The Dow Chemical Company v. United States

its dis- has not abused COMPANY, THE CHEMICAL DOW injunction issuing preliminary cretion Plaintiff-Appellee, lifetime the benefits were on the basis prior those who retired for vested and, thus, the FAS-106 to October America, limit those benefits. could not Letter UNITED STATES means, therefore, despite parties’s Defendant-Appellant. liabilities, the extent regarding error No. 03-2360. for likely to held liable America CNH health care benefits lifetime the vested of Appeals, Court United States 3, 1993 prior to October retired those who Sixth Circuit. 7.2.2, howev- Closing Date. Section on the 3, 2005. Argued: June er, assumed those provides that Tenneco par- is reinforced liabilities. This and Filed: Jan. Decided to include of “Liabilities” ties’s definition contingent, matured or or those “absolute

unmatured, unliquidated, or liquidated ... accrued or or unforeseen

foreseen unknown,

unaccrued, or whether known future.” arising

having arisen the contract is un- convinced that

We are dis- therefore affirm the

ambiguous and judgment.

trict court’s interpretation,

Finally, based on this discretion in did not abuse its

district court discovery fashioning or in an

cutting off the indemnifica- remedy under

equitable provision.

tion

V. reasons, we AFFIRM foregoing

For the judgment, respects all district court’s appeals.

on each of the four im- that the IRS had court ruled

district or- the deductions and disallowed properly favor. judgment Dow’s dered economic Because therefore were the deductions shams and Donohue, M. United Dennis disallowed, ARGUED: we REVERSE properly Justice, Washington, Department States and remand for judgment court’s district D.C., Magee, John B. Appellant. for of the judgment in favor United entry of D.C., LLP, Washington, for McKee Nelson States. M. Dono- BRIEF: Dennis

Appellee. ON Farber, Rothen- hue, Gilbert S. Richard I. BACKGROUND Hill, Metzler, D. James berg, Robert W. Background A. Factual Justice, Department United States court conducted a bench D.C., B. Appellant. for John Washington, months, heard testi lasting trial over two Goldman, Madan, Raj Rich- Magee, Gerald witnesses, twenty-six and re mony from Dillon, Stark, A. McKee Nel- Sheri ard C. 1,526 numerous factual ceived exhibits and D.C., LLP, Appellee. for Washington, son The facts of the case and stipulations. MOORE, COOK, RYAN, and Before: length arguments are discussed parties’ Judges. Circuit thorough opin in the district court’s two v. United States ions. Dow Chem. Co. (E.D.Mich. (Dow I), F.Supp.2d 2003); Dow Chem. Co. v. United States (Dow (E.D.Mich. II), 2003). not on fac Because the case turns law, we disputes tual but on issues OPINION only a factual present here brief back MOORE, Judge. Circuit ground. 1991, Plaintiff-Appellee The In and 1988, policies purchased In Dow COLI (“Dow”) pur- Company Dow Chemical 4,051 from Great employees on the lives of life insurance corporate-owned chased (“Great Company Life Assurance West (“COLI”) of thousands policies on the lives West”). purchased In Dow COLI years taxable employees. of its 17,061 employees the lives of policies on for 1989 to Dow claimed deductions Compa- Insurance Metropolitan Life pay interest incurred on loans used (“MetLife”). Dow, ny was both which premiums- related to the and for fees beneficiary policies, of these owner and the The Inter- policies. administration of the premiums through primary two paid the (“IRS”) nal Revenue disallowed Service funding mechanisms. these deductions and assessed deficien- First, money from the interest, Dow borrowed paid cies and Dow under which insurers, poli- cash values of the using the protest attempted by suing and to recover trial, policy These loans Following for a cies as collateral.1 refund. bench year, leaving relatively day policy policy-loan struc- of the 1. The transactions were premium pay small balance to in cash. tured as follows: "Dow would receive bill payment policy, which company created value in the from the insurance that netted the security repayment charges against premium and interest was used as I, F.Supp.2d at 812. proceeds the first loan." Dow 250 of a loan that was made on principal funding $201,317,000 were the source of dur- ing loans, sources: in policy first, second, third, ing the eighth, $238,844,000 and in partial withdrawals, years $9,203,000 ninth Great West and policy dividends, in and during (about the first $59,679,000 three of the MetLife premiums) 16% of the (i) For plan. example, paid Dow Great in cash. From 1991 to $40,582,000 first-year premium West’s $849,890,000 premiums $239,371,000 $38,866,000in using proceeds from pol- in interest to MetLife from following $1,717,000 icy loan and of its own cash2 $509,574,000 sources: policy loans, (ii) first-year premium MetLife’s of $495,844,000 partial withdrawals, $170,510,000 $158,756,000 using pro- (about $83,844,000 premiums) 10% of the $11,754,000 policy ceeds from the loan and in cash.

of its own cash. In addition to payment the mechanisms Second, partial Dow made withdrawals above, described both COLI plans shared from the unencumbered cash values of the several pertinent other characteristics. (i.e., policies already the value not used as First, both projected were gener- to loan).3 policy collateral for a Partial with- negative pre-deduction (i.e., ate without drawals were principal the source of fund- taking into account the benefit of income- ing during the fourth through seventh and deductions) cash many flows for through tenth years thirteenth years eighteen and years seventeen for — plan Great West and during the fourth the Great West and plans, respec- MetLife through eighth years of the plan. MetLife tively eventually generating posi- —before (i) For example, paid Dow Great West’s tive cash flows contingent on the infusion fourth-year $40,360,000 premium of (plus large of by amounts of cash Dow. The net $11,278,000in interest accrued on poli- the (“NPV”) present value of these cash flows loans) $45,149,000 cy using proceeds in positive negative, was either or depending from the partial withdrawals and on the discount rate used in analysis. the $6,489,000 (ii) of its own cash and Met- Second, projected neither to ex- fourth-year $169,770,000 Life’s premium of perience significant (i.e., build-up inside interest) $38,132,000 (plus in using the accrual of interest on the value of the $195,779,000 proceeds partial from with- term, policies) the short any because $12,123,000 drawals and of its own cash.4 such stripped value would either be from told,

