Offshore Insurance Arrangement Had Economic Substance and Business Purpose

In United Parcel Service of America, Inc. (UPS), 6/20/01, the Eleventh Circuit concluded that UPS's restructuring plan of its excess-value business had both economic substance and a business purpose, and had to be respected for tax purposes.

Excess-value Business

UPS, which has a primary business of shipping packages, had a business practice of reimbursing customers for lost or damaged parcels up to $100 in declared value. For amounts over $100, UPS would assume liability up to the parcel's declared value if the customer paid 25 cents per additional $100 in declared value (i.e., "excess-value charge"). The charges collected by UPS exceeded the amount paid out in claims. Prior to the restructuring plan, UPS included the revenue generated from the excess-value charges in income and deducted all expenses relating to the claims paid on damaged or lost excess-value parcels.

Restructuring Plan

An insurance broker suggested to UPS that taxes on the lucrative excess-value business could be avoided if UPS restructured the program as insurance provided by an overseas affiliate. As a result, UPS formed a Bermuda subsidiary, Overseas Partners, Ltd. (OPL). The OPL shares were distributed as a taxable dividend to UPS shareholders (most of whom were UPS employees). UPS then purchased an insurance policy from National Union Fire Insurance Company, under which National Union assumed the risk of damage to or loss from excess-value shipments. The policy premiums equaled the excess-value charges that UPS collected.

National Union then entered into a reinsurance arrangement with OPL. This arrangement provided that OPL assume the full risk of the excess-value shipments in exchange for premiums that equaled the excess-value payments National Union received from UPS, less commissions, fees and excise taxes. UPS deducted the fees and commissions charged by National Union; the net remaining excess-value income ultimately passed to OPL.

Tax Court

The IRS determined that the excess-value payment remitted ultimately to OPL had to be treated as gross income to UPS. The Tax Court agreed, concluding that the redesign of the excess-value business had no business purpose. According to the court, the business realities were identical before and after the restructuring plan. The premiums paid for the National Union policy were well above industry norms, and the sole motivation behind the transaction was tax avoidance.

Court of Appeals

The economic-substance doctrine (also called the sham-transaction doctrine) provides that the IRS will not respect a transaction for Federal income tax purposes when it has no economic effect other than the creation of tax benefits. Economic effect requires the creation of genuine obligations enforceable by an unrelated party. The Eleventh Circuit concluded that the restructuring of the UPS excess-value business generated such obligations. There was a real insurance policy between UPS and National Union shifting the liability for losses to National Union in exchange for the excess-value charges that UPS collected.

Even if the odds of losing money on the policy were slim, a history of not losing money on a policy is no guarantee of future results; accordingly, there was risk to National Union. In addition, while the reinsurance arrangement reduced the odds of loss, National Union still bore the risk of loss, because (like all such contracts), the contract was susceptible to default. The conclusion that the UPS excess-value plan had real economic effect provided evidence that the restructuring plan was not a sham. However, the arrangement could still be a sham if the tax-avoidance motive displaced any business purpose. The Eleventh Circuit concluded that there was indeed an adequate business purpose, because the taxpayer was able to lower its liability exposure while allowing its customers to continue to enjoy loss protection. Therefore, the restructuring of the UPS excess-value business had both real economic effect and a business purpose sufficient to be respected. The case was remanded back to the Tax Court on other grounds.

In reaching its decision, the Eleventh Circuit emphasized that tax-planning considerations are fundamental and valid factors in structuring transactions, and that a broad notion of business purpose should be part of any analysis.

From Brian Kelleher, CPA, New York, NY