IRS Can Reallocate Reinsurance Income

2. Meaning of "Source and Character" -- Whether, absent definition in section 845(a) or any regulations thereunder, the Service should argue that the term(s) "source and character," assume their traditional meaning , i.e., that "source" refers to proper entity and "character" means, in the case of income, ordinary versus capital, or whether some other meaning is contemplated by the statute.

2. Meaning of "Source and Character" -- As we have advised you informally, the terms "source" and "character" should be defined separately rather than together. In this regard, "source" relates to the Secretary's allocation and adjustment powers under section 845(a), and "character" relates to the Secretary's recharacterization authority under section 845(a). CC:INTL has agreed informally with this conclusion. We intend to supplement this advice with the formal views of CC:INTL on or about August 31, 1997.

[6] The Service is seeking to apply section 845 to the related party reinsurance transactions at issue on the basis that the transactions allowed * * * to qualify as a life insurance company under I.R.C. section 816(a), and thereby offset certain interest deductions on debentures issued in connection with its acquisition of * * * in * * * against * * *'s taxable income in a life-life consolidated return. If * * * did not qualify as a life insurance company, it would have been ineligible to file a consolidated return with * * * for the taxable years at issue because the companies had not been affiliated for five years, as required by I.R.C. section 1504(c)(2)(A). Absent a consolidated return, * * * interest deductions could not be used to offset * * * 's taxable income.

[7] The case has been formally considered by the National Office on three previous occasions. On April 1, 1994, a request for Technical Advice was returned to the Field for further factual development of a threshold issue in the case, specifically, whether * * * could qualify as a life insurance company under section 816 independent of the reinsurance transactions at issue. If * * * had an independent basis for qualifying as a life insurance company, then it would have been entitled to file a life-life consolidated return without the five-year limitation of section 1504(c)(2)(A), and the section 845 issue would be moot.

[8] On January 30, 1995, the case was resubmitted to the National Office for Field Service Advice, with additional factual development of the section 816 issue. On April 11, 1995, Field Service Advice was issued concluding that: (1) * * * did not qualify as a life insurance company under section 816(a) prior to its acquisition of * * *, specifically, for the 1984 through * * * taxable years; (2) * * * did not qualify as a life insurance company under section 816(a) after its acquisition of * * * specifically, for the * * * through * * * taxable years, if the reinsurance ceded to it by * * * is not given tax effect pursuant to section 845; and (3) The facts of the case support applying both section 845(a) and (b) to disregard the reinsurance transactions in determining whether * * * may file a consolidated return with * * * under I.R.C. section 1501.

[9] On March 1, 1996, you requested formal assistance in further developing the facts and legal theories in the case and in evaluating the case as a potential litigating vehicle. On May 31, 1996, Field Service Advice was issued concluding that: (1) The Service should clearly articulate a theory of the case under section 845(a) that * * * and * * * used reinsurance to create a life-life consolidate return in direct circumvention of a congressionally mandated limitation, the five-year waiting period in section 1504(c)(2)(A), and that, as a result, it is necessary to invoke section 845(a) to allocate, recharacterize, or adjust all effects of that consolidated return, particularly the offset of * * * interest deductions against * * * 's taxable income; (2) In the absence of a judicial determination that the Service can enforce section 845(a) without regulations, the Service may wish to consider whether it can support an alternative argument under the more stringent "significant tax avoidance effect" standard of section 845(b); and (3) The Service should consider whether it may dispose of the threshold section 816(a) issue with a summary judgment motion before expending considerable resources on the section 845 issue.

[10] The current request for Field Service Advice arose as a result of a February 5, 1997, meeting in the National Office between the * * * litigation team and Nancy Vozar, CC:DOM:FS:FI&P, Lorraine Gardner, CC:DOM:FS:CORP, and Tom Moffitt, CC:DOM:FS:IT&A. The purpose of the meeting was to further develop the applicable standards for the exercise of the Secretary's section 845(a) authority. Since the previous formal Field Service Advices had fully analyzed the relevant authorities under section 845, it was determined that formal advice should be sought from Corporate and International as to the relevance of sections 269 and 482 to section 845(a) and from International as to possible definitions of the meaning of "source and character."

