth Corp. v. United States, 865 F.2d
644, 650 (5th Cir. 1989) (addressing, but rejecting on the case’s facts, the argument
that the donation of an income source to charity was a sham, and that the income
should be reattributed to the donor); United States v. Buttorff, 761 F.2d 1056, 1061
(5th Cir. 1985) (conveying income to a trust controlled by the income’s earner has no
tax consequence because the assignment is insubstantial); Zmuda v. Comm’r, 731 F.2d
1417, 1421 (9th Cir. 1984) (similar). This economic-substance doctrine, also called
the sham-transaction doctrine, provides that a transaction ceases to merit tax respect
when it has no “economic effects other than the creation of tax benefits.” Kirchman,
862 F.2d at 1492.2 Even if the transaction has economic effects, it must be
disregarded if it has no business purpose and its motive is tax avoidance. See Karr,
2
Kirchman, which is binding in this circuit, differs in this respect from the oft-used
statement of the doctrine derived from Rice’s Toyota World, Inc. v. Comm’r, 752 F.2d 89, 91-92
(4th Cir. 1985). Rice’s Toyota World, unlike Kirchman, requires a tax-avoidance purpose as well
as a lack of substance; Kirchman explicitly refuses to examine subjective intent if the transaction
lacks economic effects.
6
924 F.2d at 1023 (noting that subjective intent is not irrelevant, despite Kirchman’s
statement of the doctrine); Neely v. United States, 775 F.2d 1092, 1094 (9th Cir.
1985); see also Frank Lyon Co. v. United States, 435 U.S. 561, 583-84, 98 S. Ct.
1291, 1303 (1978) (one reason requiring treatment of transaction as genuine was that
it was “compelled or encouraged by business or regulatory realities”); Gregory v.
Helvering, 293 U.S. 465, 469, 55 S. Ct. 266, 267 (1935) (reorganization disregarded
in part because it had “no business or corporate purpose”).
The kind of “economic effects” required to entitle a transaction to respect in
taxation include the creation of genuine obligations enforceable by an unrelated party.
See Frank Lyon Co., 435 U.S. at 582-83, 98 S. Ct. at 1303 (refusing to deem a sale-
leaseback a sham in part because the lessor had accepted a real, enforceable debt to
an unrelated bank as part of the deal). The restructuring of UPS’s excess-value
business generated just such obligations. There was a real insurance policy between
UPS and National Union that gave National Union the right to receive the excess-
value charges that UPS collected. And even if the odds of losing money on the policy
were slim, National Union had assumed liability for the losses of UPS’s excess-value
shippers, again a genuine obligation. A history of not losing money on a policy is no
guarantee of such a future. Insurance companies indeed do not make a habit of
issuing policies whose premiums do not exceed the claims anticipated, but that fact
7
does not imply that insurance companies do not bear risk. Nor did the reinsurance
treaty with OPL, while certainly reducing the odds of loss, completely foreclose the
risk of loss because reinsurance treaties, like all agreements, are susceptible to default.
The tax court dismissed these obligations because National Union, given the
reinsurance treaty, was no more than a “front” in what was a transfer of revenue from
UPS to OPL. As we have said, that conclusion ignores the real risk that National
Union assumed. But even if we overlook the reality of the risk and treat National
Union as a conduit for transmission of the excess-value payments from UPS to OPL,
there remains the fact that OPL is an independently taxable entity that is not under
UPS’s control. UPS really did lose the stream of income it had earlier reaped from
excess-value charges. UPS genuinely could not apply that money to any use other than
paying a premium to National Union; the money could not be used for other purposes,
such as capital improvement, salaries, dividends, or investment. These
circumstances distinguish UPS’s case from the paradigmatic sham transfers of
income, in which the taxpayer retains the benefits of the income it has ostensibly
forgone. See, e.g., Zmuda v. Comm’r, 731 F.2d at 1417 (income “laundered” through
a series of trusts into notes that were delivered to the taxpayer as “gifts”). Here that
benefit ended up with OPL. There were, therefore, real economic effects from this
transaction on all of its parties.
8
The conclusion that UPS’s excess-value plan had real economic effects means,
under this circuit’s rule in Kirchman, that it is not per se a sham. But it could still be
one if tax avoidance displaced any business purpose. The tax court saw no business
purpose here because the excess-value business continued to operate after its
reconfiguration much as before. This lack of change in how the business operated at
the retail level, according to the court, betrayed the restructuring as pointless.
