Principal Life Ins. Co. v. United States, 07-06T
| Decision Date | 04 February 2015 |
| Docket Number | No. 07-06T,No. 08-605T,No. 07-706T,No. 08-135T,07-06T,07-706T,08-135T,08-605T |
| Parties | PRINCIPAL LIFE INSURANCE COMPANY AND SUBSIDIARIES, et al., Plaintiffs, v. THE UNITED STATES, Defendant. |
| Court | U.S. Claims Court |
Tax; Cross-motions for partial summary judgment; Refund of taxes relating to previously taxed income (PTI); Income from controlled foreign corporation; Partnership - Culbertson; Existence of partnership with bona fide partners raised questions of fact; Debt/equity analysis; Review of debt/equity factors; Existence of partnership raises questions of fact; Section 705(a)(1)(B) - basis adjustment; Whether basis of plaintiffs' interest in LLCs must be increased by distributive share of PTI distributions; Application of section 705 and Subpart F provisions raises questions of fact.
OPINIONJay H. Zimbler, Sidley Austin, LLP, Chicago, IL, for plaintiffs.
Cory Arthur Johnson, United States Department of Justice, Washington, D.C., with whom was Deputy Assistant Attorney General David A. Hubbert, for defendant.
Before the court, on cross-motions for partial summary judgment, is the next phase of this complex refund suit.1 At issue is whether Principal Life Insurance Company and Subsidiaries (Principal Life or plaintiffs) is owed a refund on taxes relating to a transaction involvingpreviously taxed income (PTI).2 PTI is income of a controlled foreign corporation (CFC) that has already been included in the gross income of a United States shareholder (U.S. shareholder) under section 951(a) of the Internal Revenue Code (26 U.S.C.),3 and, therefore, is not included in gross income for a second time if it is distributed to a U.S. shareholder. The resolution of plaintiffs' refund suit ultimately turns on whether: (i) the Limited Liability Corporations (LLCs) were properly labeled as partnerships with Principal Life as a bona fide partner; and (ii) Principal Life correctly adjusted its outside basis in the partnerships to reflect the distributions of PTI. Because of the existence of genuine issues of fact, the court DENIES defendant's motion for partial summary judgment and DENIES, as well, plaintiffs' cross-motion for partial summary judgment. Instead, the court sets this portion of the case down for trial.
Principal Life, an Iowa corporation with principal offices in Des Moines, is engaged, and at all times relevant to this action, was engaged, in the business of writing various forms of individual and group life and health insurance and annuities. During the years in question (1999-2003), it filed consolidated returns as the parent corporation of a consolidated group of corporations. During these years, and at all times relevant to this action, Principal Life was a calendar-year, accrual-basis taxpayer subject to tax under the provisions of Subchapter L of the Code.
Before delving into the merits of this case, the court pauses to review in greater detail the statutory backdrop against which the subject transactions were made.
In general, the United States only taxes the income of foreign corporations under two scenarios: when it derives from investments or businesses in the United States or when it is actually distributed to a United States shareholder. See 26 U.S.C. §§ 61, 871, 881; see also Barclay & Co. v. Edwards, 267 U.S. 442, 448 (1925); Nat'l Paper & Type Co. v. Bowers, 266 U.S. 373 (1924); 1 Mertens Law of Fed. Income Tax'n §§ 4:37, 45:1 (2015) (Mertens).4 In thelatter instance, earnings are not taxed until they are brought into the United States, typically as a dividend to a shareholder. See Christopher Hanna, Cym Lowell, Mark Martin, Michael Donahue and Daniel Leightman, Corporate Income Tax Acc., WGL Corp. Inc. Tax Acct., "Controlled Foreign Corporations" § 9.08 (2015) ("Corporate Income Tax Acc."); James Eustice & Thomas Brantley, Fed. Income Tax'n of Corp. & Shareholders, ¶15.01 (2015) (hereinafter "Eustice"). Because of this, a corporation may defer taxation by holding its earnings offshore. See Corporate Income Tax Acc., § 9.08; Eustice, ¶15.05[1], 15.61.