All policies to (through partial Dow paid withdraw- $377,062,000 als) $131,986,000 in premiums and or encumbered (though the loans in interest to against Great West from the follow- policies). injected If Dow Where, here, component figures 4.During through to be the tenth thirteenth of total, summed do not add to the stated it is plan, poli- Great West dividends from the rounding. due to funding. cies were another source of For example, paid year’s premium Dow the tenth partial-withdrawal 3. These transactions were $3,702,000 $14,442,000 (plus of in interest "(1) gross structured premium as follows: loans) policy using accrued on (2) paid; was deemed payment the deemed of $12,343,000 proceeds partial from the value; (3) premium created cash Dow withdrawals, $3,685,000 dividends, policy value; partial made a withdrawal of the cash $2,116,000 in its own cash. Dow did not (4) partial withdrawal was used to policy any payments use dividends to make approximately premium offset 90% MetLife. I, accrued loan interest.” Dow at 814. Under each these steps were effectively carried out simulta- neously. plans’ per- the COLI projections of howev- eluded policies, into the of

large sums its in- Dow had submitted with significant accrue formance that er, Third, they both long term. protests in the terest administrative (i.e., mortality gain potential negotia- limited Dow’s in settlement made statements death greater-than-expected receipt the Federal Rules under Rule tions greater-than-expected due of Evidence.7 em- among the covered number of deaths could recover West

ployees): Great II. ANALYSIS adjustments, rate through mortality losses Principles A. General to re- charges could assess while MetLife mortality losses. coup its to de- legal right “The otherwise of what years 1989 crease the amount the taxable $33,004,360 taxes, totaling altogether avoid deductions would be his claimed pay used them, permits, loans the law interest means which to the for fees related premiums and Gregory v. Helver- cannot be doubted.” The IRS policies.5 administration 465, 469, 55 S.Ct. ing, U.S. and assessed these deductions disallowed (1935). ease, the instant Dow L.Ed. 596 In totaling interest and tax deficiencies liability prin- tax attempted to decrease its $22,209,570.6 amount and Dow this paid (26 163(a) § through I.R.C. U.S.C. cipally that the IRS protests filed administrative 163(a)), taxpayer § to de- permits which denied. accrued within paid duct “all interest or indebtedness.” For year the taxable on Background B. Procedural contracts, deduction of insurance life court to in the district suit Dow filed circumscribed: is interest indebtedness paid it had sum by recover refund the ... allowed for No deduction shall be govern- plus interest. protest, under on indebted- any paid amount or accrued that Dow’s deductions were argued ment purchase continued to ness incurred or plans were the COLI improper because ... carry life contract insurance trial, Following a bench economic shams. purchase ... of pursuant had ruled that the IRS the district court systematic di- contemplates the which the deductions be- disallowed improperly borrowing part of or all rect or indirect were not economic cause the COLI the cash value of such of the increases in consequently judgment ordered shams and .... contract government appeals in Dow’s favor. The 264(a)(3). prohibition § does I.R.C. subsidiary rulings. and this conclusion two “if 4 of the annual apply part no of First, court credited the dis- the district 7-year NPV) during period due premiums (and offered count rate concomitant premium the first (beginning with the by date than one offered by Dow rather Second, which such relates court ex- on the contract to government. the district $3,043,326, 1990, 1991, $1,367,386, 1989, and amount of years and In taxable (i) $6,836,910, (ii) expenses respectively, interest of interest claimed deductions and $13,491,825, $3,843,813, $12,968,778, $1,781,778, $3,235,630, and and the amount (ii) respectively, administrative fees of and $5,944,540, respectively. $356,221, $168,563, $2,175,160, respec- and tively. opinion aspects court's 7.Other district are not dis- appealed therefore were not 1989, 1990, 1991, For taxable cussed here. (i) in the deficiencies IRS assessed (6th Cir.1989). paid) plan by is under such If the transaction has eco substance, means indebtedness.” I.R.C. nomic question “the becomes 264(d)(1). safe-harbor, § Even under this whether the was motivated however, provision the Code in effect when profit participate the transaction.” (1988 purchased instant Comm’r, (6th 163, Illes v. 982 F.2d 1991) $50,000 cert, limited the deduction to Cir.1992), denied, 984, 507 U.S. per of indebtedness insured life. I.R.C. 1579, (1993). “If, S.Ct. 123 L.Ed.2d 147 (1988). 264(a)(4) § however, determines that sham, transaction is a course, entire transac a taxpayer

Of is not auto tion is disallowed for matically purposes, federal tax every entitled to claimed deduc [subjective] and the inquiry tion. income tax deduction is a mat “[A]n never Id.; Rose, legislative grace ter of and ... made.” the burden see also 868 F.2d at 853 (“This clearly showing right to the claimed inquire court will not into whether a INDOPCO, taxpayer.” deduction is on the objective transaction’s primary was for the 79, 84, Inc. v. U.S. S.Ct. production of income or to profit, make a (1992). Moreover, 117 L.Ed.2d 226 until it determines that the transaction is if a compli even transaction is “formal sham.”). bona fide and not a provisions,” ance with Code a deduction

will be disallowed if the transaction is an B. Standard of Review economic sham. Am. Elec. Power Co.

(AEP) States, conducting the economic-sham United cert, (6th Cir.2003), denied, inquiry, the district findings court’s of fact 540 U.S. 1043, (2004). AEP, 124 are reviewed for S.Ct. 157 L.Ed.2d clear error. 888 326 proper Comm’r, in F.3d at 741 determining (citing “The standard if a Rink v. 47 (6th Cir.1995)). 168, transaction is a sham F.3d 172 is whether the trans The district any practicable action has economic effects court’s ultimate conclusion that a transac other than the creation of income tax loss tion is is not an economic sham is Comm’r, 851, es.” Rose v. 868 F.2d 853 reviewed de novo.8 Id. at 742. (6th panel 1991).

