Tax Court holds UPS shifted income offshore in sham transaction.

In United Parcel Service of America, Inc. (UPS), TC Memo 1999-268, the Tax Court held that UPS improperly shifted $70 million of income offshore to a related Bermuda corporation, Overseas Partners Limited (OPL). Citing Basye, 410 US 441 (1973) and Lucas v. Earl, 281 US 111 (1930), the court found that UPS itself was-the true earner of the income under Sec. 61 and had improperly attempted to assign that income to OPL. According to the court, the transactional arrangements that would have allowed OPL to earn the income offshore, free of U.S. corporate income tax, lacked a legitimate, nontax business purpose. Therefore, under the sham transaction doctrine, OPL's participation in the arrangement should be ignored and the income should be taxed to UPS. In arriving at this conclusion, the court disregarded substantial testimony offered by UPS executives and relied instead on contemporaneous documentation as to the intent and purpose of the transactional arrangements. The court imposed penalties exceeding $15 million under Secs. 6653 (negligence), 6661 (substantial understatement of income) and 6621 (substantial understatements attributable to "tax motivated transactions").

UPS is engaged in the pick-up and delivery of small packages and parcels within the U.S. and in certain countries abroad. At all times, UPS's activities were regulated by the Interstate Commerce Commission (ICC), state transportation agencies, public utility commissions and the Civil Aeronautics Board. In connection with regulatory requirements, UPS's pricing structure was set forth in detailed tariffs filed with the ICC and most states' state transportation agencies. This pricing structure established certain "base rates" depending on the package size and delivery location. The base rate automatically provided the customer (the shipper) with coverage against loss or damage to its package up to $100. If a shipper desired to obtain additional coverage, it would declare the value of the package and pay an additional 25 cents ($0.25) of "Excess Value Charges" (EVCs) per additional hundred dollars of value declared.

For all of its tax years through 1983, UPS collected the EVCs and included them in its gross income. In 1983, however, UPS was approached by an insurance brokerage firm with a plan to restructure the EVC aspect of UPS's shipping business. Because the EVCs provided shippers with coverage against loss or damage to their packages, the excess value business had significant attributes resembling insurance. Under the plan, UPS would collect the EVCs on behalf of shippers as "insurance premiums" payable to an unrelated insurer (NUF), which, in turn, would pay "reinsurance premiums, to OPL. UPS had recently created OPL and declared a dividend payable to UPS shareholders equal to one share of OPL stock for each share of UPS stock held. Under the arrangement, UPS required NUF to use OPL exclusively as its reinsurer; for its participation, NUF was reimbursed for expenses and received a share of the premiums (capped at $1 million annually). OPL's reinsurance income (i.e., almost all of the EVCs) was subject only to a 1% Federal excise tax. Importantly, OPL performed little, if any, activity related to its role as reinsurer (e.g., UPS continued to investigate, settle and pay EVC claims).

UPS contended that NUF earned the EVCs as insurance premium income, that OPL earned reinsurance premium income, and, therefore, that the EVCs did not constitute income taxable to UPS. In support of the arrangements, UPS asserted that it had several legitimate, nontax business reasons for restructuring the EVC business. For example, UPS asserted that it feared state insurance regulators would find it was conducting an illegal insurance business, given that UPS was not a licensed insurer. UPS also asserted that it desired to leverage the EVC profits into the creation of a new reinsurance company.

In evaluating UPS's purported business motivations, the Tax Court started with the proposition that the "determination of whether the taxpayer had a legitimate purpose in entering into the transaction involves a subjective analysis of the taxpayer's intent." Regarding UPS's state insurance concern, the court wholly disregarded testimony from UPS executives on point, and stressed "[n]o contemporaneously prepared documentary evidence was presented to indicate that petitioner had such concerns ..." Given that no documentary evidence supported the claim, the court simply did "not believe that [UPS] would have restructured a significant portion of its business in order to avoid a potential State law problem without having thoroughly analyzed and considered the matter and the ramifications that any proposed change might have." As to the claim that UPS desired to leverage the EVC profits into a new reinsurance company, the court noted that "any investment of money into OPL could accomplish this purpose"

In sum, the court found that the UPS/NUF/OPL transactional arrangement was a prearranged plan designed to avoid Federal income tax on UPS's EVC income. The court's findings relied On several corporate documents generated at the time of the restructuring that referred to NUF as a "fronting" company and to OPL as a "captive" insurance company. Finding that the arrangement was devoid of nontax business reasons, the court held that the arrangement was a sham to be disregarded for tax purposes. As such, the court required UPS to include all of the EVCs in its gross income, and disallowed the deduction of any expenses or fees paid to NUF Finally, the court held' that UPS was liable for additions to tax under Sec. 6653 for negligence and Sec. 6661 for substantial understatements of income tax, and for increased interest under Sec. 6621 for substantial understatements attributable to "tax motivated transactions"

UPS is a significant victory for the Service in its use of nontechnical judicial doctrines in the context of international transactions, when classic "tax shelters" are not involved, such as ACM, 151 F3d 231 (3d Cir. 1998) and ASA Investerings Partnership, TC Memo 1998-305. In particular, while ACM and ASA Investerings involved relatively short-lived capital transactions, UPS involved a transactional arrangement encompassing its standard, day-to-day package delivery activities.

FROM PAUL MANNING, WASHINGTON, DC