It may be true that there was little change over time in how the excess-value
program appeared to customers. But the tax court’s narrow notion of “business
purpose” — which is admittedly implied by the phrase’s plain language — stretches
the economic-substance doctrine farther than it has been stretched. A “business
purpose” does not mean a reason for a transaction that is free of tax considerations.
Rather, a transaction has a “business purpose,” when we are talking about a going
concern like UPS, as long as it figures in a bona fide, profit-seeking business. See
ACM P’ship v. Comm’r, 157 F.3d 231, 251 (3d Cir. 1998). This concept of “business
purpose” is a necessary corollary to the venerable axiom that tax-planning is
permissible. See Gregory v. Helvering, 293 U.S. 465, 469, 55 S. Ct. 266, 267 (1935)
(“The legal right of a taxpayer to decrease the amount of what otherwise would be his
taxes, or altogether avoid them, by means which the law permits, cannot be
doubted.”). The Code treats lots of categories of economically similar behavior
9
differently. For instance, two ways to infuse capital into a corporation, borrowing and
sale of equity, have different tax consequences; interest is usually deductible and
distributions to equityholders are not. There may be no tax-independent reason for
a taxpayer to choose between these different ways of financing the business, but it
does not mean that the taxpayer lacks a “business purpose.” To conclude otherwise
would prohibit tax-planning.
The caselaw, too, bears out this broader notion of “business purpose.” Many
of the cases where no business purpose appears are about individual income tax
returns, when the individual meant to evade taxes on income probably destined for
personal consumption; obviously, it is difficult in such a case to articulate any
business purpose to the transaction. See, e.g., Gregory, 293 U.S. at 469, 55 S. Ct. at
267 (purported corporate reorganization was disguised dividend distribution to
shareholder); Knetsch v. United States, 364 U.S. 361, 362-65, 81 S. Ct. 132, 133-35
(1960) (faux personal loans intended to generate interest deductions); Neely v. United
States, 775 F.2d 1092, 1094 (9th Cir. 1985) (one of many cases in which the taxpayers
formed a trust, controlled by them, and diverted personal earnings to it). Other no-
business-purpose cases concern tax-shelter transactions or investments by a business
or investor that would not have occurred, in any form, but for tax-avoidance reasons.
See, e.g., ACM P’ship, 157 F.3d at 233-43 (sophisticated investment partnership
10
formed and manipulated solely to generate a capital loss to shelter some of Colgate-
Palmolive’s capital gains); Kirchman, 862 F.2d at 1488-89 (option straddles entered
to produce deductions with little risk of real loss); Karr, 924 F.2d at 1021 (façade of
energy enterprise developed solely to produce deductible losses for investors); Rice’s
Toyota World, Inc. v. Comm’r,, 752 F.2d 89, 91 (4th Cir. 1985) (sale-leaseback of a
computer by a car dealership, solely to generate depreciation deductions). By
contrast, the few cases that accept a transaction as genuine involve a bona fide
business that — perhaps even by design — generates tax benefits. See, e.g., Frank
Lyon, 435 U.S. at 582-84, 98 S. Ct. at 1302-04 (sale-leaseback was part of genuine
financing transaction, heavily influenced by banking regulation, to permit debtor bank
to outdo its competitor in impressive office space); Jacobson v. Comm’r, 915 F.2d
832, 837-39 (2d Cir. 1990) (one of many cases finding that a bona fide profit motive
provided a business purpose for a losing investment because the investment was not
an obvious loser ex ante).
The transaction under challenge here simply altered the form of an existing,
bona fide business, and this case therefore falls in with those that find an adequate
business purpose to neutralize any tax-avoidance motive. True, UPS’s restructuring
was more sophisticated and complex than the usual tax-influenced form-of-business
election or a choice of debt over equity financing. But its sophistication does not
11
change the fact that there was a real business that served the genuine need for
customers to enjoy loss coverage and for UPS to lower its liability exposure.
We therefore conclude that UPS’s restructuring of its excess-value business had
both real economic effects and a business purpose, and it therefore under our
precedent had sufficient economic substance to merit respect in taxation. It follows
that the tax court improperly imposed penalties and enhanced interest on UPS for
engaging in a sham transaction. The tax court did not, however, reach the IRS’s
alternative arguments in support of its determination of deficiency, the reallocation
provisions of I.R.C. §§ 482 and 845(a). The holding here does not dispose of those
arguments, and we therefore must remand for the tax court to address them in the first
instance.
