Trigon Ins. Co. v. U.S.

Citation215 F.Supp.2d 687
Decision Date09 August 2002
Docket NumberNo. 3:00cv365.,3:00cv365.
PartiesTRIGON INSURANCE COMPANY (Formerly Blue Cross and Blue Shield of Virginia), Plaintiff, v. UNITED STATES of America, Defendant.
CourtU.S. District Court — Eastern District of Virginia

Gilbert E. Schill, McGuireWoods, LLP, Richmond, VA, James D. Bridgeman, McKee, Nelson, Ernst & Young, LLP, Washington, D.C., for Plaintiff.

Debra J. Prillaman, M. Hannah Lauck, United States Attorney's Office, Richmond, VA, Angelo Frattarelli, C. Paul Hurley, United States Department of Justice, Tax Division, Washington, D.C., Carolyn V. Grady, Epperly, Follis & Schork, P.C., Richmond, VA, for Defendant.

Stephen W. Miller, United States Attorney's Office, Richmond, VA, for Government.


PAYNE, District Judge.

Plaintiff, Trigon Insurance Company ("Trigon"), formerly known as Blue Cross and Blue Shield of Virginia, filed this action to recover federal income taxes, plus interest, alleged to have been erroneously overpaid in the years 1989 through 1995. The United States opposes the refund on several grounds.

The dispute between the parties is over the meaning and effect of certain sections of the Tax Reform Act of 1986 (the "1986 Act")1 which, for the first time, subjected Blue Cross and Blue Shield health care insurance organizations to federal income taxation. The core issues are matters of first judicial impression and, therefore, it is useful to recount the factual background in which those issues arose as well as the background of the 1986 Act.

A. The Evolution Of The Blue Cross/Blue Shield Organizations In Virginia, The Competition Between Them And Their Merger To Form What Is Now Trigon

Trigon's two corporate predecessors, both Blue Cross and Blue Shield organizations (hereinafter referred to as "Blue Cross/Blue Shield"), were incorporated in the Commonwealth of Virginia in 1935 and 1945, respectively. During the years before 1986, three separate Blue Cross/Blue Shield plans operated in Virginia: Blue Cross/Blue Shield of the National Capital Area in northern Virginia (the "DC Plan"), Blue Cross/Blue Shield of Virginia in the eastern and central portions of Virginia (the "Richmond Plan"), and Blue Cross/ Blue Shield of Southwestern Virginia (the "Roanoke Plan"). The relationship among these three companies was governed, in part, by the separate license agreements between each plan and the Blue Cross/Blue Shield Association ("BCBSA"). The BCBSA licensed the rights to use the Blue Cross name and service mark and the Blue Shield name and mark under separate agreements.

Before 1986, the Richmond and Roanoke Plans operated independently in the territory that Trigon now controls. Before 1983, competition between the Richmond and Roanoke plans was prohibited by state law. Thus, each plan operated exclusively in different geographic regions. In 1983, the Virginia legislature amended the state law to eliminate the territorial restrictions on the activities for the Richmond and Roanoke Plans, thereby allowing the two plans to compete directly against each other. As a result of the change, beginning in approximately July of 1983, the two plans engaged in a period of unusually intense competition. This fierce "interplan competition" was conducted principally by offering significant premium discounts in an effort to penetrate, and to establish a significant presence in, the territory formerly occupied exclusively by the rival plans. To that end, both the Richmond and Roanoke Plans offered sizeable competitive premium discounts that were lower than the premiums otherwise set by the actuarial and underwriting departments. The Roanoke Plan, which was smaller than the Richmond Plan, was the more aggressive of the two; and many of the discounted premiums offered by the Roanoke Plan were so significant that the premiums were insufficient to cover the claims and administrative costs expected under the contracts. The Richmond Plan tracked its discounts on an account-by-account basis, keeping records reflecting the difference between the premiums actually charged and those that would have been charged but for the competition. The Roanoke Plan did not do that.

The intensity of the interplan competition was so great that the commercial health insurers operating in Virginia ceased active marketing within the geographic regions covered by the two plans during this period. As a result of their aggressive pricing strategies during the interplan competition and the corresponding absence of competition from commercial insurers, total enrollment for both the Richmond and Roanoke Plans grew during the period 1983 to 1985.

