Corporate Tax Shelters on Appeal--Big Taxpayer Win in Eighth Circuit; Mixed Results in Eleventh

Client Advisory

July 5, 2001
As reported recently in the popular press, US federal courts of appeal recently ruled against the IRS in two significant "corporate tax shelter" cases. In each case, the appellate court overturned the holding of the lower court. However, it may be too early for taxpayers to declare a total victory. The Eighth Circuit did give the taxpayer an outright win in IES Industries, Inc. v. United States, by upholding the tax benefit generated by a dividend- and foreign tax credit-stripping scheme. In the other case, United Parcel Service of America, Inc. v. Commissioner, while the Eleventh Circuit overturned the Tax Court's determination that a lack of a business purpose for using an offshore affiliate rendered the entire transaction a sham, it remanded the case to the Tax Court for a determination whether the amount of taxable income allocated by UPS to such affiliate was proper under all the facts and circumstances. And late last week, in Winn-Dixie Stores, Inc. v. Commissioner, the same Eleventh Circuit upheld another Tax Court decision, this one denying deductions for interest incurred in borrowing against corporate-owned life insurance policies.

IES Industries (Alliant Energy)

The Eighth Circuit in IES Industries, Inc. v. United States reversed a federal district court decision, and upheld a tax-driven transaction against challenge by the IRS. The transaction is essentially the same dividend- and foreign tax credit-stripping transaction struck down by the Tax Court in Compaq Computer Corporation v. Commissioner, 113 T.C. 214 (1999), currently on appeal to the Fifth Circuit. Both companies had large capital gains arising from extraordinary transactions in prior tax years. Within the period allowed to carryback capital losses, the companies entered into highly structured securities trades arranged by Twenty-First Securities Corporation, a firm which specializes in tax-oriented trades.

The form of trade utilized by IES (now called Alliant Energy), and Compaq, involved American Depository Receipts ("ADRs") representing the stock of foreign corporations traded on U.S. securities exchanges. IES bought ADRs cum-dividend using next day settlement trades and simultaneously sold ADRs ex-dividend using three-day settlement trades, thereby remaining the owner of record on the trade date plus 2, which was the record date for the dividends. The pre-arranged trades occurred within minutes of each other. In each case, it was anticipated that the issuer of the ADRs would withhold and deduct a 15% tax payable to the tax authorities in its home country. IES therefore purchased the ADRs for an amount equal to the market price of the ADRs plus 85% of the expected dividend. In the sales, of course, IES received a sales price equal to the market price of the ADRs ex-dividend. In each case, the taxpayer thus generated a capital loss equal to the amount of the net dividend it would receive. Economically, the dividend, net of foreign taxes, exactly offset the "loss" on the shares.

Critical to the transaction, from a tax point of view, was the fact that IES (like Compaq) was eligible for a tax credit in the United States for the foreign taxes withheld from the dividends, and so would not pay a full U.S. tax on the dividend income. At the same time, IES was able to carry back the capital loss to offset the large capital gain earned in a prior year, resulting in a tax benefit at the full statutory rate. The counter-party to the ADR transaction was not a U.S. taxpayer, so that it was indifferent to these U.S. tax considerations. Moreover, market conditions ascribed essentially no value to the creditability of the withheld tax, so IES could "buy" foreign tax credits for nothing.

The district court in IES, and the Tax Court in Compaq, denied the loss carryback on the basis that (a) there was no economic substance to the transactions and (b) the taxpayers had no business purpose for entering into them. There was absolutely no reasonable prospect of an economic profit (that is, a profit in a world without U.S. income taxes), and there was virtually no possibility of a loss, other than the transaction costs. There was no economic loss that corresponded to the claimed tax loss. While the lack of economic substance and business purpose has sometimes elicited the label "sham" from various courts, in IES this term seemed to throw off the appellate court's reasoning. It almost seems that the court felt that, since the trades were real, rather than fictitious, they were entitled to respect.