8. A of this court once Although may noted in an Cir. appear there judg- economic-sham case that "[w]here the be some tension between and our sub Ratliff fact, cases, ultimately finding ment below is sequent recognized a it is we in AEP that the well-settled that the panel determination of the Tax specifically "did not hold that Ratliff binding appellate Court is on the question court unless the ultimate a whether transaction Comm’r, clearly erroneous.” v. 865 clearly is sham is to be reviewed under the Ratliff 97, (6th Cir.1989) (alteration AEP, origi- F.2d 98 erroneous standard.” 326 F.3d at 742. nal) (internal omitted). Furthermore, quotation employing marks Two different standards decisions issued mere months after ques of review for the factual and ultimate Ratliff clarified that findings while the factual under- tions is Supreme more consistent with the lying a sham teaching determination are reviewed for general Court’s that "[t]he charac error, legal employed clear standards and purposes terization of a transaction for tax is the ultimate question conclusion are de subject reviewed novo. of law to review. The Comm’r, 1251, (6th Kennedy particular v. 876 F.2d 1254 facts from which the characteriza Rose, Cir.1989); 868 F.2d at 853. Since subject.” this tion is to be made are not so Frank 1989, States, 561, consistently Lyon trio of decisions in we have Co. v. United 435 U.S. 581 n. 16, 1291, (1978). followed the more nuanced formulation of 98 S.Ct. 55 L.Ed.2d 550 Kennedy explicit- parties and Rose whenever we agree although have Both factual find AEP, ly error, ings stated the standard of review. 326 are reviewed for clear the ultimate 741-42; Rink, 171; F.3d at 47 question F.3d at Smith of whether the transaction is an eco Comm’r, 1089, (6th 937 F.2d Appellant's 1096 Cir. nomic sham is de reviewed novo. 1991); 33; Bryant v. Appellee's 928 F.2d 748 Br. at Br. at 38. 742; at Holdings, 301 F.3d at CM F.3d of Dow’s COLI Substance C. Economic Winn-Dixie, at In- 103; 254 F.3d Plans nega- deed, plan’s a COLI we have called one, courts, including have this Several (that become cash flows pre-deduction tive economic substance addressed interest deduc- the benefit of positive when abe sham plans, COLI considered) of an “hallmark[] tions 744; IRS v. CM on each occasion. AEP, at 742. sham.” F.3d economic Inc.), (In Holdings, re Inc. CM Holdings, (3d Cir.2002); Winn- 96, 102-03 that the Great court found The district (Winn-Dix Stores, v. Comm’r Inc. Dixie generate plans MetLife West and (11th Cir.2001), 1313, 1317 ie), F.3d during cash flows pre-deduction negative cert, denied, 122 S.Ct. 535 U.S. years, eighteen and seventeen their first (2002). courts These L.Ed.2d plans the COLI Unlike respectively. indicators to several have looked Winn-Dixie, AEP, CM benefits: economic plans’ potential COLI however, projected were not flows, (i) “ pre-deduction projected entire negative their to be cash-flow beneficiary, (ii) mortality gains to ‘[ ] court found durations. proceeds, tax on pay who does of cash large to infuse sums Dow intended (iii) build-up ac [the inside interest-free [ ] years,9 during their middle into the plans ” policy value].’ interest on crual of pos- make the cash-flow which would (last at 742 alteration F.3d years. Because the later itive their Holdings, 301 F.3d original) (quoting have cash- projected to both 103). objective eco examine We years, cash-flow-positive flow-negative and of Dow’s nomic substance applied a NPV the district below. of these standards against each Fi- flow.10 the overall cash to determine credited the dis- nally, the district court Flows Cash 1. Pre-Deduction experts count rate utilized addressing the prior case each of each plan found the NPV plan, the of a COLI substance economic positive. without benefit court found objects district to the deductions, government The gen plan interest claimed inject to that Dow intended finding 326 court’s cash flows. negative erated called Case #23. large an illustration specify how relied on court did not 9. The district 809; I, Appellee’s to Br. F.Supp.2d would have had to in order at this Dow 250 infusion plans profitable. Based on make infusions at 16. illustration shows cash however, findings, following evidence and during $285 million the middle of about quite large figure was we infer that can (after per-in- multiplying the illustration's $315 million. indeed—about 17,800 employees that by the sured infusion plan, Great West Dow respect to the With plan, Dow projected Dow to be covered (Cash two illustrations it relied on asserts 784-85; I, Appellee's Br. at at 250 2) making purchase # Flow # 1 and 15). at 898. J.A. district Appellee’s Br. 12. The decision. cap loans "Dow’s intention court credited designed yield are 10. "In transactions basis,” $50,000 only and withdraw returns, pres- than immediate deferred rather 802, I, only reflects F.Supp.2d at which are, have adjustments as the ent courts value 1, Appellee's Br. at 9. This illus- # Cash Flow recognized, appropriate means of assess- an $30 about cash infusions of shows tration anticipated ing the transaction’s actual years. Ap- during middle Joint million P’ship ACM economic effects.” ("J.A.”) pendix at 1711. Cir.1998) cases). 231, (3d (citing plan, the MetLife the dis- respect to With it trict court credited Dow’s assertion 364, large amounts of into the upheld S.Ct. 132. The Court years. Reversing IRS’s finding taxpayer’s their middle this disallowance of the loan- have a interest deductions as the product would domino effect favorable to of a 366, sham transaction. Id. at government: it would undermine the 81 S.Ct. 132. finding generate that the would posi- aspects Two opinion Court’s years, tive in their cash flows later which light First, shed on the current inquiry. in turn preclude finding if, the Court observed that instead of ter positive each had a Review of NPV. transaction, minating the the taxpayer had this factual for clear error only held the maturity bonds to and continued however, necessary, if highly-contin- such operate as he had done for the first gent cash flows are relevant as a matter years, three he would have received an to the analysis. law economic-sham Un- $1,000. annuity 364, worth Id. at 81 S.Ct. fortunately, prior COLI-plan decisions Second, summarily reject the Court unhelpful in resolving legal ques- are this ed the taxpayer’s argument that the trans tion each case the court found action profitable would have become in ten pre-deduction negative cash flow to be years if he off the original million $4 every year and there was loan. Id. at 366 n. 81 S.Ct. 132. The possibility profitability no of future upon first statement potential demonstrates that the materialization contingency.11 of some future profitability can be relevant in as sessing whether an ongoing transaction is has, however, Supreme The pro- Court an economic sham. The contrast between guidance. vided useful In Knetsch v. the first and second statements reflects States, United U.S. 81 S.Ct. more nuanced may lesson. Courts consid (1960), L.Ed.2d 128 the Court reviewed a profits contingent er future on some future involving taxpayer’s transaction pur- action, taxpayer only but when that action 30-year chase of million worth of bonds $4 is consistent with the actual borrowing against