[11] We have incorporated into this memorandum the statements of fact and analysis from the previous Field Service Advices, issued on April 19, 1995, and May 31, 1996.

[13] CC:INTL has advised us informally that case law and regulations under section 482 are relevant to the development of the standards of the Secretary's authority under section 845(a). CC:INTL expects to formally provide its views on the issue on or about August 31, 1997. We will provide supplemental Field Service Advice to you when those views are received.

[14] CC:DOM:CORP:1 has advised us formally that a strong argument can be made under section 845(a), supported by case authority under section 482, that income from reinsurance contracts should be allocated from * * * to * * * so that * * * no longer is a life insurance company under section 816, thereby making * * * ineligible to file a consolidated return with * * *, We have incorporated their discussion into this document, with minor modifications.

[15] Under section 1504(c)(2)(A), for * * * to file a consolidated return with * * * during the * * * years at issue, * * * must be a life insurance company taxed under I.R.C. section 801. Otherwise, * * * would have had to wait five years to file consolidated returns with * * *. If the Service can allocate * * * income from the reinsurance contracts to * * * under section 845(a), * * * would not meet the definition of a life insurance company under section 816, and therefore would not be a life insurance company taxed under section 801. Accordingly, * * * would not be able to file consolidated returns with * * * until five years after the acquisition.

[16] Section 845(a) of the Code provides that in the case of a reinsurance agreement between two or more related persons (within the meaning of section 482), the Secretary may allocate among such persons income, deductions, assets, reserves, credits or any other items related to such agreement, or can recharacterize any such items, or make any other adjustment, to reflect the proper source and character of the taxable income (or any item used in determining taxable income) of each person.

[17] The Conference Report accompanying enactment of this provision, H.R. Conf.Rep. No. 861, 98th Cong., 1st Sess. 1061 (1984), 1984-3 C.B. (Vol. 2) 315, ("Conference Report") states that the operative standards for the exercise of the Secretary's adjustment authority under the related party rules of section 845(a) or the unrelated party rules of section 845(b) are objective tests of (1) whether adjustments are necessary to more properly reflect income, or (2) whether the reinsurance transaction has a significant tax avoidance effect. Any transaction that would be within the scope of the unrelated party rule but for the fact that the parties are related, would be within the scope of the related party reinsurance rule. Id. at 1062; 1984-3 C.B. (Vol. 2) 316. On the other hand, a transaction which would not give rise to adjustments if entered into by unrelated parties might result in adjustments as among related parties. Id.; 1984-3 C.B. (Vol. 2) 316.

[18] The Conference Report further states that, for purposes of determining whether adjustments may be made in a reinsurance agreement, the motivation of the parties to the agreement is wholly irrelevant, viz., the fact that a transaction has a business purpose or was not entered into with tax avoidance or evasion as a principal purpose or is entered into at arm's length does not foreclose the Secretary making an adjustment in a reinsurance transaction. Id.; 1984-3 C.B. (Vol. 2) 316.

[19] Although the Conference report provides two objective tests (necessary to properly reflect income and with a significant tax avoidance effect), there is neither case law nor regulations defining the parameters of those tests. The question is whether the authority under section 482 or section 269 can help in applying these tests. The criteria applicable to the Secretary's exercise of the authority conferred by section 482 is defined by numerous judicial precedent and extensive regulations. Merck & Co., Inc. v. U.S., 24 Cl. Ct. 73, 79 (1991).

[20] Section 482 empowers the Secretary to reallocate income, between two or more business organizations that are under common control, on a determination that such allocation "is necessary in order to prevent evasion of taxes or clearly reflect income." Id.

