The US courts upped the ante this fall in corporate tax shelter cases by signaling that they are prepared to hit companies that engage in such transactions with large penalties.

In one case involving United Parcel Service, the company had to take a charge against 1999 earnings of $1.786 billion, and it estimated in a Form 10-Q filing with the Securities and Exchange Commission that its liability could ultimately hit $2.353 billion.

The case involved a tax plan that the company put in place in 1984. It was years later before the IRS challenged the plan on audit. The company has the same issue in all the intervening years.

The decisions are important because they show that the calculation many large US companies that adopt aggressive tax positions make may be flawed. The companies figure there is little chance of discovery on audit and, even if discovered, they will be able to settle for X cents on the dollar and still show a profit from implementing the tax plan. These calculations fail to take into account the potential for large penalties and also the risk that the company could be nearly bankrupted by the tax liability if the tax plan remains in effect for many years before the IRS challenges it.

The United Parcel Service case involved use of an offshore insurance subsidiary.

Two other cases — involving computer-maker Compaq and Iowa utility IES Industries — involved a “dividend stripping” transaction that was popular with large US corporations until Congress shut down the transactions in 1997.

Offshore Insurance

The United Parcel Service case involved use of an offshore insurance subsidiary. Two other cases — involving computer-maker Compaq and Iowa utility IES Industries — involved a “dividend stripping” transaction that was popular with large US corporations until Congress shut down the transactions in 1997. United Parcel Service protected customers against the full value of their packages if the packages are lost, but only up to $100 in value. The customers had to pay an extra 25¢ per $100 of value above this amount for additional protection. By 1981, these “excess value” premiums were a substantial source of income for UPS. It reported the net amount between the premiums it collected and the losses it had to pay each year as income. For example, in 1981, “excess value” premiums were $67 million against only $20 million in losses.

The company began investigating the possibility of setting up an offshore insurance subsidiary to receive the premium income.

It eventually formed such a subsidiary at the end of 1983 in Bermuda and distributed the shares in the Bermuda company to the 14,000 UPS shareholders as a dividend. UPS retained only 2.67% of the shares for itself.

At the same time, it entered into a “fronting” arrangement with a subsidiary of US insurance giant AIG. UPS insured against its excess value exposure with the AIG subsidiary. However, the AIG subsidiary then reinsured the same risk with the Bermuda company UPS had just formed. UPS continued to collect the premiums from its customers and handled the claims. All monies were deposited in its US bank account. Claims were paid from the same account. Each month, UPS paid the net premium income — above claims — to the AIG subsidiary. The AIG subsidiary deducted a commission of $1 million a year plus another 4.1% to cover taxes, board and bureau charges, and then paid the balance over to the Bermuda company.

UPS stopped reporting the net premiums as income in the United States. Rather, it took the position that they were income of the Bermuda company. The Bermuda company was not a US taxpayer. (The US would ordinarily have looked through the Bermuda company and taxed the US parent on the income under so-called subpart F rules; however, the distribution of shares in the Bermuda company to the UPS shareholders had the effect of avoiding these rules.)

On audit, the IRS said the $99.8 million in net premium income that UPS claimed was income of the Bermuda company in 1984 was really its income.

The US tax court agreed. The court said the arrangement lacked any business purpose. UPS argued that it was prompted to act out of concern that it was offering insurance in the US without a license. However, its employees involved in implementing the plan never sought legal advice about whether its existing arrangements were illegal or whether the new arrangement addressed the concerns. The court said the Bermuda company did nothing to earn the income. All the work of collecting premiums and processing claims was still done by UPS employees in the United States. If this were real insurance, the court said, UPS could have bought the same coverage in the market for between 8¢ and 9.2¢ per $100 of value — not the 25¢ it purported to pay its affiliate.

The court also denied UPS a deduction for the commissions it paid AIG.

It also upheld a series of penalties. First, UPS was hit with a 5% penalty for “negligence or intentional disregard” of US tax rules. Second, it was ordered to pay an additional 25% penalty because it lacked “substantial authority” for its position. Third, it was assessed interest for the back taxes at 120% of the normal rate. This is a penalty interest rate that applies to “tax-motivated transactions.” Fourth, it was assessed an additional 50% interest charge on top of the penalty interest because the court said the company lacked even a reasonable basis for its position.

UPS said in a Form 10-Q filing with the Securities and Exchange Commission in mid-October that the taxes at issue for 1984 were $31 million, but that when the penalties and interest were added, the sum comes to $246 million. It estimated that the total after-tax exposure for the tax years 1984 through 1999 could be as high as $2.353 billion. The company said it was still evaluating whether to appeal.

Dividend Stripping

In a separate case, the US tax court also upheld penalties against computer-maker Compaq for engaging in a “dividend stripping” transaction intended to generate a capital loss.

Compaq sold stock it owned in another computer company in July 1992 at a capital gain of $231.7 million. A broker at Twenty-First Securities learned of the capital gain and began pitching a dividend-stripping transaction in August. Compaq agreed to do the transaction after a meeting with the broker in mid-September. The transaction involved a series of trades that the broker arranged the next day.

Compaq bought 10 million American Depository Receipts, or ADRs, in Royal Dutch Petroleum Company in 23 cross trades with Arthur J. Gallagher & Co. — another customer of Twenty-First Securities — and immediately resold the ADRs back to Gallagher. All 23 cross trades were completed within an hour.

The ADRs were purchased “cum dividend” — with the expectation that Compaq would be entitled to a dividend about to be declared — and they were resold “ex-dividend.” Compaq paid $887.6 million for the ADRs. It resold them for approximately $20 million less, or $868.4 million. The purchase leg of each cross trade settled on September 17, but the resale legs did not formally settle until September 21, thus entitling Compaq to the dividends that were declared two weeks later for persons who were shareholders of record on September 18.

Compaq paid Twenty-First Securities a commission of about $1 million.

Compaq claimed a capital loss of $20.7 million on its tax return. It also reported a dividend of $22.5 million, but claimed a foreign tax credit for the 15% withholding tax that was subtracted from the dividend in Holland.

The US tax court said the transaction lacked any business purpose other than tax planning. It quoted from an opinion by the 7th circuit court of appeals in another case: “The freedom to arrange one’s affairs to minimize taxes does not include the right to engage in financial fantasies with the expectation that the Internal Revenue Service and the courts will play along.” The court noted that Compaq did no market research before deciding to buy the ADRs and, about a year later, it shredded the spreadsheet that Twenty-First Securities had used in pitching the transaction.

The court upheld a 20% negligence penalty after concluding that Compaq could not show it had a reasonable basis for its position or that it acted in good faith.

An Iowa federal district court in September also disallowed $82.8 million in losses that Iowa utility IES Utilities claimed from dividend-stripping transactions in 1991 and 1992.

Congress closed the door on dividend-stripping transactions in 1997 by requiring that a company have held common stock for at least 16 days and preferred stock for at least 46 days before it will be entitled to foreign tax credits on dividends.

by Keith Martin, in Washington