Moreover, the Eighth Circuit, in its very brief opinion, seemed to misapply both the "economic substance" and the "business purpose" tests. The tests have traditionally been applied by looking at a transaction's substance and purpose without considering the tax effects. Here, the Eighth Circuit seemed to find that IES made a "profit" on each trade because under the Internal Revenue Code a shareholder is considered to receive the gross amount of a dividend before the foreign withholding tax, while IES only paid 85% of the dividend as part of its purchase price for the ADRs. Put another way, IES was able to "buy" foreign tax credits for nothing. Since IES made a profit on every trade, the transactions had "economic substance" and a "business purpose." But that analysis assumes its own conclusion. In contrast, the Tax Court in Compaq reasoned that the economic substance doctrine is based on the principle that a loss not economically suffered, in a transaction that has no business purpose, cannot be deducted for tax purposes.

The Eighth Circuit went on to state that the trades were bona fide because IES was exposed to the risk of loss if the ADR issuer failed to pay the dividend. (The opinion does not indicate whether, under relevant foreign law, a dividend once declared represents a binding legal obligation of the issuer, as is generally true under U.S. law.) Certainly, none of the ADR issuers ever failed to pay any of the declared dividends. Moreover, it is not clear that the mere possibility that the taxpayer will suffer an economic loss should insulate a transaction where there is no possibility of profit. In any event, the Eighth Circuit simply congratulated IES for having minimized its exposure to loss through diligent investigation of each trade. The Eighth Circuit even noted approvingly that, unlike Compaq, IES had consulted with its professional tax and securities law advisers, showing more good business judgment!

Section 901(k) of the Internal Revenue Code, enacted in 1997, now prevents a U.S. shareholder from taking a foreign tax credit unless the shareholder holds the stock (or ADR) for a period of at least 16 days during a prescribed 30 day period. The holding period is tolled if the shareholder has diminished its risk of loss. Thus, the IES and Compaq transactions clearly would not work under current law.

United Parcel Service

United Parcel Service of America, Inc. v. Commissioner
involved an attempt by the package delivery company to move certain income offshore. Under its arrangement with its customers, UPS was liable for damage to goods only up to $100. Customers could choose, however, to purchase "insurance" on the excess at the rate of $0.25 per additional $100 of declared value ("excess value charges"). Initially, UPS itself billed its customers and collected these charges. It saw an opportunity, however, to avoid U.S. federal income tax on such income by organizing an insurance company in Bermuda, which would collect the excess value charges and make good on any claims by customers. As UPS saw it, and accounted for it, this was a highly profitable operation.

UPS organized a Bermuda insurance subsidiary, Overseas Partners, Ltd. ("OPL"), capitalized it, and spun it off to its shareholders. (UPS was at the time a privately-held company, and its stock was held mostly by employees.) UPS then entered into an insurance agreement with National Union Fire Insurance Company, a subsidiary of AIG, which entered into a reinsurance agreement with OPL. In a sense, National Union could be viewed as a conduit and administrator for insurance provided by OPL. The excess value charges OPL collected always exceeded the amount of claims it paid out for lost or damaged packages, usually by $40,000,000 to $60,000,000 per year. In this manner, the income attributable to the excess value charges were directed to OPL for a net federal income tax savings of approximately $16,000,000 per year.

The Tax Court had found that the restructuring was done for the sole purpose of avoiding taxes and that the arrangement between UPS, National Union Fire and OPL had no economic substance or business purpose. Therefore, the arrangement was an anticipatory assignment of income and a "sham." UPS was required to recognize all of the income earned by OPL.

