Capital Blue Cross v. C.I.R.

• Court: U.S. Court of Appeals — Third Circuit
• Writing for the Court: Becker
• Citation: Capital Blue Cross v. C.I.R., 431 F.3d 117 (3rd Cir. 2005)
• Decision Date: 05 December 2005
• Docket Number: No. 04-2645.,04-2645.
• Parties: CAPITAL BLUE CROSS and Subsidiaries, Appellant v. COMMISSIONER OF INTERNAL REVENUE.

431 F.3d 117

CAPITAL BLUE CROSS and Subsidiaries, Appellant v. COMMISSIONER OF INTERNAL REVENUE.

No. 04-2645.

United States Court of Appeals, Third Circuit.

Argued April 20, 2005.

December 5, 2005.

Peter H. Winslow (Argued), Samuel A. Mitchell, Scribner, Hall & Thompson, LLP, Washington, D.C., for Appellant.

Eileen J. O'Connor, Assistant Attorney General, Jonathan S. Cohen, Steven W. Parks (Argued), Tax Division, United States Department of Justice, Washington, D.C., for Appellant.

Alan I. Horowitz, Frederick W. Robinson, Maria O'Toole Jones, Miller & Chevalier, Chartered, Washington, D.C., for Amicus Curiae Blue Cross and Blue Shield Association.

Before ROTH, FUENTES, and BECKER, Circuit Judges.

OPINION OF THE COURT

BECKER, Circuit Judge.

Table of Contents

I. Introduction ........................................................ 119
                II. Facts and Procedural History ....................................... 120
                    A. Introduction .................................................... 120
                    B. Initial Taxation of Blue Cross Blue Shield Entities ............. 120
                    C. Capital's Contracts in 1987 ..................................... 121
                       1. Premium structures ........................................... 121
                       2. Renewals ..................................................... 122
                       3. Valuation .................................................... 122
                    D. The Present Controversy ......................................... 122
                III. Deductibility of Losses on Health Insurance Contracts ............. 124
                    A. The Blue Cross Blue Shield Fresh Start Basis Rule ............... 124
                    B. Deductibility of Non-Sale Losses by Blue Cross Blue Shield
                         Organizations ................................................. 125
                    C. Are the Insurance Contracts Mass Assets? ........................ 125
                IV. Burden of Proof of Deduction Amounts ............................... 128
                    A. Who Bears the Burden of Proof? .................................. 128
                    B. Proof of Separate Valuation ..................................... 129
                V. Capital's Valuation ................................................. 131
                    A. The Reinsurance Model ............................................ 131
                       1. Highest and best use .......................................... 131
                       2. Separate values .............................................. 132
                       3. The goodwill adjustment ...................................... 133
                    B. Specific Contract Characteristics ............................... 134
                    C. Lapse Rates and "Lifing Analysis" ............................... 136
                       1. Prospective changes in the market ............................ 137
                       2. Human factors ................................................ 139
                       3. The Commissioner's lifing arguments .......................... 139
                    D. The Commissioner's Objections ................................... 140
                    E. Summary and Conclusions ......................................... 140
                

I. Introduction

Capital Blue Cross ("Capital") appeals from a decision of the United States Tax Court denying its request for a refund of overpayment of taxes for tax year 1994. Capital claims that it properly established a basis in hundreds of insurance contracts that were terminated in that year, and that it is therefore entitled to take a loss deduction under 26 U.S.C. § 165 to account for the cancellation of those contracts. The Tax Court found that Capital had not established its basis in those contracts; it therefore treated Capital's basis as zero and denied any deduction.

We agree with Capital that the Tax Court improperly discounted expert testimony that tended to establish Capital's basis in the disputed contracts, and that the zero basis found by the Court was inconsistent with the facts and hence clearly erroneous. Capital engaged in an extensive and professional valuation process in order to calculate its basis in the lost contracts. While the Tax Court correctly found that the Commissioner of Internal Revenue ("the Commissioner") established several flaws in Capital's valuation, overall, we are convinced that Capital's process was thorough and professional, and that it arrived at an essentially reasonable valuation for the cancelled contracts. Given these conclusions, we are unwilling to affirm the Tax Court merely because we find some flaws in Capital's valuation process. Instead, we will reverse and remand for further proceedings.