To avoid the potential for abuse, there are important exceptions to these rules. Subpart F of the Code provides a comprehensive set of rules governing income generated by CFCs and limiting the deferral of taxes. See 26 U.S.C. § 951(a); Treas. Reg. § 1.957-1(a); Rodriguez v. Comm'r of Internal Revenue, 722 F.3d 306, 309 (5th Cir. 2013) (). In general, these rules are designed to prevent U.S. taxpayers from using CFCs to shift their earnings to lower-taxed foreign jurisdictions. See 26 U.S.C. §§ 951(a)(1), 956(a); Schering-Plough Corp. v. United States, 651 F. Supp. 2d 219, 224 (D.N.J. 2009), aff'd sub nom., Merck & Co., Inc. v. United States, 652 F.3d 475 (3d Cir. 2011); Elec. Arts, Inc. v. Comm'r of Internal Revenue, 118 T.C. 226, 272 (2002); 12 Mertens, § 45E:179.5 This is accomplished by eliminating the deferral benefits of retaining certain types of earnings in a foreign corporation. Rodriguez, 722 F.3d at 309; 12 Mertens, §§ 45E:179, 181; Allison Christians, Samuel A. Donaldson, & Philip F. Postlewaite, United States International Taxation ¶ 17.09. In this fashion, subpart F "imposes United States taxation on United States shareholders of controlled foreign corporations . . . even though funds may not have been received by the United States shareholder." 12 Mertens, § 45E:1.
Certain other subpart F rules preserve the proper treatment of subpart F income when it is actually distributed to the U.S. shareholders, where it has already been included in gross income pursuant to section 951 of the Code. Because this income was taxed when earned, it is not included in the shareholder's income when the earnings are subsequently distributed pursuant to section 959(a) of the Code. Such amounts are typically given the designation previously-taxed income or PTI. The subpart F rules provide a set of offsetting adjustments to the shareholder's basis in the CFC stock. When the subpart F income is included in the gross income of theshareholder, its basis in the stock is increased by "the amount required to be included in [its] gross income." 26 U.S.C. § 961(a). This adjustment prevents the shareholder from incurring a second tax on the same amount if it were to sell its interest in the CFC before the distribution of the PTI. Mertens, § 45E:179; Eustice, ¶ 15.61. Once PTI amounts are actually distributed, however, there is no need for a basis adjustment to protect the shareholders from tax in the event of a sale. Accordingly, the basis increase is reversed, in order to prevent a shareholder from taking a phantom loss. Mertens, § 45E:179 (); Eustice, ¶ 15.61. Accordingly, under section 961(b) of the Code, when a shareholder receives a distribution of PTI, it reduces its basis of the stock by the amount of that distribution. S. Rep. No. 1881 at 3397.
A recitation of the basic facts sets the context for the remainder of this decision.
In the late 1990s and early 2000s, Deutsche Bank (DB) and its affiliates marketed several "standardized structured products" to taxpayers. One of these products, based on PTI, was developed to monetize certain tax attributes that DB had - specifically, net operating losses (NOLs)6 and foreign tax credits (FTCs).7
At issue in this case are two transactions between Principal Life and DB: the Whispering Woods LLC (Woods) transaction that was initiated in 1999 and the Whistling Pines LLC (Pines) transaction that initiated in 2001. In both transactions, Principal Life received distributions of PTI through its membership in a LLC. The parties dispute whether Principal Life owed taxes on the PTI it received through the LLCs or, alternatively, owed more capital gains taxes on the transactions than Principal Life determined in its tax returns.
The two transactions at issue in this case were similarly structured, in accordance with DB's promotional materials. The transactions began with the creation of an LLC, intended to be treated as a partnership, with Principal Life and a DB subsidiary as the only two members. Principal Life paid cash ($500 million in the case of Woods; $370 million in the case of Pines) in exchange for a Class A Member interest in the LLC. DB received a Managing Member interest in the LLC in exchange for its contribution of 100 percent of the stock of several CFCs, which were created for these transactions and contained PTI transferred to them by another Cayman Islands affiliate of DB.
In each transaction, the LLC invested the cash received from Principal Life in a domestic corporation (USCO) in exchange for stock in the USCO. DB and the CFCs also contributed cash to the USCO in exchange for stock, with the result that DB was the controlling shareholder of the USCO. The USCO then used the cash to purchase DB debt securities and non-DB debt securities that met certain agreed-upon investment guidelines.
Separate from the LLC transaction, Principal Life and DB entered into a series of bond forward agreements, based on the bonds purchased with Principal Life's investment in the LLC. Each agreement provided Principal Life with the return on a referenced bond over the two-year term of the agreement, minus an annual fixed-rate payment to DB. The payment rate was equal to the swap rate plus the credit spread, which reflected DB's borrowing rate at the time. Principal Life selected the bonds to be covered under the bond forwards. Technically, DB had the authority to select the bonds that were purchased by the USCO, but in both transactions DB selected the same bonds that were subject to the bond forward agreements.
During the two-year term of the LLC, the CFCs issued two after-tax, fixed-rate payments to the LLC from their reserves of PTI. The LLC then distributed 99 percent of the PTI to Principal Life and one percent to the DB subsidiary. The amount of PTI distributed...
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