and his simultaneous past conduct. skeptical, Courts should be them, generated which hundreds of thou- however, profits when the asserted future sands of dollars in interest deductions in hinge on taxpayer action that seri just 362-63, years. two Id. at 81 S.Ct. 132. ously conduct, departs past especially terminated the transaction where such departure expen involves the years: after three he surrendered the large money.12 diture of sums of (now $4,308,000), bonds worth his loan (now $4,307,000) cancelled, worth was These principles have obvious relevance ($1,000). he received the difference Id. at to the instant case. It proper for the context, Beyond COLI-plan 11. taxpayer the courts have termined that the did not intend to disfavored the deduction of interest on greater by paying make the future investment See, contingent investments with benefits. loan, therefore, potential off the the future Comm’r, 178, 208-09, e.g., Coleman v. 87 T.C. cash flows were not relevant to the economic (1986), aff'd, 1986 WL 22162 833 F.2d 303 analysis.” substance Dissent at Our 605. (3d Cir.1987); World, Toyota Rice’s Inc. v. reading of Knetsch is consistent with this Comm’r, 89, (4th Cir.1985); 92-93 (and ignores statement. What the dissent we Comm'r, (CCH) 2897, Smoot v. 61 T.C.M. recognize) is the reason the Court's behind (1991); 1991 WL 97650 Goldwasser v. large the determination: future investment Comm’r, (CCH) 56 T.C.M. 1988 WL altogether past would be inconsistent with his (1988); Zegeer 54 T.C.M. paying conduct. This is what made off the (CCH) (1987). 1987 WL 49205 Knetsch, "wholly unlikely.” loan 364 U.S. at objects reading 12. The dissent to our of 366 n. 81 S.Ct. 132. Knetsch, asserting simply that the Court "de- teachings of light In of the in the future. whether to consider district future; Knetsch, in includ- in court erred the the district profitable be plans would case, the COLI-plan indeed, prior analysis highly- the in each cash-flow ing its cash flows. future court looked projected cash flows positive contingent however, said, for the dis- be cannot same infusion the future years.14 later When for positive of cash trict court’s consideration anal- removed from the properly is of cash Dow’s even- contingent on that were flows flows remain. only negative cash ysis, significant amounts spending tual inter- Therefore, without the benefit Knetsch, the transaction Like the cash. deductions, cash- plans were the COLI est profit- become would instant COLI periods, all relevant negative flow future taxpayer’s large the only upon able of an economic “hallmark[] is a which cash, and, considering outlay of additional F.3d at 742. sham.” made similar no Dow had heretofore that positive future cash holding that the Our infusions, spending additional such cash it makes ignored have been flows should from the departure would be drastic ap- unnecessary to reach the government’s Moreover, conduct.13 past (i) choice of the district court’s peal of requir- provision no contractual there was NPV rate to credit the discount cash infusions substantial ing Dow to make (The pos- say.) does One sider? dissent the demon- recited in text As the facts 13. transaction, profitability strate, sibility is the had funded policy premiums been taxpayer likely to make a through against and with- is more loans because principally using policies, with if it will make the transac- Dow investment future drawals from circular, profitable. $315 Yet the million be own cash. But this would little of its tion purportedly projected profitability investments requiring future us to look to the limiting coupled Dow with been likelihood of would have to determine the transaction I, investment, borrowing and withdrawals. we then use to which 801-02, 807, (i.e., 809-10. On these prof- at the economic substance determine facts, projected that be no doubt again. there can itability) over of the transaction all required Dow to would have plans, cash infusions taxpayer's possibility is the Another past drastically conduct. depart from its might show deliberations because internal Thus, day conse- for another we leave likely to occur. investment that future is departures. obvi- quences of less drastic inqui- subjective over to But crosses that holding that concern our ates the dissent's transac- ry we do not conduct until the contingent fu- prohibits consideration sub- to have economic tion determined is depends on future profits it ture whenever liles, place. F.2d at stance in first merely "greater than investment is difficulties, light the better of these past Dissent investment." by limit- to remain true to Knetsch course is future invest- ing inquiry to whether the Also, authority, citing any the dis- without drastically departs past conduct. ment we consider argues should also sent investment is projected future "whether the profits contin- not hold that 14. We do future likely is is evidence it feasible there taxpayer expenditures gent new agree we at 605. While to occur.” Dissent (as example we may For never considered. feasibility of a future investment that the in text), con- suggest if a in the transaction, fact that sham indicative of a obligated tractually additional infuse likely pro- less is feasible is an investment point in the fu- an investment some into large vide useful information ture, spending constitute would not such always be will almost feasible investments departure past conduct from serious tax- large or other resource-rich corporations disregarded Knetsch. In- should under easily too met is no payers. that is A factor stead, outlay be consistent eventual the factor at all. conduct, i.e., obligation past the with actual presents problems of its A factor likelihood course, likelihood, along. Dow was all Of that existed determine own. one How would obligation instant case. i.e., such the under no one con- types what of evidence would (ii) exclusion of tax protest let- COLI plans, id. at “stated that for ters under Rule 408 of the Federal Rules some of the the purpose was to have First, of Evidence. the equity,” removal the low net id. at 774. Based on its highly-contingent positive cash from finding flows that in the future Dow would in- analysis only negative the leaves plans cash fuse the large cash, with sums of flows, yield however, which of course a negative the district court held that no NPV matter what the discount company rate. “stood to realize substantial eco- Second, government offered the gain nomic from tax-free inside build-up” protest letters to cast doubt on in- respect with plans. 807; both Id. at see inject tent to large amounts of cash into also id. at 810. future, plans in the which is irrelevant For the same reasons discussed above in in light of our holding putative that this flows, the context of cash the district court (or, outlay additional precisely, more erred in considering in its inside build-up profits contingent on spending) such prospect of large cash invest- disregarded should be aas matter of law. (but ments that might be did not have to be) Instead, made in the future. given the Build-Up Inside district court’s factual findings with re- case, prior COLI-plan each spect to Dow’s actual conduct of maintain- court found plan that the ensured that at ing little or no equity, net a simple applica-