We leave it to the Tax Court to find the correct valuation for Capital's contracts. On remand, the Commissioner may again press his objections to Capital's methods, and the Tax Court may consider those objections in arriving at a final valuation. But the existence of some problems in Capital's valuation process will not justify finding a zero basis in the lost contracts. Instead, the Tax Court must do its best to calculate a reasonable and correct basis; the Commissioner can best assist the Court by raising specific and quantifiable objections to Capital's valuation, and by proposing alternative methods that will lead to what, in his submission, would be a more reasonable valuation. Thus far, the Commissioner has pointed to alleged flaws in the valuation methodology without explaining or quantifying how they impacted the bottom-line calculation, and without offering any alternatives. We conclude that, on the facts before us, such a procedure is insufficient to reject Capital's claimed deductions.

II. Facts and Procedural History

A. Introduction

As suggested above, this case concerns the procedures under which Blue Cross Blue Shield organizations may take loss deductions for terminated subscriber contracts. Since Blue Cross Blue Shield organizations became taxable in 1986, this issue has slowly grown in importance. It has only recently reached the attention of the courts and the Internal Revenue Service ("IRS" or "the Service"). The Service has

inform[ed] Blue Cross Blue Shield insurance organizations that the Service will challenge deductions for losses that relate to the termination of individual customer, provider, or employee contracts or relationships associated with customer lists, provider networks, and workforce in place with respect to which the taxpayer claims an adjusted basis derived from section 1012(c)(3)(A)(iii) [sic] of the Tax Reform Act of 1986.

I.R.S. Notice 2000-34, 2000-2 C.B. 172.

We are the second Article III court to consider the deductibility of these losses. The first case was Trigon Insurance Co. v. United States, 215 F.Supp.2d 687 (E.D.Va.2002), which found for the Commissioner and disallowed the deductions. The court ultimately held that the taxpayer — Trigon, a success or to two Blue Cross Blue Shield insurers — had not established the 1987 fair market value of its insurance and provider contracts and was therefore not entitled to a deduction. The decision has not been appealed, and our analysis will be guided in part by Judge Payne's thorough opinion. Since Trigon, the IRS has reaffirmed and clarified the position of Notice 2000-34 in a Coordinated Issue Paper dated May 27, 2005. See 2005 WL 1412148 (I.R.S.).

B. Initial Taxation of Blue Cross Blue Shield Entities

Capital Blue Cross is a Blue Cross Blue Shield organization that sells health insurance to individuals and groups in central and northeastern Pennsylvania. It was founded in 1938, became a Blue Cross organization in 1972, and became a Blue Cross Blue Shield licensee when Blue Cross and Blue Shield merged in 1982.

Historically, Blue Cross Blue Shield organizations were not subject to federal income taxes. In 1986, the Congress, concerned that this gave Blue Cross Blue Shield organizations an unfair competitive advantage over other for-profit insurers, eliminated the tax exemption effective January 1, 1987. See Tax Reform Act of 1986, Pub.L. No. 99-514, § 1012, 100 Stat.2085, 2390-94 (codified at 26 U.S.C. §§ 501(m) & 833). When Blue Cross Blue Shield entities became taxable, they needed to have a way to determine their tax basis in their assets. Congress therefore provided that Blue Cross Blue Shield organizations could take a basis step-up in their assets, so that their tax basis in each asset would be its fair market value ("FMV") on January 1, 1987. Tax Reform Act of 1986, § 1012(c)(3)(A)(ii). This basis step-up is sometimes called the "Fresh Start Basis Rule," see Trigon, 215 F.Supp.2d at 691.

C. Capital's Contracts in 1987

On January 1, 1987, when Capital became a taxable entity, it had 23,526 group health insurance contracts outstanding, as well as a number of individual contracts. Many groups had entered into multiple contracts with Capital; the 23,526 group contracts represented a total of 12,579 separate insured groups.

Under each of these group health insurance contracts, Capital agreed to provide health insurance coverage to the individual members of each group (typically the employees of a company), and the group agreed to pay premiums. Individual group members could elect the type of insurance benefit (individual, single parent with dependents, or family) and coverage (basic medical, basic hospital, major medical, or comprehensive) that they wanted to receive.

1. Premium structures

Each group was charged a total annual premium; the group decided what portion of the premium was to be paid by the employer and what was to be paid by the individual group members. The premium for a group was determined in one of three ways.

Groups with fewer than one hundred individual members were community-rated. Under community rating, premiums for a particular type of coverage and benefit were based on the cumulative claims history of all of Capital's community-rated contracts for that coverage/benefit. Claims experience for all community-rated contracts in one year would serve as the basis for the premiums on community-rated contracts in the following year. Some 90 percent of Capital's group contracts were community-rated....