[21] The purpose of section 482 is to prevent the arbitrary shifting of income and deductions among controlled corporations and to place such corporations on a tax parity with uncontrolled corporations. Young & Rubicam, Inc. v. U.S., 410 F.2d 1233, 1244 (Ct. Cl. 1969). Specifically, Treas. Reg. section 1.482-1(b)(1) provides that if parity has not been achieved, the district director may intervene to distribute, allocate, or apportion income, deductions, etc., to determine the true taxable income of each controlled taxpayer.

[22] The income tax regulations also set forth an "arm's- length" standard to determine whether allocations between controlled entities are necessary. To make such a determination, the regulations attempt to identify the "true taxable income" of each entity based on the taxable income which would have resulted had the entities been uncontrolled parties dealing at arm's length. Sundstrand Corp. v. Comm'r., 96 T.C. 226, 353 (1991).

[23] The "arm's-length" standard is reached by using one of three allocation methods described in detail in the regulations. These methods are the comparable uncontrolled price method, the resale price method, and the cost plus method, in that order of priority. Treas. Reg. section 1.482-2(e)(2), (3), and (4).

[24] By allowing the Secretary to make adjustments regardless of whether a transaction passes muster under the "arm's-length" standard, the legislative history of section 845(a) necessarily reflects Congressional intent to expand on the authority granted the Secretary under section 482. Included in the Secretary's expanded authority is any transaction that does not reach the level of an "arm's-length" standard or that is subject to adjustment under section 482. Otherwise, the Secretary's authority under section 845(a) would not reach the level of authority of section 482, its regulations, or the case law formed by its principles. Therefore, any transaction that is subject to adjustment under section 482 must be included within the definition of a proper reflection of income or significant tax avoidance effect under section 845(a) and its legislative history.

[25] In order to justify an allocating of income pursuant to section 482, the Commissioner must find that: (1) there are two or more trades, businesses or organizations; (2) owned or controlled by the same interests; and (3) that it is necessary to allocate gross income . . . among them . . . to prevent evasion of taxes or to clearly reflect . . . income. B. Forman Co. v. C.I.R., 453 F.2d 1144, 1152 (2d Cir. 1972). Where the clear reflection of income branch of [the test] is invoked, the presence of a business purpose or the absence of any plan to lessen taxes does not, in and of itself, exclude the operation of the provision. Eli Lilly & Co. v. U.S., 372 F.2d 990, 998-99 (Ct. Cl. 1967). Here, there are two or more businesses owned by the same interests. Thus, the Service only need establish the third step.

[26] Treas. Reg. section 1.482-1(c) provides that in determining the true taxable income of a controlled taxpayer, the district director is not restricted to the case of improper accounting, or to the case of a fraudulent, colorable, or sham transaction. It further provides that the authority to determine true taxable income extends to any case in which either by inadvertence or design the taxable income, in whole or in part, of a controlled taxpayer, is other than it would have been had the taxpayer . . . been dealing at arm's length with an other uncontrolled taxpayer. Id. Thus, the presence of a sham transaction ostensibly indicates the taxpayer was not dealing at arm's length.

[27] A corporation remains a separate taxable entity as long as the purpose for its incorporation "is the equivalent of business activity or is followed by the carrying on of business by the corporation . . . the corporate form may be disregarded where it is a sham or unreal." Moline Properties, Inc. v. Comm., 319 U.S. 436, 439 (1943). A "sham in substance" has been defined as "the expedient of drawing up papers to characterize transactions contrary to objective economic realities and which have no economic significance beyond expected tax benefits." Falsetti v. Comm., 85 T.C. 332, 347 (1985).

[28] Factors . . . used to determine whether a transaction is a sham [are]: (1) Whether the taxpayer had a business purpose for engaging in the transaction other than tax avoidance, and (2) whether the transaction had economic substance beyond the creation of tax benefits. Bail Bonds by Marvin Nelson, Inc. v. Comm., 820 F.2d 1543, 1549 (9th Cir. 1987). There is no real difference between the business purpose and the economic substance rules. Both simply state that the Commissioner may look beyond the form of an action to discover its substance. Zmuda v. Comm., 731 F.2d 1417, 1420 (9th Cir. 1984).