regular equity adjusted intervals net was AEP, tion of Holdings, CM and Winn- to zero or some small number. yields Dixie the result that Dow would 740, 742; F.3d at Holdings, CM have been unable to realize the benefit of 103; Stores, Winn-Dixie Inc. v. inside build-up. This conclusion further 254, 281, 284, 113 T.C. 1999 WL suggests that COLI were an (1999). or equity low zero net economic sham. precluded the realizing the benefit of inside build-up, Mortality because there Gains would be little no equity net up build The district court found that interest). (i.e., earn plans contained designed features to neu

The district court found that “on the last tralize taxpayer’s ability to realize day of each policy years four through mortality gains. The-district court never seven, the cash value of Dow’s Great West theless found that were policies MetLife fully encum- neutral because neither one bered, yielding virtually zero equity.” net a 100% retrospective adjust “containfed] I, Dow 250 F.Supp.2d at mechanism,” 814. The district ment a requirement that the Lake, court also Gary noted that an actu- court divined from the three prior COLI- arial consultant I, who advised Dow on decisions.15 Dow 250 F.Supp.2d at 15. The agreement district court read the three cases as contained in the to make follows: payments policy after the conclusion of a [Cjourts found year that the COLI equals were so that the COI the amount designed flawed because of devices benefits, into the paid out in death risk is eliminated plans that eliminated the transfer risk. and, insurance, the COLI transaction is adopted government’s Those courts thus economically meaningless. terminology and found that the I, (citing at 807-08 when, "mortality neutral” after relevant Winn-Dixie, 268-69, 285; 113 T.C. at IRS v. period, usually year, the cost of insurance (In Inc.), Holdings, Inc. re CM (COI) and up” death benefits were "trued (D.Del.2000); 254 B.R. 632-35 Am. Elec. is, retrospectively. That when there is an between in a closer match” 808, “result much

811; at also id. see Am. and actual death benefits.16 expected of this application its reiterated court States, Power, Inc. v. United it ex- when Elec. requirement 100%-adjustment (em- 2001) (S.D.Ohio plan “a opinion F.Supp.2d that in amended plained added). phrase of the every The use phasis to eliminate designed that is not like than a word ... cannot closer” rather mortality profit “much dime of “total,” long implies term.” “absolute” “complete,” over ‘mortality neutral’ add- for 100% II, (emphasis provide at 851 did not F.Supp. plan that Dow 278 Indeed, nine-year pe- ed). over a adjustment. mortality a riod, experienced taxpayer cases, the COLI-plan prior In the three than (i.e., deaths there were loss neutral, fewer were deemed mortality provisions bene- less in death so it received expected, mortality gains making potential for) million be- it of fits than $38.8 previously the three two of Yet sham. actual death projected tween clearly did not eliminate challenged unadjusted. Id. at went apparently that and losses. mortality gains of all 100% opinion in nothing 788. There is a to- taxpayer received CM have mortality gain would indicate that a over of million mortality gain tal $1.3 though a completely eliminated even been F.3d at plan. eight first Fur- uncorrected. mortality loss was left noted Third Circuit 101. The fact is the this conclusion supporting ther taxpay- “assessed company [the insurance same COLI AEP was “the plan that the in recoup ... its losses surcharges er] insurer and by the same plan ... offered for- neutrality going mortality ensure as the one by the same brokers” sold Holdings The at 103. CM ward.” (as 768-69, has Holdings, id. at which re- description of the district court’s shown) limited the insurer’s already been did however, surcharges these veals, mortality recoup taxpayer’s ability of mor- elimination a 100% not constitute gains. provi- The contained tality gains. capping maximum cost-of-insurance

sion the mortal- precise details of Finally, (“COI”) the district charges, which led provision Winn-Dixie ity-neutralizing com- that the insurance conclude for the plan provided The are unclear. recoup taxpayer’s] “may never pany [the reserve of a claims-stabilization creation through increased COI mortality windfall (“CSR”) charges was funded COI B.R. Holdings, 254 In re CM charges.” paid. from which death claims (D.Del.2000). 70-71 635 & nn. Winn-Dixie, If the tax- at 268. 113 T.C. mortality gains giv- experienced payer mortality-neu- precise The details was deducted year, then the excess en clear in AEP are less tralizing provision func- “[T]he from the CSR. Id. 268-69. suggestive Holdings but still than in CM reserve was tion of the claims stabilization mor- less-than-complete elimination mortali- to ameliorate fluctuations actual advised taxpayer tality gains. The Winn- Id. at 285. ty experience.” plan’s that the mechanism States, year plan” expecting in each Power Co. v. United —does quoted in the text. 762, 777, 2001)). sentence (S.D.Ohio undermine the 787-88 Indeed, qualifier "that we are the use assertion, modify "volatility or variation” expecting” to Contrary Dissent to the dissent’s mortality gains given suggests that the of the advice the next sentence they completely if any would not be eliminated volatil- will eliminate —"This expectations. we are exceeded ity in the cash or variation flow Dixie district court’s opinion does elab- conclusion provides further evidence that orate, however, what if happen plans the COLI economic were an sham. taxpayer’s mortality gains exhausted the Summary might imagine

CSR. While one the insurer recouping gains through some other Courts have recognized three non-tax mechanism, might imagine one also relevant to the economic-sub- taxpayer keeping any mortality gains over stance plans: of COLI positive and above the value of the In light CSR. of flows, inside build-up, and mortality uncertainty, this the district court below gains. plans Dow’s COLI did not generate could not have concluded that the Winn- any of these benefits. Because the Dixie plan provided complete for the elimi- “any practicable did not have economic mortality nation of gains. effects other than the creation of income losses,” Rose, 868 F.2d at we

This review of the cases demonstrates they conclude that had no economic sub- adjustment that a “100% retrospective stance. This conclusion makes it unneces- requirement mechanism” simply cannot be sary subjective to discuss Dow’s motiva- discerned from past COLI-plan cases. Ules, tion. 982 F.2d at 165. fact, In permitted rule that a COLI plan mortality only be deemed neutral upon III. CONCLUSION proof “every mortality dime of profit” For outright above, is eliminated would conflict the reasons set forth with we the facts of two of the three REVERSE the district judgment cases. There- court’s fore, by entry judgment the district court erred remand for of imposing favor such a high hurdle as a United States. prerequisite to finding that designed Dow’s were RYAN, Judge, dissenting. Circuit mortality gains. neutralize My colleagues conclude aas matter erroneously When this high bar is re- law, of profits contingent taxpay- moved, it is clear that er action are an appropriate component of (even designed by reduce if not the economic substance only calculus when 100%) ability mortality realize comports that action with the gains. plan permitted The Great West past actual conduct related to the transac- insurer to recoup mortality (i.e., losses tion in question. disagree. my I opin- gains) through rate ad- ion, there is no precedential such rule I, justments. Dow 250 F.Supp.2d at 808. law and no warrant creating one in this plan gave MetLife the insurer “the validity case. The Dow’s COLI right to increase charges COI to recoup investments having economic substance if losses claims for death benefits exceeded turns on the findings district court’s of fact COI charges.” Id. at 810. The fact that sufficiency and the supporting evidence such increase was stop-loss limited findings. those I judg- would affirm the id., provision, is no to a finding bar ment in favor of Dow because I believe (as mortality neutrality, because discussed that the district court correctly applied the above) recoupment mechanism in law of findings this circuit to factual Holdings also capped. apparent, It is clearly are not erroneous. then, that sufficiently these features are similar to COLI-plan the other cases for I no disagreement majori- have with the us to conclude that Dow signifi- ty would not opinion’s statement of the complex fac- cantly mortality gains. benefit from program, tual details of Dow’s COLI in that past the investment than greater principles general summary of taxpayer is what question The plan. doctrine. substance economic