The Eleventh Circuit reversed and remanded. The Court reasoned that the transaction simply altered the form of an existing, bona fide business arrangement with UPS's customers. Such business had real economic substance and a business purpose. OPL had to be respected as a separate entity. The Court held that the restructuring was not a sham. We believe that the Eleventh Circuit's holding is correct. There is little doubt that any court would have respected the arrangement had it been adopted by UPS from the inception of its excess loss coverage program. It is simply an efficient tax structure applied to a bona fide business transaction. There is nothing in the case law that says that a switch from an inefficient tax structure to an efficient structure, even if the switch is motivated solely by tax considerations, can be disregarded by the IRS.

Importantly, the Circuit Court decision is not a total victory for the taxpayer. The court remanded the case and directed the Tax Court to address certain arguments that the IRS had made, but the Tax Court did not consider because of the sweeping nature of its original decision. In particular, the Tax Court will now consider the IRS's arguments under section 482 of the Code that the way UPS and OPL accounted for the excess loss program resulted in excessive income being allocated to OPL. There are strong suggestions in both the Circuit Court's decision and the Tax Court's more complete Statement of Facts that the IRS could be successful in this approach.

Although UPS shifted all of the payments from customers from the excess value program to OPL, UPS retained all of the costs and expenses in reducing the occurrence of lost and damaged parcels, processing claims, and defending against lawsuits. UPS even implemented a program to reduce claims, including excess value claims. Its drivers paid extra attention to declared value packages. UPS incurred extra costs in handling such packages, including implementing procedures for segregating and tracking high-value parcels. UPS drafted a loss prevention manual and performed audits throughout its delivery operations to ensure the security of high-value packages. The UPS loss prevention program was apparently highly successful. But the costs and expenses of these programs reduced UPS's taxable income, not OPL's. Section 482 provides the IRS with ample authority to prevent taxpayers from distorting income in such a manner.


Winn-Dixie Stores, Inc. v. Commissioner, addressed a widely promoted, complex program of corporate-owned life insurance which covered almost all of Winn-Dixie's full-time employees. Policy loans were used to pay most of the premiums, as well as the interest on the loans themselves, so that the taxpayer's net equity in the policies remained small. It was clearly recognized at the time the program was adopted that it could not possibly be profitable to Winn-Dixie on a pre-tax basis, and that the program was entered into solely to produce interest deductions on the policy loans. There was no showing that the taxpayer had a true "insurance" purpose for entering into the program.

The interest rate on the loans was unreasonably high, but was offset by an almost equally high rate of interest credited on the leveraged portion of the gross cash surrender value. In contrast, the rate credited on the equity portion of the cash surrender value was less than one-half of those rates. Under the letter of the tax law, Winn-Dixie was entitled to deduct the interest paid on its borrowings and the increase in the cash surrender value of the policies was not currently taxable. The Eleventh Circuit held that the case was controlled by the 40-year old Supreme Court sham transaction decision in Knetsch v. United States, which also involved a contract issued by an insurance company: As in Knetsch, "the transaction offered the taxpayer no financial benefit other than its tax consequences." The court disallowed not only the interest expense, but the administrative costs of the program, as well, because they were incurred in connection with a sham transaction.


While the Eleventh Circuit's decision in UPS represents an appropriate slap on the wrist of the IRS for its sometimes lazy tendency to argue every case on the basis of sham or lack of business purpose, the Eighth Circuit's decision in IES appears weak. Even allowing that there is some merit in the taxpayer's position, the decision by the Circuit Court is almost bereft of sound arguments. If the inclusion of an item in gross income, even where such item does not represent a net, pre-tax economic benefit to the taxpayer, is all that is required to establish a bona fide business purpose, provided the taxpayer has dutifully minimized its real economic risk and diligently consulted its outside tax professionals, then there is not much left of the business purpose doctrine or, ultimately, of the corporate income tax. If the Tax Court's decision in Compaq is upheld on appeal to the Fifth Circuit, one or both of these cases could go to the United States Supreme Court for clarification of the "sham transaction" doctrine. As indicated by the Winn-Dixie decision, however, rumors of the death of this important judicial doctrine are premature.

Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. © 2020 Carter Ledyard & Milburn LLP.
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