UPS v. Commissioner of Internal Revenue

• Decision Date: 20 June 2001
• Docket Number: No. 00-12720,00-12720
• Parties: (11th Cir. 2001) UNITED PARCEL SERVICE OF AMERICA, INC., Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee
• Court: U.S. Court of Appeals — Eleventh Circuit

Page 1014

254 F.3d 1014 (11th Cir. 2001)

UNITED PARCEL SERVICE OF AMERICA, INC., Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 00-12720

IN THE UNITED STATES COURT OF APPEALS

FOR THE ELEVENTH CIRCUIT

June 20, 2001

[Copyrighted Material Omitted]

Appeal from a Decision of the United States Tax Court T. C. Docket No. 15993-95

Before WILSON and COX, Circuit Judges, and RYSKAMP ^*, District Judge.

COX, Circuit Judge:

The tax court held United Parcel Service of America, Inc. (UPS) liable for additional taxes and penalties for the tax year 1984. UPS appeals, and we reverse and remand.

I. Background

UPS, whose main business is shipping packages, had a practice in the early 1980s of reimbursing customers for lost or damaged parcels up to $100 in declared value.¹ Above that level, UPS would assume liability up to the parcel's declared value if the customer paid 25¢ per additional $100 in declared value, the "excess-value charge." If a parcel were lost or damaged, UPS would process and pay the resulting claim. UPS turned a large profit on excess-value charges because it never came close to paying as much in claims as it collected in charges, in part because of efforts it made to safeguard and track excess-value shipments. This profit was taxed; UPS declared its revenue from excess-value charges as income on its 1983 return, and it deducted as expenses the claims paid on damaged or lost excess-value parcels.

UPS's insurance broker suggested that UPS could avoid paying taxes on the lucrative excess-value business if it restructured the program as insurance provided by an overseas affiliate. UPS implemented this plan in 1983 by first forming and capitalizing a Bermuda subsidiary, Overseas Partners, Ltd. (OPL), almost all of whose shares were distributed as a taxable dividend to UPS shareholders (most of whom were employees; UPS stock was not publicly traded). UPS then purchased an insurance policy, for the benefit of UPS customers, from National Union Fire Insurance Company. By this policy, National Union assumed the risk of damage to or loss of excess-value shipments. The premiums for the policy were the excess-value charges that UPS collected. UPS, not National Union, was responsible for administering claims brought under the policy. National Union in turn entered a reinsurance treaty with OPL. Under the treaty, OPL assumed risk commensurate with National Union's, in exchange for premiums that equal the excess-value payments National Union got from UPS, less commissions, fees, and excise taxes.

Under this plan, UPS thus continued to collect 25¢ per $100 of excess value from its customers, process and pay claims, and take special measures to safeguard valuable packages. But UPS now remitted monthly the excess-value payments, less claims paid, to National Union as premiums on the policy. National Union then collected its commission, excise taxes, and fees from the charges before sending the rest on to OPL as payments under the reinsurance contract. UPS reported neither revenue from excess-value charges nor claim expenses on its 1984 return, although it did deduct the fees and commissions that National Union charged.

The IRS determined a deficiency in the amount of the excess-value charges collected in 1984, concluding that the excess-value payment remitted ultimately to OPL had to be treated as gross income to UPS. UPS petitioned for a redetermination. Following a hearing, the tax court agreed with the IRS.

It is not perfectly clear on what judicial doctrine the holding rests. The court started its analysis by expounding on the assignment-of-income doctrine, a source rule that ensures that income is attributed to the person who earned it regardless of efforts to deflect it elsewhere. See United States v. Basye, 410 U.S. 441, 450, 93 S. Ct. 1080, 1086 (1973). The court did not, however, discuss at all the touchstone of an ineffective assignment of income, which would be UPS's control over the excess-value charges once UPS had turned them over as premiums to National Union. See Comm'r v. Sunnen, 333 U.S. 591, 604, 68 S. Ct. 715, 722 (1948). The court's analysis proceeded rather under the substantive-sham or economic-substance doctrines, the assignment-of-income doctrine's kissing cousins. See United States v. Krall, 835 F.2d 711, 714 (8th Cir. 1987) (treating the assignment-of-income doctrine as a subtheory of the sham-transaction doctrine). The conclusion was that UPS's redesign of its excess-value business warranted no respect. Three core reasons support this result, according to the court: the plan had no defensible business purpose, as the business realities were identical before and after; the premiums paid for the National Union policy were well above industry norms; and contemporary memoranda and documents show that UPS's sole motivation was tax avoidance. The revenue from the excess-value program was thus properly deemed to be income to UPS rather than to OPL or National Union. The court also imposed penalties.