this court’s legal princi- intended. with the is disagreement My mistakenly invent and colleagues my ples are future cash flows potential If Dow’s States, 364 v. United to Knetsch attribute economic from the arbitrarily excluded not 5 L.Ed.2d S.Ct. U.S. on the this case turns inquiry, substance (1960). regarding findings of fact court’s district that Knetsch colleagues my of Dow’s COLI agree operation I with intended profita- future potential that crucial two demonstrates court made plans. inquiry of whether to the (1) bility oper- is relevant to of fact: intended findings an econom- plan is investment long-term a that it would realize such ate its term has “sham,” unfortunate that ic buildup; inside of tax-deferred benefits our some of by the IRS and used been (2) plans transferred Dow’s and read my colleagues But courts. federal The aggregate. on the risk to the insurers Supreme more than the far into Knetsch legal prin- correctly applied the then court concerning the in that case wrote Court sham- in the so-called down ciples set taxpayer’s accept the to refusal Court’s that, cases, unlike the concluded and have the transaction that argument had eco- plans, sham COLI paid he years had in ten profitable become investment long-term a substance as nomic million loan. original off the $4 program. summarily did not Supreme Court The that the explain sham-COLI cases rather, it argument; reject taxpayer’s life insurance main benefits of two “predicated argument stated deductions potential than the other unlikely assumption that wholly on (1) benefi mortality payments to the are: in cash the have off Knetsch would (2) taxable; not ciary, which are ” at 366 n. $4,000,000‘loan.’ original policy interest accrual of tax-deferred that this My colleagues insist 81 S.Ct. (inside is, the increase buildup), that value of law general a principle language implies cash value attributable policy’s relevant are not even profits that future the invest upon earned income interest when inquiry substance the economic value. The ment of the cash in a future investment projected shams cases were economic sham-COLI past than its greater plan is particular either they failed realize because wheth- regardless plan, investment in of a life insurance two benefits is feasi- future investment projected er the solely for the created they were likely to it is is evidence that ble and there Am. Elec. deductions. tax benefit of See only to indicate I Knetsch occur. read States, 326 F.3d 737 Power Co. United credibility assess- that the made Court Cir.2003) (6th (AEP); In re CM and determined ment (3d Cir.2002); Inc., Winn- F.3d future greater make the did not intend Comm’r, 254 F.3d Stores, Inc. v. Dixie loan, and off the by paying investment Cir.2001). (11th flows future cash therefore, potential concluded, case, the district In this sub- to the economic relevant find- factual its two central on the basis of not hold The Court did analysis. stance plans, that, the sham-COLI ings, unlike law, project- feasible as matter both plans realized Dow’s COLI particu- in a of cash ed investment of life insurance non-deduction sub- to the economic irrelevant lar is sub- had and therefore economic policies investment when inquiry, stance tion, stance. Unless both of those factual find- the district court noted that a strate- ings by clearly the district court are erro- gy of capping policy $50,000 loans at they neous—and I conclude are not—the withdrawing only to basis was more consis- judgment court’s for Dow should be af- tent with purpose of producing cash firmed. flows to fund future retiree benefit ex- penses than a minimum-payment strategy Buildup I. Inside capped-loan because the strategy produced The first basis for the district court’s higher positive cash flows years. after 18 determination that Dow’s plans COLI had Id. at 801-02. The capped-loan strategy economic substance finding was its that was also more consistent with Dow’s over- Dow would realize the benefits the tax- of all goal of tax avoidance than the minimum deferred buildup inside of the policies. payment strategy because interest on There were no such benefits in the COLI $50,000 loans above deductible, was not tax plans found to be in shams and withdrawing cash above basis would Holdings, and Winnr-Dixie. pre- Dow’s have exposed Dow to taxes that could have purchase projections showed that plans been avoided if that cash had been generated flows, positive cash even out as death benefits. absence of the interest deductions. The district court noted that although pre- (NPV) A. Net Analysis Present Value deduction negative cash flows were for the court’s conclusion that first 18 of plan, positive plans Dow’s COLI had economic substance flows, delayed years, for 18 were consis- they generated buildup inside was subjective tent with Dow’s pur- business based, part, upon the acceptance court’s pose funding of expenses retiree benefit (NPV) of the net long present term. value analysis Dow Chem. Co. v. of United States, (E.D.Mich. F.Supp.2d Dow’s financial expert. That a finding 2003). fact, of I and am satisfied the court did not commit legal Dow’s, error in accepting

I think got the district court it right, rather than government’s, analy- NPV analyzing first each of Dow’s plans COLI sis. as a whole and correctly then concluding substance, had economic recognized Courts have analy- NPV because, among other things, they realized sis is an appropriate method to determine the benefits of inside buildup. That con- the economic effects of transactions de- rested, first, clusion upon the court’s factu- signed yield deferred returns. ACM finding al that Dow intended from the (3d P’ship cap $50,000, outset to policy loans at to Cir.1998). analysis NPV consists of dis- basis, only

withdraw funds and to invest counting earnings by a factor in- cash into the Great West and MetLife tended to reflect the time money. value of years. after 17 See id. at Dow, See at 806. The dis- The district court based this not count rate used the rate of return anon only testimony witnesses, on the of Dow’s alternate investment. but also on contemporaneous documenta- The accepted district court the testimo- Dow, tion by introduced including Dow’s ny of expert, Dow’s Stewart Myers, who (RFP) original Request Proposals appropriate stated that the discount rate to the industry; analysis insurance pro- of for the posals by delayed Dow’s NPV Dow’s actuarial consultant and recommendation; his final cash flows is an pre-pur- Moody’s “after-tax” Cor- chase cash flow illustrations. Id. In addi- porate Average, by which is calculated the invest- expert concluded Average Dow’s Moody’s Corporate