III. Conclusion
For the foregoing reasons, we reverse the judgment against UPS and remand
the action to the tax court for it to address in the first instance the IRS’s contentions
under §§ 482 and 845(a).
REVERSED AND REMANDED.
12
RYSKAMP, District Judge, dissenting:
I respectfully dissent. Although I agree with the majority’s recitation of the
facts as well as its interpretation of the applicable legal standard, I find that its reversal
of the tax court is contrary to the great weight of the evidence that was before the
lower court. The majority, as well as the tax court below, correctly finds that
the question before the Court is whether UPS’s insurance arrangements with NUF and
OPL are valid under the sham-transaction doctrine. Under the sham-transaction
doctrine, UPS’s transaction ceases to merit tax respect when it has no “economic
effects other than the creation of tax benefits,” Kirchman v. Comm’r, 862 F.2d 1486,
1492 (11th Cir. 1991), or has no business purpose and its sole motive is tax avoidance.
See Karr v. Comm’r, 924 F.2d 1018, 1023 (11th Cir. 1991). Thus the question before
the Court is not strictly whether UPS had a tax avoidance motive when it formulated
the scheme in question, but rather whether there was some legitimate, substantive
business reason for the transaction as well. There clearly was not.
As the tax court articulated in great detail in its well-reasoned 114-page
opinion, the evidence in this case overwhelmingly demonstrates that UPS’s
reinsurance arrangement with NUF and OPL had no economic significance or
business purpose outside of UPS’s desire to avoid federal income tax, and was
therefore a sham transaction. First, the tax court based its decision upon evidence that
13
the scheme in question was subjectively motivated by tax avoidance. For example,
the evidence showed that tax avoidance was the initial and sole reason for the scheme
in question, that UPS held off on the plan for some time to analyze tax legislation on
the floor of the United States House of Representatives, and that a letter sent to AIG
Insurance from UPS detailing the scheme claimed that AIG would serve in merely a
“fronting” capacity and would bear little or no actual risk. The evidence thus showed
that this scheme was hatched with only tax avoidance in mind.
Second, the tax court based its decision on overwhelming evidence that UPS’s
scheme had no real economic or business purpose outside of tax avoidance. For
example, the evidence showed that NUF’s exposure to loss under the plan (except in
the very unlikely event of extreme catastrophe) was infinitesimal, and that UPS
nevertheless continued to fully bear the administrative costs of the EVC program.
NUF was only liable for losses not covered by another insurance policy held by UPS
, yet UPS still collected the EVC’s and deposited the money into UPS bank accounts,
still processed EVC claims, and continued to pay all EVC claims out of UPS bank
accounts (while collecting the accrued interest for itself). All NUF really did in the
scheme was collect over $1 million in fees and expenses before passing the EVC
income on to OPL, which was of course wholly owned by UPS shareholders. In
14
essence, NUF received an enormous fee from UPS in exchange for nothing.
Moreover, the tax court systematically rejected every explanation of the scheme
put forth by UPS. UPS claimed that the scheme was meant to avoid violation of state
insurance laws, yet the evidence showed no real concern for such laws and that in fact
UPS was well aware that federal preemption of these state laws likely made its old
EVC plan legal. UPS claimed that it intended OPL to become a full-line insurer
someday, yet the evidence showed that it was nevertheless unnecessary to specifically
use EVC income for such a capital investment. UPS claimed that elimination of the
EVC income allowed it to increase its rates, yet one of its own board members
testified that this explanation was untrue. I also note that UPS’s claim that OPL was
a legitimate insurance company fails in light of the fact that OPL was charging a
substantially inflated rate for EVCs. Evidence in the tax court showed that in an arms-
length transaction with a legitimate insurance company, EVC rates would have been
approximately half those charged by UPS (and in turn passed on to OPL), providing
further evidence that the transaction was a sham. In sum, UPS failed to show any
legitimate business reason for giving up nearly $100 million in EVC income in 1984.
For these reasons, I would affirm the holding of the tax court and find that
15
UPS’s arrangement with NUF and OPL was a sham transaction subject to federal tax
liability.
16