Dow Chemical Co. and Subsidiaries v. U.S.

Decision Date31 March 2003
Docket NumberNo. 00-10331-BC.,00-10331-BC.
Citation250 F.Supp.2d 748
PartiesDOW CHEMICAL COMPANY AND SUBSIDIARIES, Plaintiffs, v. UNITED STATES of America, Defendant.
CourtU.S. District Court — Eastern District of Michigan

Valorie J. Gilfeather, Midland, MI, Richard C. Stark, John B. Magee, Nelson McKee, Washington, DC, for plaintiff.

Dennis M. Donohue, Joseph A. Sergi, Alex E. Sadler, Washington, DC, James A. Brunson, Bay City, MI, Nicole M. Bielawski, Maggie O'Shaughnessy, Washington, DC, for defendant.

OPINION

LAWSON, District Judge.

Dow Chemical Company and its subsidiaries (Dow) have filed a complaint in this Court against the United States claiming that they are entitled to refunds for taxes paid for calendar/fiscal years 1989, 1990, and 1991, totaling $22,209,570, plus interest. The center of the dispute is the disallowance of deductions which Dow claimed for payment of interest on loans that were used to pay premiums on broad-based, corporate owned life insurance (COLI) policies purchased by Dow, and for administrative expenses associated with the purchase and maintenance of those insurance policies. In a very real sense, then, this case involves both death and taxes.

Dow purchased COLI policies on the lives of 4,051 of its upper management employees from Great West Life Assurance Company in 1988. In 1991, Dow purchased a group COLI policy on the lives of 17,061 employees from Metropolitan Life Insurance Company (MetLife). The premiums on these policies were financed by means of an elaborate plan to borrow from the insurer to pay premiums in the first three and eighth years of the policies. The loans were secured by the cash value of the policies. Premiums in years four through seven were paid by means of partial withdrawals of the accumulated cash value of the policies. The policy acquisition plan thus drastically minimized the initial cash outlay for premium payments.

The United States claims that because the payment of the premiums and the loans and withdrawals occurred simultaneously on the first day of each policy anniversary, and were accomplished virtually or literally simultaneously by means of netting transactions, the transactions never actually occurred and constitute factual shams. The United States also asserts that the COLI plans had no practical economic purpose apart from generating the tax deductions for the interest payments and therefore are shams in substance. The government also contends that the Great West COLI plan does not constitute "life insurance" under Michigan law because Dow did not have an insurable interest in all of the 4,051 employees insured under that plan. Consequently, the argument goes, the plan fails to comport with Internal Revenue Code § 7702(a) and therefore Dow is not entitled to any of the tax advantages afforded life insurance, particularly the deferral of tax on the "inside build-up," and the interest paid on policy loans is not deductible under Internal Revenue Code § 161. Further, the government argues that the use of simultaneous netting transactions to finance the premiums by means of policy loans and withdrawals, which it believes are factual shams, causes the plan to fail the "four-ofseven" test set forth in Internal Revenue Code § 264(c)(1), and therefore, for that additional reason, interest deductions should be disallowed.

Many of these issues were thoroughly litigated in three prior cases, American Electric Power, Inc. v. United States, 136 F.Supp.2d 762 (S.D.Ohio 2001), In re CM Holdings, Inc., 254 B.R. 578 (D.Del.2000), affd 301 F.3d 96 (3d Cir.2002), and Winn-Dixie Stores, Inc. v. Commissioner of Internal Revenue, 113 T.C. 254, 1999 WL 907566 (1999), in which the courts have found that the broad-based COLI plans constituted shams in substance. The constellation of these cases has formed a lodestar which has guided and shaped the parties' presentation of evidence; the plaintiff has endeavored to demonstrate through testimony and exhibits that its COLI plans are substantially different from the plans condemned in the prior cases, while the defendant has attempted to show that the Great West and MetLife COLI plans are virtually identical, with nearly all of the offending features of the other plans in common.