UPS now appeals, attacking the tax court's economic-substance analysis and its imposition of penalties. The refrain of UPS's lead argument is that the excess-value plan had economic substance, and thus was not a sham, because it comprised genuine exchanges of reciprocal obligations among real, independent entities. The IRS answers with a before-and-after analysis, pointing out that whatever the reality and enforceability of the contracts that composed the excess-value plan, UPS's postplan practice equated to its preplan, in that it collected excess-value charges, administered claims, and generated substantial profits. The issue presented to this court, therefore, is whether the excess-value plan had the kind of economic substance that removes it from "shamhood," even if the business continued as it had before. The question of the effect of a transaction on tax liability, to the extent it does not concern the accuracy of the tax court's fact-finding, is subject to de novo review. Kirchman v. Comm'r, 862 F.2d 1486, 1490 (11th Cir. 1989); see Karr v. Comm'r, 924 F.2d 1018, 1023 (11th Cir. 1991). We agree with UPS that this was not a sham transaction, and we therefore do not reach UPS's challenges to the tax penalties.

II. Discussion

I.R.C. §§ 11, 61, and 63 together provide the Code's foundation by identifying income as the basis of taxation. Even apart from the narrower assignment-of-income doctrine -- which we do not address here -- these sections come with the gloss, analogous to that on other Code sections, that economic substance determines what is income to a taxpayer and what is not. See Caruth Corp. v. United States, 865 F.2d 644, 650 (5th Cir. 1989) (addressing, but rejecting on the case's facts, the argument that the donation of an income source to charity was a sham, and that the income should be reattributed to the donor); United States v. Buttorff, 761 F.2d 1056, 1061 (5th Cir. 1985) (conveying income to a trust controlled by the income's earner has no tax consequence because the assignment is insubstantial); Zmuda v. Comm'r, 731 F.2d 1417, 1421 (9th Cir. 1984) (similar). This economic-substance doctrine, also called the sham-transaction doctrine, provides that a transaction ceases to merit tax respect when it has no "economic effects other than the creation of tax benefits." Kirchman, 862 F.2d at 1492.² Even if the transaction has economic effects, it must be disregarded if it has no business purpose and its motive is tax avoidance. See Karr, 924 F.2d at 1023 (noting that subjective intent is not irrelevant, despite Kirchman's statement of the doctrine); Neely v. United States, 775 F.2d 1092, 1094 (9th Cir. 1985); see also Frank Lyon Co. v. United States, 435 U.S. 561, 583-84, 98 S. Ct. 1291, 1303 (1978) (one reason requiring treatment of transaction as genuine was that it was "compelled or encouraged by business or regulatory realities"); Gregory v. Helvering, 293 U.S. 465, 469, 55 S. Ct. 266, 267 (1935) (reorganization disregarded in part because it had "no business or corporate purpose").

The kind of "economic effects" required to entitle a transaction to respect in taxation include the creation of genuine obligations enforceable by an unrelated party. See Frank Lyon Co., 435 U.S. at 582-83, 98 S. Ct. at 1303 (refusing to deem a sale-leaseback a sham in part because the lessor had accepted a real, enforceable debt to an unrelated bank as part of the deal). The restructuring of UPS's excess-value business generated just such obligations. There was a real insurance policy between UPS and National Union that gave National Union the right to receive the excess-value charges that UPS collected. And even if the odds of losing money on the policy were slim, National Union had assumed liability for the losses of UPS's excess-value shippers, again a genuine obligation. A history of not losing money on a policy is no guarantee of such a future. Insurance companies indeed do not make a habit of issuing policies whose premiums do not exceed the claims anticipated, but that fact does not imply that insurance companies do not bear risk. Nor did the reinsurance treaty with OPL, while certainly reducing the odds of loss, completely foreclose the risk of loss because reinsurance treaties, like all agreements, are susceptible to default.

The tax court dismissed these obligations because National Union, given the reinsurance treaty, was no more than a "front" in what was a transfer of revenue from UPS to OPL. As we have said, that conclusion ignores the real risk that National Union assumed. But even if we overlook the reality of the risk and treat National Union as a conduit for transmission of the excess-value payments from UPS to OPL, there remains the fact that OPL is an independently taxable entity that is not under UPS's control. UPS really did lose the stream of income it had earlier reaped from excess-value charges. UPS genuinely could not apply that...