Amicus Argues UPS Insurance Contracts Were Valid

UPS's principal business is the delivery of small packages, in direct competition with the U.S. Postal Service. Initially, UPS charged an additional fee when a shipper declared that the value of a package was more than $100, called an excess value(EV) charge. UPS reported these EV charges as income.

Later, UPS restructured its EV program and stopped offering shippers EV indemnity directly from UPS. Instead, UPS arranged primary insurance for its EV shippers with a large, unrelated insurance company, National Union Fire Insurance Company (NUF). UPS also created and funded Overseas Partners Ltd. (OPL) in Bermuda to reinsure NUF's EV risks, and distributed as a taxable dividend OPL's stock to UPS's shareholders. Under this restructuring UPS reported that the bulk of EV premium income was earned by OPL. The IRS issued a deficiency notice, determining that the EV charges must be included by UPS in its gross income. The Tax Court agreed, finding that the EV charge restructuring was a sham transaction. (For a summary of that opinion, see Tax Notes, Aug. 16, 1999, p. 1025; for the full text, see Doc 1999-26528 (114 original pages) or 1999 TNT 153-1 .)

Amicus argues that under long-standing judicial principles applicable to insurance arrangements, the EV insurance program had economic substance. Amicus further maintains that a fronting company provides valid insurance protection and that risk distribution among a large pool of risks is the essence of insurance and cannot support a finding that an insurance transaction lacks economic substance. Amicus further asserts that the Tax Court's use of a business-purpose test was erroneous. Amicus insists that the creation of an insurance company to achieve insurance company taxation is a legitimate business purpose and a taxpayer's business purpose is irrelevant to whether there has been an assignment of income.

2855-8278 Quebec, Inc.

1. May an insurance contract that transfers risk from customers of a shipping company to a third-party insurance company, and therefore has economic substance, nevertheless be treated as a sham?

2. May a business-purpose test be applied to negate the tax consequences of an insurance contract between two unrelated parties and to negate the tax consequences of the formation of a reinsurance company to assume the insurance risk?

STATEMENT OF INTEREST OF AMICUS CURIAE

[3] The Alliance of American Insurers ("Alliance") is a non- profit trade association representing over 320 property and casualty insurance companies. Alliance members collectively wrote approximately $23 billion in premiums last year and provided homeowners, automobile, liability, workers compensation and other forms of personal and business insurance to policyholders throughout the United States. The Alliance serves its member companies by providing a responsible voice on important public policy issues and providing services to member companies that enhance their ability to serve policyholders. Occasionally, the Alliance has participated in the judicial process as amicus to assist courts with insurance- related issues that directly affect the interests of its members.

[4] The Alliance believes that the court below erred by combining the assignment-of-income doctrine with a business-purpose test to disregard as a sham the arrangement by which the customers of United Parcel Services of America ("UPS") obtained insurance protection from an unrelated third party insurer. The Alliance recognizes that the facts in this case, which may involve significant tax reduction through the creation of an off-shore reinsurance company (Overseas Partners, Ltd., or "OPL"), invite close scrutiny; however, the decision of the court below is based on overly broad formulations of legal principles which, if upheld on appeal, may result in shamming valid insurance arrangements that, up to this time, have never been questioned. In this regard, the Internal Revenue Service ("IRS") has characterized the opinion below as "treat[ing] as a sham a seemingly valid insurance transaction on the basis that the transaction was tax-motivated and resulted in an impermissible assignment of income." Field Service Advice ("FSA") 200023010 (Feb. 11, 2000). ¹ The IRS also has been citing the Tax Court's opinion with increasing frequency to raise questions about a variety of other insurance transactions. See FSA 200027008 (Mar. 31, 2000); FSA 200026016 (Mar. 31, 2000); FSA 200009006 (Nov. 8, 1999).

[5] The Alliance is especially concerned that the broad analyses of the court below could be applied to disregard as a sham the creation of a domestic insurance company that otherwise would be subject to U.S. tax under provisions of the Internal Revenue Code applicable to insurance companies. The IRS recently has suggested that an off-shore reinsurance company similar to OPL would not qualify for insurance company treatment if it were a domestic company. See FSA 200031015 (Apr. 17, 2000).

