Principal Life Ins. Co. v. United States

Decision Date09 May 2014
Docket NumberNo. 08-135T,No. 07-706T,No. 07-06T,No. 08-605T,07-06T,07-706T,08-135T,08-605T
CourtU.S. Claims Court

Tax refund suit; Cross-motions for partial

summary judgment; Loss deduction -

section 165 of the Code; "Actual economic

loss"; Basis allocation - Treas. Reg. § 1.61-

6(a); "Carved-out income interests";

Allocation of basis in "Perpetuals"

transaction violated Treasury Regulation;

"Investment trusts"; "Sears Regulations" -

Treas. Reg. § 301.7701-4; Multi-class

"investment trust" not "trust" for tax

purposes; Loss disallowed; Custodial

arrangements and investment trusts not

"trusts" for tax purposes; Income from

Custodial Share Receipts includible in

taxable income.


Jay H. Zimbler, Sidley Austin, LLP, Chicago, IL, for plaintiffs.

Bart Duncan Jeffress, United States Department of Justice, Washington, D.C., with whom was Acting Assistant Attorney General David A. Hubbert, for defendant.


"[T]he tax could not be escaped by anticipatory arrangements and contracts

however skillfully devised . . . by which the fruits are attributed to a

different tree from that on which they grew."1

Before the court, on cross-motions for partial summary judgment, is the next leg of this complex tax refund suit.2 At issue is the tax treatment of two distinct, but structurally-similar,series of investments made by Principal Life Insurance Company and Subsidiaries (PLIC). Eight of these investments related to so-called "custodial share receipts" or "CSRs," while three others involved so-called "perpetual securities" or "Perpetuals." The CSRs and Perpetuals were similar in that both sets of transactions involved carving out an interest in future income payments from a security. In the case of the CSRs, those interests were carved out by a third party, which sold the residual equity interest to PLIC. In the case of the Perpetuals, PLIC itself bought the securities, carved out and retained the income interest, and then sold the residual principal interests to a third party.

Springing from these transactions, so PLIC claims, are twin tax benefits: the exclusion of approximately $21 million in income on the CSRs, and an approximately $291 million loss deduction generated by the sale of the Perpetuals principal interests. PLIC asserts that its treatment of these items was impelled by the relevant provisions of the Internal Revenue Code of 1986,3 and associated "common law" principles. Not so, defendant remonstrates. It asserts that PLIC was required to report income from the CSRs, which it claims involved partnerships under the controlling Treasury regulations. It further argues that PLIC's claimed loss deduction stems from a gross misapplication of the loss provisions of section 165 of the Code and the rules for calculating the adjusted basis of the certificates sold. For the reasons that follow, the court concludes that defendant is right.


A recitation of the underlying facts sets the context for this decision.

PLIC, 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 (1996-2001), 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, PLIC was a calendar-year, accrual-basis taxpayer subject to tax under the provisions of Subchapter L of the Code.


The CSRs. Between September 1996 and October 2001, PLIC purchased residual interests in money market mutual fund shares from six separate sellers in eight separate transactions. PLIC engaged a variety of entities to act as custodians or trustees associated with these transactions, including Wilmington Trust Company, the United States Trust Company of New York, the First Union Trust Company, and Chase Manhattan Bank.

In these transactions, PLIC acquired a residual interest in each investment that entitled it to all dividends, appreciation, and voting rights in the specified shares, except for dividends paid out on the shares during a prescribed time period.

These transactions took one of three forms:

• Six of these investments used a custodial arrangement, in which an unrelated financial institution (the Depositor) transferred money market fund shares (or the money to buy such shares) to a custodian. In return, the custodian issued to the Depositor both CSRs and Custodial Dividend Receipts (CDRs). The Depositor then sold the CSRs to PLIC.
• One of the investments employed a trust in place of the custodial arrangement. In this instance, the Depositor deposited the money market shares directly into a trust, which issued Dividend and Corpus Certificates. The Depositor then sold the Corpus Certificates to PLIC.
• The eighth and final investment employed two trusts. The Depositor deposited money market fund shares (or the money to buy such shares) into a trust in exchange for Principal and Dividend Certificates. The Principal Certificates were transferred to a second trust in exchange for a "Principal Unit" and a "Termination Unit." PLIC then purchased the Principal Unit.

