The United States Supreme Court let stand last week a lower court ruling 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 Sixth Circuit Court of Appeals ruling in the case of American Electric Power Co. v. United States, in which the Internal Revenue Service disallowed $66 million in interest deductions and assessed AEP with an additional $25 million in taxes in a dispute over the companys COLI policies.
The case involves a pre-1997 COLI policy which covered more than 20,000 AEP employees. These policies, which some critics call “janitors insurance,” have not been sold since the tax code was changed in 1997.
The AEP policy dates back to 1990 and was sold by Mutual Benefit Life.
According to the Sixth Circuit Court of Appeals ruling, the COLI plan utilized 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, while MBL paid AES a dividend if fewer employees than expected died.
AEP also had the option of selecting from a menu of interest rate options that MBL would pay on policy loans, the court said.
AEP, the court said, always picked one of the highest interest rate options.
This component of the plan, the court said, was one of many provisions designed to exploit certain aspects of the Internal Revenue Code then in effect.
AEP, 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.
However, the court noted, 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 citing precedents, the court said where it is patent that when 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 transactions formal compliance with code provisions.
“This is known as the economic sham, or sham-in-substance, doctrine,” the Sixth Circuit said.
One of the arguments raised by AEP as to why the plan was not a sham involves what it called its good faith intent to utilize the tax savings to offset dramatically increased costs due to a mandated accounting change regarding employee medical benefits.
But the Sixth Circuit said that money generated by abusive tax deductions always can be applied to beneficial causes. However, the court said, the eventual use of the money is not part of the economic sham analysis.
Reproduced from National Underwriter Edition, January 16, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.