[6] The Alliance submits this brief under the authority of Federal Rule of Appellate Procedure 29 to urge the Court to reject the overly broad reasoning that underlies the Tax Court's conclusions and to recognize the validity of well-established tax principles that apply to insurance arrangements.

SUMMARY OF ARGUMENT

[7] As a result of the transactions at issue, UPS stopped accepting primary liability for the excess value ("EV," i.e., over $100) of lost or damaged parcels, and its customers purchased EV insurance protection from an established, independent insurance company, National Union Fire Insurance Company ("NUF"). For an arm's- length premium, each shipper shifted its risk to NUF, and this risk was distributed widely among insurance risks of other shippers. NUF, in turn, reinsured the risks to OPL, a new reinsurance company created by UPS, the stock of which had been distributed to UPS shareholders in a fully-taxable dividend. These arrangements resulted in the issuance of valid insurance to the shippers and had economic substance.

[8] The court below, without considering established precedent for analyzing the economic substance of insurance arrangements, erroneously relied on several factors in concluding the transactions were a sham: that NUF acted as a fronting company and reinsured its risk to OPL; that the amount of premiums and predictability of losses rendered an overall business loss by NUF or OPL unlikely; that UPS retained secondary liability for the EV coverage in the event NUF failed to pay; that UPS continued to administer the insurance program; and that the EV business which UPS discontinued was very profitable. These factors, individually and collectively, are common to many insurance transactions and do not negate what should be indisputable: that the insurance arrangements between the shippers and NUF and between NUF and OPL had economic substance and therefore cannot be treated as a sham.

[9] Rather than address the UPS facts under I.R.C. section 482, ² which specifically permits reallocation of income between parties under common control, the court below instead introduced a subjective business-purpose test into the assignment-of-income doctrine to conclude that all of OPL's income (as well as NUF's income) should be taxable to UPS. The court below erred in applying this hybridized theory. The creation of an insurance company to achieve the tax treatment Congress specifically prescribed for insurance a valid business purpose. NUF and OPL were insurance companies that earned underwriting income for assuming insurance risk; that income cannot be reallocated back to UPS, which had not assumed primary liability for the risk.

ARGUMENT

I. BACKGROUND: SELLER'S GUARANTEE VS. INSURANCE

[10] Before 1984, in addition to providing parcel shipping services, UPS also offered to indemnify its customers, for a fee, against loss or damage in excess of $100 to their parcels. Like extended warranties offered by sellers of goods, this EV coverage was in the nature of a guarantee of UPS's service and was similar to insurance coverage. Whether such a seller's guarantee is insurance for state regulatory purposes depends on the laws and regulations of the particular state. ³ Regardless of the treatment under state law, for federal income tax purposes the seller would not receive insurance tax treatment because it is not an insurance company. ⁴

[11] The tax treatment of a seller's guarantee typically results in a mismatching of income and deductions, which distorts the seller's taxable income. The seller of the service or product receives income up front when the customer pays for the guarantee protection, but is entitled to a deduction for its cost of fulfilling the guarantee only later, when its obligations to its customers accrue. See generally, American Automobile Ass'n v. United States, 367 U.S. 687 (1961); but see Rev. Proc. 71-21, 1971-2 C.B. 549 (IRS provided limited exception for prepaid service income).

[12] On the other hand, in the case of guarantee protection provided by insurance from an insurance company, this mismatching of income and deductions is alleviated under the accounting rules of I.R.C. Subchapter L (section 801-845) applicable to insurance companies. In recognition that premiums for insurance coverage may be received before they are earned and related claims are paid, insurance company accounting under Subchapter L permits the use of reserves for unearned premiums and estimated losses. I.R.C. section 832(b); Treas. Reg. section 1.832-4(a) and (b) (1963). The unearned premium reserve defers recognition of premium income until it is earned, and loss reserves allow claims to be deducted on an estimated basis (rather than an accrual basis), bridging the time lag between the receipt of premiums and the payment of claims. These insurance accounting principles match the premium income and estimated loss so that they are taken into account for tax purposes at the same time, to provide clear reflection of an insurance company's income.