[29] The Bail Bonds factors were used in the case William T. Wright and Lynne L. Wright, et al. v. Comm., 66 T.C.M. 214 (1993). In Wright, the Court held that a reinsurance company was a sham formed for purposes of avoiding tax on income earned by the parent car dealerships because: (1) It insured no other unrelated businesses than the parent and its affiliates; (2) It took reduced commissions on the reinsurance contracts; (3) It had no offices, furniture, or equipment; the officers of both companies were the same; and (4) The parent and subsidiary displayed a pervasive lack of formality in documentation of transactions. Id. at 228. The court noted, that in addition to lacking a business purpose, neither the transactions nor the reinsurance corporation itself had economic substance. Id.

[30] Similar to Wright, * * *: (1) assumed no other business than reinsurance ceded to it from * * *; (2) took no reinsurance commissions on the ceded business; (3) had no employees, offices, furniture, or equipment; and (4) had all of its administrative functions performed by * * * employees. Consistent with Moline, * * * in essence performed no activity the equivalent of business activity or that could be considered the carrying on of business by the corporation . . . [thus] the corporate form may be disregarded as a sham or unreal.

[31] A strong argument can be made that the reinsurance business ceded to * * * was a sham transaction under the case law of section 482 and is thus subject to adjustment under section 845(a) as necessary to properly reflect income. As a result, the Secretary, pursuant to section 845(a), may allocate to * * * the income received by * * * from the reinsurance ceded to it by * * *. Thus, * * * would not have been an insurance company consistent with the section 816 definition during the years * * * and could not have filed a consolidated return under 1504(c)(2)(A).

[32] Section 269 provides for the disallowance of a tax benefit, inter alia, if the principal purpose of the acquisition of direct or indirect control of a corporation is tax avoidance through the securing of such benefit. Princeton Aviation Corp. v. C.I.R., 47 T.C.M. (CCH) 575, 582 (1983). Section 269 is designed to prevent the use of other sections of the Code to provide deductions, credits, or allowances in evading or avoiding federal income tax. Treas. Reg. section 1.269-2(a).

[33] For tax avoidance to constitute the "principal purpose" of an acquisition within the intendment of section 269, such purpose must outrank or exceed any other single purpose. S. Rept. No. 627, 78th Cong., 1st Sess. (1943), 1944 C.B. 1017. Moreover, the determination of a principal purpose requires an examination of all of the facts and circumstances in which the acquisition occurred. Inductotherm Industries, Inc., v. Comm'r., 48 T.C.M. (CCH) 167, 192 (1984). Although, in theory, the question of purpose is subjective, "pragmatically, . . . the trier of fact can only determine purpose from objective facts." Bobsee Corp. v. U.S., 411 F.2d 231, 238 (5th Cir. 1969). Finally, the purpose which is relevant is the purpose which existed at the time of the acquisition, although facts occurring prior to and following the acquisition may be considered to the extent that they tend to support or negate the forbidden purpose. Hawaiian Trust Co., Ltd. v. U.S., 291 F.2d 761, 768 (9th Cir. 1961).

[34] The relationship of section 269 to section 845(a) is similar to that of section 482 to section 845(a) in that the expanse of authority contemplated under section 845(a) must also include any case that is subject to adjustment under section 269. However, the principal purpose standard has been historically more difficult to meet than section 482's "arm's-length" standard. Thus, section 482 is more helpful than section 269 in supporting the application of section 845(a) in the * * * case.

2. Meaning of "Source and Character" -- As we have advised you informally, the terms "source" and "character" should be defined separately rather than together. In this regard, we believe that "source" relates to the Service's allocation and adjustment powers under section 845(a), and that "character" relates to the Service's recharacterization authority under section 845(a). CC:INTL has agreed informally with this conclusion. We intend to supplement this advice with the formal views of CC:INTL on or about August 31, 1997.

[35] Please contact Nancy Vozar at FTS 622-7870 if you have any questions about these matters.