Trial began on January 8, 2002, and the proofs concluded on March 12, 2002. The Court heard the testimony of 26 witnesses and received 1,526 exhibits. The parties filed a stipulation of facts consisting of 137 separate paragraphs. Initial and amended proposed findings of fact were filed, along with post-trial briefs. The parties then presented their final arguments in open court on May 28, 2002. The following constitutes the Court's findings of fact under Federal Rule of Civil Procedure 52, followed by its application of the governing law.

I. Background and Facts of the Case
A. Life Insurance General Terms and Features

In its most basic form, a life insurance contract consists of an agreement by an insurance company to pay a sum of money, known as a death benefit, to the beneficiary named on the insurance policy upon the death of the insured life. In consideration of the payment of a premium, the insurance company assumes the risk that the insured will die during a fixed period of time, usually one year. The premium charged for that year is calculated based upon data which includes the age of the insured, life expectancies of individuals of that same age, the likelihood that individuals of that age will die during that year, and the amount of the death benefit. If there are no other features to the insurance contract, this kind of insurance coverage is known as term insurance or "pure insurance," and the charge associated with assuming the risk of premature death of the insured during that period is called the cost of insurance (COI). Because the likelihood of death increases as age advances, the COI for renewable term insurance becomes increasingly expensive as an insured grows older.

The insurance industry over the years has developed products that ameliorate the high cost of term insurance in the later years. "Whole life insurance" is a form of cash value insurance that is designed to provide coverage over the course of one's entire life, which is typically calculated at 95 years. A level, annual premium in excess of the cost of insurance is charged. The excess premium is invested by the insurance company so that the insurance policy accumulates "cash value," which consists of the accumulation of the excess premiums and earnings. The earnings are referred to as "inside build-up." If the insured dies, the cash value is paid out as part of the death benefit. As the insured advances in age, the cash value becomes an increasingly larger component of the total death benefit, and the pure insurance element correspondingly decreases, thereby moderating the COL

In a typical whole life insurance policy, the annual premium is comprised of the COI, an excess amount which is invested for the purpose of accumulating cash value, charges for expenses such as policy administration and commissions, and a profit for the insurance company. The COI element of the premium is based in part on calculations using complex actuarial formulae which endeavor to quantify the risk of mortality of an insured in relation to a given population. Information concerning rates of death generally comes from statistical studies and compilations by actuaries who assess the mortality experience of a given population. The results are assembled in mortality tables. In some circumstances, the actual mortality experience of an insurance company, that is, the frequency of the incidence of death among actual policy holders compared to the expected mortality of the comparator population, can determine the profitability of an insurance company. Another component of profitability comes from the performance of the insurance company's investment of excess premium. However, an insurance company may choose to share favorable mortality, expense, and investment experience with its policy holders by paying dividends when this experience outperforms expectations. Insurance policies which have this feature are known as participating (par) policies. Those without this feature are known as non-participating (non-par) contracts. Generally, in whole life policies the expense and pricing components of the premiums and, in par policies, dividends formulae, are not revealed to the policy holder.

In some cash value insurance policies, the policy holder has a contractual right to access the cash value. This may occur in the form of loans from the insurance company which are secured by the cash value of the policy. The insurance company charges interest, usually at a rate in excess of the rate of return paid on the investment principal of the contract. The rate of return on the investment portion of the insurance premium is known as the "credited rate." The amount of interest charged on the policy loan is known as the "loan rate." The difference between the loan rate and the credited rate is called the "spread," which can be established or adjusted to serve a variety of payment and financing goals. If an insured dies, a portion of the death benefit is used to pay off the loan and outstanding interest charges.

The policy holder may also access the cash value of the policy in certain insurance contracts by partial withdrawals, or "partial surrender," of the policy. Partial withdrawals need not be repaid, but there is a corresponding reduction in the death benefit of the policy.

When the cash value of the policy reaches a point where the return on investment covers the COI required to satisfy the death benefit along with the accumulated cash value and the expense of administration, the policy is considered "paid up" and no further premiums are due. Some policies are designed to require premium...

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