[13] The seller providing a guarantee may seek to eliminate the mismatching of income and deductions by converting the guarantee coverage into an insurance business. This could be accomplished by the following steps: a new insurance company is created; the seller stops providing guarantee coverage; and the customer is offered indemnity insurance from the new insurance company. ⁵ Although this separation of the insurable risks into an insurance business may result in proper matching of income and expenses and a reduction in taxes, that result was intended when Congress enacted Subchapter L. See Alinco Life Ins. Co. v. United States, 373 F.2d 336, 341 (Ct. C1. 1967).

[14] There are significant administrative and regulatory hurdles in implementing the steps described above. Obtaining the necessary licenses and approvals of policy forms from state regulators is an expensive and time-consuming process. To address these problems, a "fronting company" typically is used. The fronting company is an established insurance company authorized to engage in the insurance business in the states where the seller's customers will purchase the policies. The fronting company issues the insurance policies and is directly liable for the insured losses. The fronting company then reinsures the business to the seller's newly created insurance company, keeping an arm's-length fee negotiated between the parties to reflect the risks incurred and the services provided.

[15] From the customer's perspective, this is a classic insurance arrangement because a third-party insurance company is assuming the risk, for which the customer pays an arm's-length insurance premium. From the fronting company's standpoint, it assumes an insurance risk that is distributed among its and the reinsurer's other insurance risks. The fronting company is directly liable to its policyholder -- the seller's customer -- even if is unable to obtain reimbursement from the reinsurer.

[16] It is appropriate that this arrangement be taxed as insurance under Subchapter L. If the reinsurer is a domestic U.S. company or a foreign company engaged in business in the U.S., it pays tax under Subchapter L on its net income from the business assumed from the fronting company, just as if it were the direct writer of the business. If it is a "controlled foreign corporation" not engaged in a U.S. business, its U.S. shareholders pay a similar tax based on Subchapter L principles on the net income from U.S. risks. ⁶ Of course, application of Subchapter L may result in a deferral of taxable income because of the better matching of income and deductions. However, if inappropriate tax reduction occurs due to a lack of arm's-length dealing, the problem is addressed by I.R.C. section 482. For example, it might be appropriate to apply I.R.C. section 482 if the seller continues to administer the program and is not adequately compensated for its services. Nevertheless, the fronting company and reinsurer are entitled to arm's-length compensation for assuming the insurance risk, and this compensation cannot be reallocated to the seller under I.R.C. section 482.

[17] The UPS case fits neatly within this framework. UPS created a structure under which shippers, who previously could obtain EV coverage from UPS, could now buy EV insurance from NUF. Under the arrangement, UPS provided administrative services under the NUF policy. NUF, which assumed the shippers' risks under the policy, reinsured those risks with OPL. Each of the elements of this arrangement is common to everyday insurance and reinsurance transactions engaged in by Alliance members. ⁷

II. THE COURT BELOW ERRONEOUSLY DETERMINED THAT A VALID

[19] Risk shifting occurs when the person facing the possibility of economic loss shifts some or all of the risk of loss to an insurer. Steere Tank Lines, 577 F.2d at 280. Risk distribution involves the pooling of risks of one insured with those of other insureds. Pooling of a sufficient number of insureds' risks brings into play the law of large numbers and increases the predictability of aggregate losses. Clougherty Packing, 811 F.2d at 1300. This permits the insurer to charge each insured only a small fraction of its potential loss, because any instance of total loss is expected to be offset by a large number of instances of little or no loss. See Rev. Rul. 92-93, 1992-2 C.B. 45.

[20] Under the EV insurance program, shippers paid premiums for coverage of loss or damage to their parcels. If a shipper did not opt for coverage, any loss or damage to its parcel in excess of $100 would be borne by the shipper. A shipper's election of EV insurance coverage was a risk-shifting event; in event of a loss, the shipper was contractually entitled to recover the amount of the loss (in excess of $100) from NUF. The EV insurance program also provided risk distribution because the risks of all shippers electing coverage were pooled in NUF (and, under the reinsurance, in OPL). Thus, notwithstanding the holding below, the EV insurance program meets the long-established tax-law test for valid insurance which has economic substance.