multiplying plan had an minus tax rate. Dow’s MetLife leg Dow’s ment one by a factor million and the rate reflects adjusted approximately discount $370 NPV of from Dow’s the death reality that the Great West had leg of investment taxable, whereas COLI the after-tax million at an NPV $76 income tax on the pay have Dow would the invest- By analyzing rate. discount actual investments. from alternate viewed expert leg separately, ment would investments from alternate return begin- a whole—from as the transaction rate, but its income be reduced challenged removed ning to end—but not. from the return AEP re- as from consideration deduction mat- argues an after-tax discount By using government quires. an rate is law, discount proper rate, reality corpo- the that recognized the ter he Average Corporate Moody’s unadjusted in a with taxes and operate world rations that reflects rate using discount tax favored. are that some investments con- of death benefits the tax-free nature a form of analysis is expert’s Dow’s Since analysis required “pre-tax” flicts with the required by this analysis the “pre-tax” Circuit, and Third by this circuit and AEP, that the dis- I am satisfied court in in a “world without mistakenly puts Dow by error legal not commit trict court did 743-44; AEP, CM 326 F.3d at taxes.” See analysis. NPV accepting expert’s Dow’s F.3d at 95. Holdings, 301 Mortality II. Gains government’s with the agree I do not analysis re- “pre-tax” argument basis for district court’s The second requires AEP circuit under quired in this plans had that Dow’s COLI determination Third rate. As the unadjusted an discount substance was economic this Holdings, in CM explained Circuit plans, Dow’s COLI unlike the sham COLI only there requires “pre-tax” mortality to the in- risk plans transferred chal- consideration the be removed from and aggregate on the therefore surers and the transaction lenged deduction There is no mortality were not neutral. Holdings, merits. CM on its evaluated that this factual find- concluding basis for necessary, as It is not erroneous, disagree I clearly and ing was must suggests, government we that the district court my colleagues with taxes,” and we without imagine a “world distinguishing error in legal committed reality account may take into mortality features Dow’s COLI are tax favored. some investments Holdings. in AEP and CM from those separated Dow’s COLI expert in AEP the Third Cir- circuit and fi- and their investment transactions into Holdings that the cuit found in CM ana- “legs” nancing components and operated designed cases were those leg sepa- each flows from lyzed the cash “ neither ‘mortality-neutral,’ with to be flows leg” cash rately. The “investment employ- risk of making money side buildup, from inside the benefits showed early or late.” CM dying ees “financing leg” flows whereas mortali- chance of “[T]he F.3d financing added showed the value —in being enough to render the ty gains ever case, interest deductions. The this essentially non- was pre-tax profitable separating not claim that government does taxpayer nor Neither the existent.” legs, as financing the investment company able benefit was did, insurance practice expert is not standard deaths be- timing of employee from the analysis. in financial company paid Power, cause the insurance the tax- Am. States, Elec. Inc. v. United payer “mortality if (S.D.Ohio dividends” the cost of 2001) F.Supp.2d insurance exceeded death (citation benefits as- omitted). surcharges taxpayer’s sessed COI if the contrast, the district court below projec- death benefits exceeded actuarial found that Dow’s COLI did not con- 740;