By late 1985, however, the Roanoke Plan was near financial collapse as a result of the interplan competition and its unsound pricing policies. Consequently, the Roanoke Plan approached the Richmond Plan with a proposal to consolidate. In September 1985, the Plans entered into an affiliation agreement and formally merged in March 1986. Trigon formed Consolidated Healthcare, Inc. ("CHI") in early 1986 as an affiliated management company to facilitate the merger between the two plans. The consolidation began in early 1986 and was not completed until the middle of 1987. Following the merger, the combined company began to manage the Roanoke Plan's business by offering the same products and using the same pricing methodology that the Richmond Plan used. Wood Tr. 11/15/01 855:5-18.2

B. The 1986 Act And Trigon

The merged company immediately faced a changed tax landscape. Specifically, before 1987, Blue Cross/Blue Shield organizations were exempt from federal income tax pursuant to sections 501(a) and (c) of the Internal Revenue Code of 1954 ("I.R.C." or "the Code"). As part of the 1986 Act, Congress determined that Blue Cross/Blue Shield organizations should become subject to federal income taxation beginning with their first taxable years after December 31, 1986. Congress implemented this decision by enacting section 501(m) of the Code. When it subjected Blue Cross/Blue Shield organizations to income tax, Congress enacted a number of transitional rules, including section 1012(c)(3)(A)(ii) of the 1986 Act (the "Fresh Start Basis Rule") which provides that:

for purposes of determining gain or loss, the adjusted basis of any asset held on the 1st day of such taxable year shall be treated as equal to its fair market value as of such day.

The purpose behind the Fresh Start Basis Rule was to prevent any unrealized gain or loss that had accrued while a Blue Cross/Blue Shield organization was exempt from tax from being factored into the determination of tax liability once it became a taxpayer. See H.R. Conf. Rept. 814, 99th Cong., 2d Sess. Vol. II at 350, reprinted in 1986 U.S.C.C.A.N. 4075, 4437-38 ("The basis adjustment is provided because the conferees believe that such formerly tax-exempt organizations should not be taxed on unrealized appreciation or depreciation that accrued during the period the organization was not generally subject to income taxation."). By requiring that the basis of each asset held on January 1, 1987 be adjusted to its fair market value on that date, the Fresh Start Basis Rule ensures that taxable income or loss of a Blue Cross/Blue Shield organization will be based solely on items of income and loss that economically accrue after the organization became subject to federal income tax.

Trigon's taxable year coincides with the calendar year, thus its first taxable year beginning after December 31, 1986, was the calendar year that began January 1, 1987. Pursuant to the Fresh Start Basis Rule, Trigon's basis in each asset owned on January 1, 1987, was equal to the asset's fair market value on that date.

In 1987, after the merger of the two Plans and after the 1986 Act took effect, Trigon began to identify its assets so as to apply the Fresh Start Basis Rule in filing federal income tax returns. This task was assigned to Stephen Meyer, director of corporate tax, who undertook to "understand the new tax law and its ramifications and implications to the plan and to explain that to management." Meyer Tr. (11/13/01) 342:2-4. As a result, by late 1987 or early 1988, Trigon had identified as among its assets, the contracts with subscribers (Trigon's customers) and providers (the doctors and hospitals who agreed to provide service to Trigon subscribers). Meyer Tr. (11/13/01) 345:23-346:2; 347:1-2.

Trigon has claimed, at various times that, on January 1, 1987, it owned between 20,000 and 24,000 group health insurance subscription contracts organized into the following lines of business: (1) Community Rated groups; (2) Local Experience Rated contracts; (3) Local Cost plus contracts; (4) Small Business contracts; (5) Control National contracts; (6) Participating National contracts; (7) the State of Virginia account; (8) the Federal Employee Program; and (9) Large Accounts (Local Experience Rated, Control National, and Local Cost Plus). Defense Exh. 103 at TR46012165.

Even now, after extensive and exhaustive pre- and post-trial briefing, as well as teleconferences on this point, the precise number of group subscriber contracts actually owned by Trigon as of January 1, 1987 is difficult of ascertainment. For example, in its Proposed Findings of Fact ¶ 19, Trigon said that it owned 23,780 subscriber contracts which included a number of "sub-contracts," thereby reducing to 21,642 contractual relationships with subscriber groups. Trigon's valuation expert valued 22,509 subscriber contracts. At trial, a Trigon witness said that the number ought to be reduced by "at least" or "approximately" 500. Hunt Tr. (11/13/01) 448:9-449:18. When, in August 2002, Trigon was asked to supply citations in the record to document the number of subscriber contracts owned, Trigon responded in a letter dated August 6, 2002, that the 22,509 number used by the valuation expert ought to be reduced, and not by 500, but by 793....

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