[21] The court below erred in failing to apply this specific economic substance test tailored by the courts for evaluating the tax consequences of purported insurance transactions. Although the court cited these cases in its consideration of UPS's workers compensation insurance arrangement, Appellant's Excerpts of Record ("ER") 237-241, it inexplicably ignored them in its discussion of the EV insurance program. If the court had considered all of the factors it found relevant -- NUF's role as a fronting company, the reinsurance with OPL, the predictability of losses, UPS's secondary liability, the profitability of the program -- in the context of the proper risk shifting/risk distribution analysis, it could not have concluded that the EV insurance program lacked economic substance.

B. A FRONTING COMPANY PROVIDES VALID INSURANCE PROTECTION.

[22] There is no dispute that the EV insurance premium of 250 per $100 of parcel value was an arm's-length charge for the insurance coverage purchased by the shippers. From the shippers' perspective, the premium was entirely for EV insurance coverage of their packages, whether or not it was the best price they could obtain, and many shippers willingly elected insurance at that premium rate. ¹⁰ From NUF's perspective, it had to fulfill two services related to the EV insurance -- administer the insurance program, and underwrite the insurance risk. NUF satisfied its obligations by unbundling and delegating these functions: it relied on UPS to administer the program, ¹¹ and it assumed the underwriting risk and then reinsured that risk with OPL. Thus, while NUF was fully liable to the shippers, it acted as a "fronting company" in performing its obligations. ¹²

[23] The court below concluded that the use of NUF as a fronting company was a sham. ER 234-35. NUF, however, assumed primary liability for the shippers' claims under the EV insurance program. While NUF reinsured 100% of the insurance risk with OPL, it retained the credit risk that OPL, because of these or other liabilities, might become financially unable to meet its responsibilities to NUF. The court acknowledged that, had OPL become insolvent, NUF would have remained primarily liable for all individual EV claims up to $25,000, which totaled over $22 million in 1984. ER 222. Given OPL's liabilities on the reinsurance of UPS's workers compensation risks (see ER 237-241) and on its growing reinsurance of other risks (see Appellant's Opening Brief, 16 n.9), a default by OPL was not beyond the realm of possibility. Thus, after reinsuring the EV insurance risks with OPL, NUF was exposed to credit risk from all of OPL's business, including OPL's other unrelated insurance risks.

[24] The National Association of Insurance Commissioners ("NAIC") has recognized that insurance companies assume substantial insurance risks under fronting arrangements. ¹³ In 1993, the NAIC adopted a model law to regulate fronting arrangements and to prevent problems where insurers might fail adequately to evaluate the financial solvency of reinsurers. See Fronting Disclosure and Regulation Act, NAIC, Model Laws, Regulations and Guidelines. vol. II, 323-1 (adopted Sept. 1993, 1993-3 Proceedings of the NAIC ("NAIC Proc.") 649). The model law recognizes that fronting, with appropriate safeguards, is legitimate and useful. ¹⁴

[25] Despite the legal validity of fronting arrangements, the court below focused most of its attention on the fact that NUF relied on UPS to administer the EV insurance program. In the insurance industry, however, it is not unusual to unbundle administration from underwriting the risk. That parties other than the insurance company perform administrative functions does not negate the existence of insurance risk. See Kidde Industries, Inc. v. United States, 40 Fed. Cl. 42, 51-53 (1997). ¹⁵ The fact that UPS was not compensated for its service is not a reason to disregard as a sham the valid insurance between the shippers and NUF or the reinsurance with OPL; it only suggests that a reallocation of some income might be considered under I.R.C. section 482.

C. RISK DISTRIBUTION AMONG A LARGE POOL OF RISKS IS THE

[27] First, the preoccupation of the court below with whether UPS's risks were shifted betrays an incomplete analysis of the economic consequences of the arrangement. By focusing on only one segment of the overall transaction, the court ignored the fact that in the beginning before any risk is transferred, the EV risk always resides with the shipper. Before 1984, shippers could shift this risk to UPS by electing EV coverage; after 1983, shippers could transfer the risk to NUF by electing coverage under the EV insurance program. The only risk shifting that occurred in the EV insurance program was from UPS's customers to NUF, and then from NUF to OPL. There was never an insurance relationship between UPS and NUF or OPL which could have shifted any EV risk from UPS.

