NU Online News Service, Jan. 13, 2004, 5:36 p.m. EST, Washington – The U.S. Supreme Court today let stand a lower court ruling that held that a broad-based corporate-owned life insurance policy lacked economic substance and thus did not qualify for an interest deduction on policy loans.[@@]
The high court, without comment, declined to hear an appeal of a 6th Circuit Court of Appeals ruling in the case of American Electric Power Company vs. United States, in which the Internal Revenue Service disallowed $66 million in interest deductions and assessed American Electric with an additional $25 million in taxes in a dispute over the company’s COLI policies.
The case involves a pre-1997 COLI policy which covered more than 20,000 American Electric employees. This type of policy, which some critics call “janitors’ insurance,” has not been sold since the tax code was changed in 1997.
The American Electric policy dates back to 1990 and was sold by Mutual Benefit Life.
According to the 6th Circuit Court of Appeals ruling, the COLI plan used an intricate funding mechanism that was designed to have zero equity and “mortality neutrality.”
In other words, the court said, the cost-of-insurance charges increased if more employees than expected died. Mutual Benefit Life paid American Electric a dividend if fewer employees than expected died.
American Electric also had the option of selecting from a menu of interest rate options that Mutual Benefit Life would pay on policy loans, and American Electric always picked one of the highest interest rate options, the court said.
This component of the plan was one of many provisions designed to exploit certain aspects of the Internal Revenue Code then in effect, the court said.
American Electric, the court said, understood fully that the plan would generate positive cash flow in every policy year only if it could deduct the policy loan interest from its income taxes, and it decided to implement the COLI plan on this expectation.
The IRS refused to allow the claimed deduction.
In upholding the IRS refusal, the court noted that the COLI policy met all the technical requirements of the Internal Revenue Code relating to COLI plans.
But, when it is patent that there is nothing of substance to be realized by the taxpayer from a transaction beyond a tax deduction, the deduction is not allowed despite the transaction’s formal compliance with code provisions, the court said, citing precedents.
“This is known as the economic sham, or sham-in-substance, doctrine,” the 6th Circuit said.
One of the arguments raised by American Electric as to why the plan was not a sham involves what it called its good faith intent to use the tax savings to offset dramatically increased costs due to a mandated change in accounting for employee medical benefits.
Money generated by abusive tax deductions can always be applied to beneficial causes, but the eventual use of the money is not part of the economic sham analysis, the court said.