Eleventh Circuit Reverses TC Decision in UPS

In June 20, 2001, the Eleventh Circuit reversed and remanded the Tax Court's decision in United Parcel Service of America, Inc. (UPS), TC Memo 1999-268. The Tax Court held that UPS's restructured insurance program lacked economic substance and business purpose. On appeal, the Eleventh Circuit held that UPS's restructured insurance program should be respected. The case was remanded for consideration of the IRS's alternative arguments on income allocation under the Secs. 482 and 845(a) transfer-pricing provisions.

UPS was responsible for reimbursing customers for lost or damaged parcels up to $100 in declared value. Above that level, UPS would assume liability up to the parcel's declared value if the customer paid $0.25 per additional $100 in declared value (the "excess-value charge"). Under this program, UPS reported the excess-value charge as income and deducted the paid claims as expenses.

In 1984, UPS restructured its program for handling lost or damaged packages. First it formed and capitalized a Bermuda subsidiary, Overseas Partners, Ltd. (OPL), and then distributed OPL shares as a taxable dividend to UPS shareholders. As part of the new structure, UPS arranged for an insurance policy for its customers from National Union Fire Insurance Company (National Union), an unrelated insurance provider. Under the policy, UPS paid National Union the excess-value charges it collected as premiums; in return, National Union assumed the risk of damage to (or loss of) excess-value shipments.

National Union then entered into a reinsurance contract with OPL. Under the contract, OPL assumed risk commensurate with National Union's in exchange for premiums that equaled the excess-value payments National Union received from UPS, less commissions, fees and excise tax. After the restructuring, OPL received the excess-value payments (less paid claims and National Union's administration charges) and assumed ultimate liability for lost or damaged excess-value parcels.

Under the new structure, UPS did not report the premiums as income, nor deduct the paid claims as expenses. The IRS determined a deficiency in the amount of the excess-value charges collected in 1984 and imposed penalties. UPS petitioned for a redetermination; following a hearing, the Tax Court found for the Service under a combination of the assignment-of-income and economic-substance doctrines, and sustained the penalties.

On appeal, the Eleventh Circuit considered whether the restructured insurance program had enough substance and business purpose to meet the economic-substance doctrine. It defined the economic-substance doctrine as a two-pronged analysis, guided primarily by Kirchman, 862 F2d 1486 (1989). The first prong was whether the transaction had no other economic effects other than the creation of tax benefits. If a transaction passed the first prong and was found to have economic effects, then, according to the Eleventh Circuit, the analysis proceeded to the second prong.

The second prong of the analysis provided that despite economic effects, the transaction had to be disregarded if it had no business purpose and its motive was tax avoidance. (The Eleventh Circuit noted that this approach differs from the approach taken in Rice's Toyota World, Inc., 752 F2d 89 (4th Cir. 1985), which required both a tax-avoidance purpose and a lack of economic effects.)

Proceeding under this analytical framework, the Eleventh Circuit found that the UPS insurance restructuring had economic effects. The Eleventh Circuit relied on Frank Lyon Co., 435 US 561 (1978), and held that, despite National Union's slight risk of loss on the deal, the transaction still had economic effects, because it comprised genuine exchanges of reciprocal obligations enforceable by unrelated parties.

Addressing the difference in the Tax Court's opinion (which ignored these obligations, saying that National was no more than a "front" in the transfer of revenues to OPL), the Eleventh Circuit stated "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."

The Eleventh Circuit next considered business-purpose and tax-avoidance motives. Relying on an interpretation of business purpose adopted from ACM Partnership, 157 F3d 231 (3d Cir. 1998), the Eleventh Circuit stated that, in the context of a going concern like UPS, a transaction has business purpose as long as it "figures" in a bona fide profit-seeking business, and emphasized that a valid business purpose does not require that the reasons for a transaction be free of tax considerations.

The court relied on other cases that upheld transactions involving going concerns, even though the facts produced tax benefits (e.g., Frank Lyon, and Jacobson, 915 F2d 832 (2nd Cir. 1990)). Accordingly, the court concluded that UPS's insurance restructuring had business purpose, as the arrangement "simply altered the form of an existing, bona fide business" which, the court determined, put UPS within the set of cases "that find an adequate business purpose to neutralize any tax-avoidance motive."

Finding both economic substance and business purpose, the Eleventh Circuit reversed the lower court's decision and remanded the case for consideration in the first instance of other arguments put forth by the IRS that were not addressed by the Tax Court. The IRS argued, alternatively, that it could proceed to allocate the income from the excess-value charges under a transfer-pricing framework, under Secs. 482 and 845.

From Kerwin Chung, J.D., Giovanni DiCenso, J.D., LL.M., and Richard J. Safranek, J.D., Washington, DC