[28] More importantly, the court below erred in its conclusion that the level of risk shifting is insignificant where the losses are predictable, or where the insurance is priced so that the likelihood of the insurer losing money on the pool of risks is small. The risk- shifting test is concerned with INSURANCE RISK; the court confuses this with the BUSINESS RISK of making a profit. A similar contention about quantifying insurance risk, made by the IRS in Trans City Life Ins. Co. v. Commissioner, 106 T.C. 274 (1996), was properly rejected. The court there determined that in analyzing risk, the proper evaluation is to measure the face amount of insurance (i.e., the aggregate maximum exposure), not the probability that the maximum exposure will be realized. Id. at 309. See also Alinco, 373 F.2d at 342-343. For 1984, OPL's total exposure on EV risks approximated $40 billion. ER 222 ($99,794,90 in EV premium collected at a rate of 25 cents per $100).

[29] In fact, the view of the court below on the significance of the predictability of the pool of EV insurance losses is exactly backwards. Rather than indicating a lack of shifting of significant insurance risk, the predictability of the large pool of risks demonstrates that the EV insurance program achieved risk distribution and had economic substance. It is the very essence of insurance that this risk of loss was distributed widely among a very large universe of shipments and that the aggregate loss -- and overall business profit -- were predictable. See Clougherty Packing Co., 811 F.2d at 1300.

[30] Finally, whether the risk is viewed as originating with UPS (per the court below) or properly with the shippers, the fact that UPS retains residual liability under the EV insurance program does not affect the conclusion that risk has been shifted in a valid insurance arrangement. The insured almost always retains risk. For example, in a tort case the insured remains liable for tort damages even though it can look to the insurer to cover its liability and defense, within the limits of the policy. Likewise, in an indemnity reinsurance arrangement between insurance companies, the ceding company (UPS under the analysis of the court below) always remains primarily liable to the policyholders. See Colonial American Life Ins. Co. v. Commissioner, 491 U.S. 244, 247 (1989); cf. United States v. Consumer Life Ins. Co., 430 U.S. 725, 737 (1977) (rejecting argument that reinsurance was sham: "indemnity reinsurance of this type does not relieve the ceding company of its responsibility to policyholders. Had the taxpayers become insolvent, the insurer still would have been obligated to meet claims." (footnote omitted)). If residual liability of the insured were a badge of lack of economic substance, every insurance arrangement would be subject to challenge as a sham.

III. THE TAX COURT'S USE OF A BUSINESS-PURPOSE TEST WAS ERRONEOUS.

[31] Assignment-of-income questions arise under a judicially created doctrine that requires the true earner of income to be taxed, despite the attempted assignment of the income to a third party. Application of the doctrine should depend exclusively on the objective facts necessary to answer the controlling question: who truly earned the income? Motivation is not relevant to answering that question. In fact, the seminal assignment-of-income cases arose in the context of donative transfers where business purpose was entirely absent. See Joe T. Taylor and L. Andrew Immerman, The Curious Role Of Motive In The Tax Court's Analysis In UPS, 85 Tax Notes 1321 , 1328 (1999). Nevertheless, the Tax Court made the issue whether UPS had "business purposes for engaging in the transaction other than tax avoidance" an essential part of its assignment-of-income inquiry. ER 191.

A. THE CREATION OF AN INSURANCE COMPANY TO ACHIEVE INSURANCE

[33] First, it bears emphasis that sham treatment is not justified by a tax avoidance purpose alone, but only in combination with lack of economic substance. See, e.g., ACM Partnership v. Commissioner, 157 F.3d 231, 248 n.31 (3d Cir. 1998), cert. denied, 526 U.S. 1017 (1999). Where a purported insurance transaction involves risk shifting and risk distribution, these elements necessarily impose significant economic consequences on the parties so that the arrangement is not a sham, notwithstanding any tax avoidance motive.

[34] More importantly, an intention to qualify an insurance transaction for insurance tax treatment under Subchapter L does not constitute tax avoidance. Subchapter L establishes a special statutory scheme for taxing insurance companies in recognition of the fact that the proper matching of insurance company income and expense requires reserve accounting. A company writing insurance that brings its insurance business within the coverage of Subchapter L cannot be faulted for having engaged in a "tax-motivated" transaction, for it is merely availing itself of a special tax treatment that Congress recognized as appropriate for companies engaged in this type of business.