In each of these transactions, the Depositor, i.e., the financial institution, retained a carved-out income interest in the underlying money market shares. Via that interest, the Depositors were entitled to all dividends paid in connection with the money market shares for a prescribed period of between 20 and 23 years (the Restricted Period). At the end of the Restricted Period, the Depositors had no future right to the shares. The interests purchased by PLIC represented a residual interest in the money market shares and entitled PLIC, after the expiration of the Restricted Period, to either the money market shares or any amount paid with respect to those shares.

To guard against the possibility that the money market shares held in the custodial arrangement would be prematurely redeemed or lose their money market status, PLIC entered into a "Termination Agreement" with each Depositor. Under this agreement, upon the occurrence of an adverse event, PLIC was required to purchase the CDRs (or the equivalent) from the Depositor at a price designed to prevent the Depositor from losing the value of the dividends for the Restricted Period. Absent bad faith, nothing in any other agreement created obligations running from the Depositor to PLIC. Nonetheless, PLIC had the right to terminate certain of the custodial arrangements at any time, and take possession of the corresponding money market shares, as long as it provided the Depositors with a valid, perfected, first-priority security interest in the shares.

The annual internal economic yields for the eight CSR investments, before taxes, ranged from 7.225 to 9.903 percent. PLIC claimed that in addition to the expected yields, the CSRs presented attractive benefits for its long-term portfolio. For example, in contrast to holding money market shares directly, the CSRs did not present reinvestment risk, in that the yields built up internally at a fixed rate without creating cash flows that might have had to be reinvested at lower market interest rates. As a result, PLIC asserts that they could be confident that its initial investments in the CSRs would yield fixed amounts at pre-specified times in the future, at which time that income would be needed to satisfy specific long-term liabilities such as payouts under life insurance policies. On its returns for its tax years 1999 through 2001, PLIC reported no income from the CSRs.


The Perpetuals. PLIC entered into three Perpetuals investments in 2000 and 2001. These transactions were known as "Asgard," "Seve," and "Evergreen," named after the primary trusts involved. As will be seen, Morgan Stanley & Co. (Morgan Stanley) was involved in each of the Perpetuals transactions in a variety of ways. The Perpetuals were similar to the CSRs, in that PLIC retained the carved-out interests in the underlying perpetual securities while selling the residual equity interests. The CSR and Perpetuals transactions differed, however, in that in the former the financial institutions stripped out the carved-out income interests from the residual interests, while in the latter, PLIC did so. Each of the Perpetuals transactions involved a double-trust structure similar to that employed in the eighth CSR transaction described above.

The Perpetuals transactions were similar in structure. At the inception of each transaction, PLIC engaged an investment banker - Morgan Stanley - to buy a portfolio of eight to ten perpetual floating-rate securities from third parties in the secondary market assertedly at arm's length prices. Morgan Stanley then sold the securities to PLIC, earning a spread on the transaction. PLIC held the securities in its portfolio for a relatively brief period of time (one to two months). At the end of this holding period, on the "Transaction Date," PLIC deposited the securities into a "Primary Trust." Chase Manhattan Bank was the trustee of each of these Primary Trusts. The Primary Trust issued to PLIC a series of "Interest Certificates" and "Principal Certificates." Each of the Interest Certificates entitled the holder to the interest paid on the underlying perpetual security from the inception of the Primary Trust to a specified "Redemption Date," 16 to 18 years after the Transaction Date, unless a defined "Reference Event" occurred. The Principal Certificates entitled the holder to the underlying perpetual security on the Redemption Date and any other distributions or payments received by the Primary Trust, other than the interest payable to the Interest Certificate holder. On the Transaction Date, PLIC sold the Principal Certificates to Morgan Stanley; it retained the Interest Certificates.

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