tions. 326 F.3d at CM Hold- adjustment tain retroactive mechanisms ings, 301 F.3d at 104-05. designed to eliminate the transfer of mor- my out, Although, colleagues point tality risk equating the COI with the company insurance Holdings death paid. benefits The district court pay did out in mortality gains million $1.3 found that the Great plan paid West early years in the plan, the Third dividends to share favorable mortality ex- Circuit found the designed to perience, but those retrospective adjust- retrospectively eliminate equalize ments could not COI and death ability because, mortality gains to realize because Dow’s plans were “[rjather accept than this loss as one that part pool of a that shared may sometimes occur no matter how care- experience upon which the fully actuaries attempt vaga- to chart the Dow, dividends paid. death, ries of life and insurance com- [the at 808. The Great West plan also had an pany] assessed surcharges recoup to adjustment feature which increased the mortality neutrality losses and ensure COI to prior account for unfavorable mor- the Holdings, future.” CM 301 F.3d at tality experience, but that was a prospec- 104-05. As the lower court in CM Hold- tive “designed measure to fine tune the ings explained, although the may insurer forward,” risk allocation going not a retro- never recoup taxpayer’s mortality spective designed measure to eliminate gains, “this is a function of a policy con- past risk transfer. Id. The plan MetLife tract provision capping maximum COI paid mortality dividends, also they but did charges, not a function of risk shifting.” not away transfer risk from the insurance Inc., Holdings, In re CM 254 B.E.. company, and only benefitted Dow. Id. at (D.Del.2000). 810. MetLife also right reserved the to in AEP designed was also to charges increase COI to recoup losses if retrospectively eliminate mortality experience unfavorable, was but ability mortality gains. My to realize col- adjust that right to by stop- was limited a leagues selectively quote the advice re- provision, loss which is in group common ceived the taxpayer to support their life insurance contracts. Id. argument that in AEP was not The district court concluded that designed provide to Dow’s adjustment. a 100% However, plans COLI had features that were de- when that advice quoted in its signed to entirety, supports it reduce but not opposite conclu- eliminate the mortality sion: risk transferred to the insurers. The court found that Dow had poten- representative] [A advised AEP that tial to mortality realize substantial gains, mortality “this mechanism will result in including loss, catastrophic a much closer match which was a between expected possibility realistic given cash flow from projected death Dow’s em- ployees, Winn-Dixie, and claims actually paid. that are unlike those were any will eliminate volatility or located in geographic variation concentrated areas. in the Stores, cash flow that expecting we are in See Winn-Dixie Inc. v. year each plan.” 254, 284-85, 113 T.C. 1999 WL 907566 B.R. Holdings, 254 CM rate of 10.66%.See concluding (1999). no basis There is Winn-Dixie, at 113 T.C. 594-95, 606; court’s factual at that the district mortality realize deviated potential large differentials had These transferred plans its COLI industry practice gains because standard insurance insurers, ag- mortality risk strong incentive to very and created that its clearly erroneous was gregate, throughout policy loans taking continue were plans Dow’s COLI conclusion Holdings, 254 plan. See CM the life aas was erroneous neutral not contrast, there B.R. at 585-86. AEP. under law matter of between differential much smaller crediting and loaned unloaned MetLife Purpose Subjective Business III. unloaned rates, and Dow’s Great West Dow’s COLI study close A identical. crediting were rates loaned same that Dow’s shows Dow, 789. Dow’s shams found those rates were be- crediting unloaned MetLife Winn-Dixie, and that Dow 6.81%, loaned credit- and its tween 4% for the sole into did not enter 4% and 8.65%. were between ing rates sham avoidance. The of tax purpose higher un- negotiated Dow also at 789. features a number plans shared poli- MetLife crediting rate for the loaned avoid- of tax purpose a sole that indicated at 809. year 18. Id. begin cies to operated First, taxpayers ance. crediting rate choices and loaned unloaned possi- highest chose plans always those loans cap policy encouraged Dow loans, or policy for their ble interest rates $50,000 into its COLI and invest cash they thought rates the highest at least year. 17th after Hold- scrutiny. See CM pass IRS Winn-Dixie, 100; 254 F.3d 301 at ings, AEP, Holdings, CM taxpayers The Elec., at F.Supp.2d 1315; 136 F.3d at Am. also discontinued their and Winn-Dixie high, commercial- choice of such The 787. passed the Health Congress plans after because was rational rates ly unreasonable Portability Accountability and Insurance max- to taxpayers rates those allowed (HIPAA) out the phased Act of 1996 in- without interest deductions imize their plans even on COLI deductions interest spread 1% to the fixed cost creased due corporate purposes proposed their though and the rate interest the loan between expenses did funding retiree benefit In con- value. policy on the credited rate plans. See cancellation require commercially reason- trast, Dow chose 740; Holdings, 301 F.3d 326 loans based policy for its able interest rate Winn-Dixie, 101; 254 F.3d at F.3d at typical Average, a Moody’s Corporate contrast, stopped paying policy rate for regulatory-favored policies, but oth- premiums on MetLife Dow, F.Supp.2d at 813. 250 loans. intact after the its COLI kept erwise also offered The sham Dow, F.Supp.2d HIPAA. passage of greatly exceed- crediting rates loaned to There is no reason conclude at 793-94. For crediting rates. unloaned ed their lacked economic that Dow’s COLI unloaned in CM example, substance. of 4% or greater crediting rate was company, by the insurance rate declared Evidentiary Rulings IV. be- crediting rate varied and the loaned given its treat- majority opinion, The 13%; and the approximately tween 9% issue, substance” the “economic ment of an unloaned plan offered Winn-Dixie argu- government’s address crediting does not loaned and a crediting rate of 4% ment the district court abused its lecturer in the Federal Rules of Evidence. excluding discretion in protest Dow’s IRS He would have had in mind policy “ letters as conduct or “[evidence state- objective of Rule 408 ‘weigh the need compromise negotiations” ments made in for such against evidence potentiality under Fed.R.Evid. 408. Dow’s pro- IRS discouraging negotia- settlement ” test letters included cash-flow illustrations tions.’ See Sportswear Trebor Co. v. $50,000. capped that did not show loans Stores, Inc., (2d Limited 865 F.2d Dow, 250 F.Supp.2d at 802. Cir.1989) (citation omitted). court’s factual government The argues also that Dow’s protests Dow submitted the in compromise protests should not have been excluded negotiations is reviewed for clear error. they because were being offered to im- Trans Union Credit Co. v. Associat Info. peach rather than prove liability or Servs., Inc., ed Credit 192 damages. The district court found that (6th Cir.1986). ruling The court’s that the there is little difference between using a protests were inadmissible is reviewed for statement to impeach the liability denial of an abuse of discretion. United States v. and offering prove liability it to and there- (6th Cir.2001). Logan, 250 F.3d fore refused to apply the pur- “another government argues The pro- pose” exception of Fed.R.Evid. 408 and test letters were not “made in compromise Dow, admit the evidence. negotiations” they were filed with at 805. the IRS Examination Division rather than I agree that using settlement evidence Division, Appeals whose mission is to impeach the denial of liability is virtual- Dow, resolve tax controversies. ly indistinguishable using it prove F.Supp.2d at It asserts that the Ex- liability; both equally uses would discour- amination Division’s investigation process age negotiations. settlement do not We an adversarial one that involves deter- review the district evidentiary court’s rul- mining whether the IRS erred. novo, ing de and I am satisfied the district given district court found judge did not abuse his discretion. undisputed large corporate facts that tax- payers protest majority the vast of IRS Y. Conclusion great disallowances and that the majority I respectfully dissent I disagree because settled, protests of those are Dow reason- majority’s with conclusion aas ably believed that it pro- must first file a law, matter of profits contingent test before it could Appeals reach the Divi- taxpayer action are relevant to the eco- compromise sion and its claim. Id. at 805- nomic inquiry only substance when that basis, Largely on this the district comports action with the actual protests found that the were “made past conduct particular related to that in compromise negotiations” and excluded transaction. I disagree my also col- with them under Rule 408. Id. at 806. I am leagues’ conclusion that Dow’s unable conclude that the district court’s neutral and that the dis- factual regarding pro- Dow’s IRS trict court in distinguishing erred the mor- clearly tests was erroneous. tality features of Dow’s COLI from Federal trial courts have wide discretion those in the sham-COLI cases. in determining whether to admit offers of I judgment would affirm the purpose.” settlement for “another favor District Lawson, Judge David I judge the trial be- believe that the district low, nationally recognized is a writer and court correctly applied this court’s eco- doctrine, not commit did substance

nomic the NPV accepting error

legal abuse its discre- did expert,

of Dow’s letters protest excluding Dow’s

tion clear evidence, not commit and did findings. factual making its central

error America, STATES

UNITED

Plaintiff-Appellee, (04-5101) and

George BLOOD William (04-5261),

Stephen L. Crittenden

Defendants-Appellants. 04-5101, 04-5261.

Nos. Appeals, States Court

United

Sixth Circuit. 1, 2005. Nov.

Argued: Jan. and Filed:

Decided

Case Details

Case Name: The Dow Chemical Company v. United States

Court Name: Court of Appeals for the Sixth Circuit

Date Published: Jan 23, 2006

Citation: 435 F.3d 594

Docket Number: 03-2360

Court Abbreviation: 6th Cir.