[35] In Alinco, 373 F.2d at 340, the government challenged the taxpayer's status as a life insurance company under Subchapter L on the ground that the taxpayer was created for a tax avoidance purpose. ¹⁶ Alinco was created as a subsidiary of Associates, a large finance company, and was qualified under the technical requirements of Subchapter L as a life insurance company. Before the creation of Alinco, Associates sold its customers, through an affiliated insurance agency (Morco), credit life insurance policies issued by an unrelated insurer, Old Republic, which paid Morco commissions and Associates experience refunds in consideration for their sales and other services. Morco and Associates were subject to federal income tax on this income. With the creation of Alinco, Associates and Old Republic made a new arrangement. Morco continued to sell Old Republic policies, but without any compensation from Old Republic. Instead, Alinco entered into an agreement with Old Republic to reinsure a significant, and profitable, block of Old Republic's life insurance business. Under the provisions of Subchapter L at the time, Alinco, as a life insurance company, was exempt from tax on underwriting income, including the premiums it received from Old Republic.

[36] Like the conclusion of the court below in this case, the government argued in Alinco that the "only, or at least principal, purpose in forming Alinco as a life insurance company and arranging for its reinsurance treaty with Old Republic was thereby to convert Morco's ordinary commission income and Associates' retrospective rate adjustment income into tax-free underwriting income." Alinco, 373 F.2d at 341. However, in refusing to set aside the insurance arrangement, the Court of Claims rejected this argument and noted that, even if the government's factual contention were true, its legal position that this constituted tax avoidance was contrary to long-standing analogous authorities that hold that qualifying for a special tax status intended by Congress does not constitute tax avoidance. See Rev. Rul. 70-238, 1970-1 C.B. 61, 62; A.P. Green Export Co. v. United States, 284 F.2d 383, 389 (Ct. Cl. 1960); Barber-Greene Americas, Inc. v. Commissioner, 35 T.C. 365, 386 (1960).

[37] Courts have applied this same principle in cases involving taxpayers' efforts to achieve other special tax status. In Supreme Investment Corp. v. United States, 468 F.2d 370, 376 (5th Cir. 1972), the Fifth Circuit summarized the proper standard for determining tax avoidance --

There is no tax avoidance . . . when a taxpayer determines its

[39] These cases fall in line with the Supreme Court precedent delineating the economic substance doctrine, which require consideration whether the tax advantage sought was, under the circumstances, intended by Congress to apply. In Knetsch v. United States, 364 U.S. 361, 365 (1960), the Court addressed the economic substance of the taxpayer's insurance and loan arrangement. Setting aside the finding of the trial court that the taxpayer's only motive was to obtain a tax deduction, the Court quoted Gregory v. Helvering, 293 U.S. 465, 469 (1935), in summarizing the limited role of a tax- avoidance motive (364 U.S. at 365):

But the question for determination is whether what was done,

[41] In summary, the case law is clear that a taxpayer's effort to qualify itself for a more favorable, but Congressionally sanctioned, tax status (such as taxation as an insurance company) does not constitute impermissible tax avoidance. It follows that creation of an insurance company to obtain tax treatment under Subchapter L is a legitimate business purpose.

B. A TAXPAYER'S BUSINESS PURPOSE IS IRRELEVANT TO WHETHER

[43] The court went off track, however, and shifted focus to UPS's business purpose. ER 191-216. But business purpose is irrelevant to an assignment-of-income inquiry. This is clear from the discussion of the Supreme Court in Lucas v. Earl, 281 U.S. 111, 114- 115 (1930), the original assignment-of-income case (emphasis added):

There is no doubt that the statute could tax salaries to those

[45] As discussed above, risk shifting and risk distribution are the essence of insurance, and it follows that income from an insurance transaction is earned by the party which assumes and distributes the risk. The court acknowledged that NUF and OPL were fully liable for the risks they assumed, amounting to over $22 million in payments for 1984, and that other insurers provided similar insurance coverage for substantial premiums. ER 170, 172-73, 218, 224-232. These facts lead to the conclusion that NUF and OPL earned, at a minimum, the amounts that ordinarily would be charged for underwriting the EV insurance risks. Nevertheless, the court concluded that the risks were "insignificant." The court had to ignore the risk assumed by NUF and OPL in order to conclude that they did nothing to earn the income. None of the assignment-of-income cases on which the court relies supports such treatment or suggests that business purpose is relevant.

