This is an old article that is still worth reading. By Susanne Sclafane, Associate Editor Mar. 20 (National Underwriter)With the class-action lawsuits and whopping tax penalties coming out of a U.S. Tax Court decision handed down against United Parcel Service of America last year, you wouldnt expect tax experts to be promoting the captive-like structure that got the shipping giant in trouble. But at least one expert calls the structure "ideal." Others say it wasnt the structure but the implementation of its insurance program that made UPS a target for the Internal Revenue Service. In the early 1980s, officials of UPS, American International Group and insurance brokerage Frank B. Hall devised a structure enabling the nations largest package-delivery company to ship profits earned from the collection of certain delivery charges, called "excess-value charges," off to Overseas Partners Ltd., a Bermuda-based reinsurer owned by the shareholders of UPS. Excess-value charges, a part of the tariff or rate schedule UPS was required to report to the U.S. Interstate Commerce Commission, were fees collected from shippers that declared the values of their packages to be over $100. If a shipper didnt declare a value greater than $100, the liability of UPS for damage or loss of shipped items was limited to $100. If a shipper did declare an excess valueand paid an EVC of 25 cents per $100 of additional declared valueUPS was liable for the amount declared. The EVCs added up to $77.7 million in profit for UPS for 1984 (one of the tax years in question). But in 1983 UPS had stopped recording such profit in income it reported to the Securities and Exchange Commission and the IRS. In 1984, AIGs National Union, acting as a fronting carrier, passed on $60 million of that profit to OPL, after deducting expenses. As a foreign corporation, OPL was not subject to U.S. tax. Since OPL was set up as a non-controlled foreign corporation, tax rules that existed then and that exist now allowed shareholders of OPLwho were also shareholders of UPSto defer income-tax payments on insurance profits recorded by OPL until they were repatriated, tax experts say. UPS said the reason for the arrangement in the first place was not to escape or defer taxes. Instead, it was a concern over the possibility that insurance regulators might view its continued receipt of EVCs as unlicensed insurance activity, illegal under state insurance laws. The Tax Court, using the "assignment of income" doctrine, said the arrangement was a sham concocted to avoid taxes. "It is fundamental to our system of taxation that income must be taxed to the one who earns it," Judge Ruwe wrote in his Aug. 9, 1999 opinion. He listed 17 insurance-related activities UPS engaged in both before and after setting up OPL as part of the evidence supporting a finding that UPS, not OPL, earned the income from shipping charges. "The incidence of taxation cannot be avoided through an anticipatory assignment of income," the opinion said. The ruling, which not only directed UPS to pay taxes it owed on diverted income but also found the company liable for penalties and penalty interest for "intentional disregard of rules and regulations," may cost UPS $2.35 billion, based on SEC filings. While the ruling only covered the tax years 1983 and 1984, the $2.35 billion amount includes liabilities for 1985 through 1999, assuming the IRS will take similar positions in those remaining years. The IRS has already sent notices to UPS regarding the taxes it owes for 1985 through 1990. Class-action lawsuits filed by UPS customers using facts of the tax case could end up costing UPS even more. Unlike most past decisions related to captive insurers, the central question here was: "Who earned income?" In contrast, past decisions have hinged on whether the defining characteristics of insurancerisk sharing and risk distributionexisted, and whether conditions existed to allow premium deductibility. In fact, while OPL is often referred to as a captive, and although transactions with OPL did include the use of a fronting carrier, the arrangement departed from traditional captive arrangements in several ways. For one thing, the "quasi-captive" wasnt set up to insure UPSs own risks, in the way traditional captives most often are, but those of its customers. (Later, UPS did retain part of its own workers compensation exposure in OPL, insuring the excess with Liberty Mutual.) Further, while UPS officers first toyed with the idea of having an insurance operation that was a subsidiarylike a typical captiveOPL was not a subsidiary. At a 1983 meeting, the UPS tax counsel suggested that the insurer be a Bermuda company owned by UPS employees, not UPS, so that it would be classified as a non-controlled foreign corporation, according the history given in the court decision. Initially, UPS set up OPL (then called UPSINCO) as a wholly owned subsidiary, but UPS later transferred 98 percent of the stock of OPL to UPS shareholders by issuing a stock dividend, explained Roy Sedore, a partner with Baker & McKenzie in New York. The dividendone share of OPL capital stock for each outstanding share of UPS stockshifted majority ownership from UPS to its shareholders. UPSs shareholders were current and former UPS employees, Mr. Sedore noted, adding that UPS also put certain restrictions on the sale of OPL shares. Mark Anderson, a partner in KPMGs alternative risk practice in Atlanta, said UPS was in a unique position to issue the stock dividend that made the shareholders of UPS and OPL essentially the same people because, until a recent initial public offering, UPS was a privately held corporation. He explained that for a large company traded in public markets, like General Motors, for example, shares could change hands at the moment of the dividend transaction. There would be no assurance of maintaining common shareholders in both companies at that instant, he said. Mr. Anderson argues that not only could UPS create a non-controlled foreign corporation owned by its shareholders in this way, but they should have. "Any corporation in America would take the opportunity to set up a structure with the least tax," he said, calling the "sham" finding of the Tax Court an "overreaction." In 1983 and 1984, it would have been impossible to set up a captive, he said. Those were the days of Revenue Ruling 77-316, when transactions made to transfer risk between related parties were deemed not to be insurance, he said. "It was not a good landscape for setting up a subsidiary," he said. If a company faces the same situation today that UPS did then, how could it lessen the risk of an unfavorable tax decision? "Probably the way they did it would still be best way," Mr. Anderson asserted. "They had it structured just perfect[ly] in terms of tax efficiency, [and] everything they did was within the law." "We have encountered other privately held companies and looked to UPS-OPL as an ideal way to structure them. You try to make these as tax-efficient as possible. Thats what we get paid to do," he said. The only other ruling on a similar structure tax experts could recall went in a way other than the UPS decision did. The ruling in Crawford Fitting v. United States, decided in the U.S. District Court for the Northern District of Ohio in 1985, dealt with an individual shareholder that owned the insured and the insurance company. "If you have stick figure A, the insured, and stick figure B, the insurance company, and A hands premium to B, the court said thats deductible," Mr. Anderson said. UPS is "one step better" in that OPL assumed business written by AIG, he said. So what went wrong? "UPS was a victim of the Tax Courts crackdown on tax shelters [that] have little economic purpose outside of a tax benefit," he said. "Why would UPS take $100 million [of gross revenue] out of its books and put it on the books of OPL" other than for tax reasons, he said, articulating the Tax Courts basic question. In recent months there have been several adverse rulings by the Tax Court on tax shelters, he said. The UPS decision "is something that captives need to pay attention tonot because it changes captive law, but because it highlights a change in the IRSs focus," Mr. Sedore said. "What it tells youand what most advisors have always told companies thinking of setting up captivesis that you need to have a legitimate business reason, you have to document it, and you need to follow through," he said. If you state that your business purpose for setting up a captive is access to the reinsurance market, the IRS would want to see if you actually did that, he said. Your feasibility study shouldnt just have tax savings all over it, he added. "The thing that yells out at you is that contemporaneous documentation of business purpose is critical. It has always been," said William Conroy, an attorney for Baker & Hostetler in Washington. Such documentation was one thing UPS did not have. What it did provide was testimony about "a vague regulatory concern," Mr. Sedore said. That testimony, recounted in the Tax Court opinion, revealed that UPS officials never asked in-house or outside counsel if there was a regulatory problem, he noted. Once the program was in place, they never asked for legal advice about regulatory issues, he said.