[46] The assignment-of-income doctrine is a sweeping, all-or- nothing instrument used only where it is not inconsistent with the scope and purpose of specific statutory provisions, such as I.R.C. sections 482 or 269. See Foglesong v. Commissioner, 621 F.2d 865, 872-873 (7th Cir. 1980); Rubin v. Commissioner, 429 F.2d 650, 653 (2d Cir. 1970); Ach v. Commissioner, 42 T.C. 144, 123-124 (1964), aff'd, 358 F.2d 342 (6th Cir. 1966). For this reason, the issue of who should be taxed on the income-generating activities of the EV insurance arrangement is better addressed under I.R.C. section 482, which would have permitted the court to examine an arm's-length pricing analysis to determine what amounts, if any, were earned by UPS through its administrative services and what amounts were earned by NUF and OPL for assuming risk. ¹⁹

CONCLUSION

[47] Based on the foregoing, the Alliance urges the Court to reverse the decision below or to remand the case to consider the Commissioner's more focused and statute-based alternative arguments.

Dated: August 18, 2000

[48] I certify that pursuant to Fed. R. App. P. 32(a)(7)(C), as referenced in Fed. R. App. P. 29(c)(5), the attached Amicus Curiae Brief is proportionately spaced, has a typeface of 14 points and contains 6977 words.

Dated: August 18, 2000

² References to "I.R.C." are to the Internal Revenue Code (26 U.S.C.) as in effect during the tax year in issue.

³ Possible state regulation was not an unreasonable concern in this case, in light of litigation over whether similar coverage -- acceptance by rental car companies of customers' liability for collision damage -- is insurance for state regulatory purposes. See, e.g., Davis v. M.L.G. Corp., 712 P.2d 985, 986 (Colo. Sup. Ct. 1986) (collision damage waiver not insurance, but vacating earlier opinion holding it was).

⁴ Treas. Reg. section 1.831-3(a) (1963) and 1.801-3(a)(1) (as amended in 1972) provide that to be taxed as an insurance company, a taxpayer must be primarily engaged in the issuance of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies.

⁵ Sellers offering extended warranties often engage in this type of tax planning. Up until now, the IRS has not attacked the resulting tax effects. See, e.g., Private Letter Ruling ("PLR") 199903024 (Oct. 27, 1998) (company established to issue warranty supplements treated as insurance company); PLR 199926033 (Apr. 7, 1999) (same, for roadside assistance); Technical Advice Memorandum ("TAM") 9601001 (Aug. 10, 1995) (same, for extended repair contracts). PLRs and TAMs are rulings by IRS Chief Counsel on legal issues for specific taxpayers. While under I.R.C. section 6110(j)(3) the rulings are not precedent, they are relevant to show a consistent pattern of IRS interpretation (Rowan Cos., Inc. v. United States, 452 U.S. 247, 261 n. 17 (1981)) and show how the IRS would rule on similar facts.

⁶ This tax is imposed under Subpart F, I.R.C. sections 951- 964; see I.R.C. section 953, concerning insurance income.

⁷ Although UPS may not have experienced as severe a mismatch of premiums and deductions as the typical case because losses on packages generally are claimed within a short time after delivery, the Tax Court's analysis concerns the Alliance because it could be applied equally to all insurance arrangements that are undertaken to achieve Subchapter L treatment.

⁸ Although there is no I.R.C. definition, Congress recently defined insurance by examples of lines of business for purposes of functional state regulation under the Gramm-Leach-Bliley Act, Pub. L. No. 106-102, section 302(c), 113 Stat. 1138, 1407-1408, 15 U.S.C. section 6712 (1999). This is the first time insurance has been formally defined in federal law. The definition includes "inland marine" insurance (see 15 U.S.C. section 6712(2)(A)), which covers the protection against loss or damage to goods or property in transit. Roderick McNamara et al., Inland Marine Insurance, Vol. I, 1 (1987). The NUF contract, a classic inland marine insurance contract, was "insurance" within the commonly understood sense of the word.

⁹ Even where a court has determined a purported insurance arrangement to be a "sham," it has analyzed the substance of the transaction within this risk shifting/risk distribution framework. See Malone & Hyde, Inc. v. Commissioner, 62 F.3d 835, 840-841 (6th Cir. 1995) (taxpayer's risk reinsured with new Bermuda affiliate; court noted that affiliate was undercapitalized foreign captive propped-up by guarantees from taxpayer and that taxpayer agreed to hold third-party fronting insurer harmless in event affiliate unable to pay claims; court found no risk shifting to Bermuda affiliate and sham).

¹⁰ The conclusion of the court below that UPS (as opposed to the shippers) could have obtained coverage on its own for much less misses this point. Although most of the court's analysis of arm's- length price is based on what it sees as NUF's unreasonably low loss ratio, this could result from the fact that NUF's expenses were low because it was not required to pay for UPS's administrative services. In any event, sham treatment cannot be based on lack of arm's-length pricing alone. Certainly, if NUF had performed its own administration and not reinsured the risks with OPL, the court could not have found a sham, notwithstanding the amount of the premiums the shippers might have paid.

¹¹ The court below listed numerous administrative functions that UPS performed. ER 183-84.

¹² The Internal Revenue Manual implicitly acknowledges the validity of a fronting arrangement, defining it as "[a] reinsurance contract in which business produced by an insurer not licensed in a particular state is written on another company's policy form, with the intention of ceding the entire policy liability to the producing (acquiring) company." 3 Audit, Internal Revenue Manual (CCH), sec. 4.4.2.5.6.1.1, at 10,430.

¹³ The NAIC is an association of state insurance regulatory officials whose objectives are to maintain and improve state regulation of insurance, promote financial solidity, guaranty against loss, and promote fairness to policyholders and claimants. See NAIC, Accounting Practices and Procedures Manual, vol. I, P-5 n.1 (2000). The NAIC promulgates model laws and statutory accounting principles for purposes of insurance company annual statement reporting. The Internal Revenue Code adopts NAIC accounting for tax purposes. See I.R.C. section 832(b).

¹⁴ An NAIC working group considering the model law in 1992 stated that:

As for the practice of "fronting," it was agreed at the working

¹⁵ The IRS itself has recognized the validity of insurance arrangements, even though the seller of the goods or services, rather than the insurance company, is responsible for administrative functions. See the rulings listed supra, n. 5.

¹⁶ The challenge was made under I.R.C. section 269, which permits the IRS to disallow a deduction, credit or other allowance where the principal purpose of an acquisition of a corporation is the evasion or avoidance of tax.

¹⁷ In addition, the focus of the court below on UPS's risks under the pre-1984 guarantee coverage confuses its business purpose discussion. If UPS had never provided EV guarantees before offering its customers EV insurance through a related and appropriately licensed company, it is hard to see how the court could have concluded that the post-1983 insurance arrangement would lack a business purpose. Yet where a taxpayer could have achieved a tax result by such direct means, it is not tax avoidance to achieve the same result by a different route. See Cromwell Corp. v. Commissioner, 43 T.C. 313, 318 (1964). Thus, UPS cannot be denied the tax results of its insurance arrangement for lack of a business purpose simply because it had taken on the risks directly for an interim period.

¹⁸ In this regard, the IRS recently issued FSA 200031015 (Apr. 17, 2000), in which it stated that an off-shore reinsurance company similar to OPL was a passive foreign investment company because it would NOT qualify as a reinsurance company subject to Subchapter L if it was a domestic company.

¹⁹ There are issues whether I.R.C. section 482 applies in this case. For example, the provision requires that UPS and NUF or OPL have been under common control. See Treas. Reg. section 1.482-1A (as amended in 1993). In addition, the section cannot be applied to allocate income to a taxpayer if it would be illegal for the taxpayer to receive the income. See Commissioner v. First Security Bank of Utah, 405 U.S. 394, 404-405 (1972). The Alliance takes no position on these issues.