Source: https://www.copetax.com/principal-life-insurance-united-states
Timestamp: 2019-04-20 04:54:19+00:00

Document:
On May 9, 2014, the U.S. Court of Federal Claims issued a decision in favor of the government in Principal Life Ins. Co. v. United States. The case consider the taxation of a dividend stripping transaction involving shares of a money market fund. The case is significant because it clarifies when and how tax basis is allocated when rights to receive future dividends are separated from the underlying shares.
Seeking to generate a tax loss, Principal Life Insurance Company (“PLIC”) entered into eight transactions during the period September 1996 - October 2001 involving investments known as custodial share receipts (“CSRs”). The CSRs were not identical, but they shared certain characteristics. PLIC acquired certain investments that entitled it to all dividends, appreciation and voting rights in shares of certain money market mutual funds from a custodian or trustee, except for dividends paid on the shares for a specified term of years.
PLIC also entered into three transactions during 2000 and 2001 involving investments in a trust known as perpetual securities (“Perpetuals”). The Perpetuals were similar to the CSRs in that PLIC retained a carved-out interest and sold a residual interest in shares of a money market fund. This was accomplished through a trust that issued Interest and Principal Certificates. Morgan Stanley helped arrange the Perpetuals transactions and facilitated the transactions by acquiring the Principal Certificates from the trust.
All of the investments were structured using trusts or custodial arrangements in order to allow PLIC to take the position that it should allocate the entire tax basis associated with the money market shares to the interest PLIC retained, rather than apportioning its tax basis between the carved-out and the residual interests. In general, the carved-out interest was significantly less valuable than the residual interest, and the tax basis of the carved out interest exceeded its fair market value. Due to the disparity between tax basis and value, PLIC realized a tax loss when it sold the residual interests, which is invariably did.
In 2004, the IRS issued a notice of deficiency to PLIC, inter alia, denying PLIC capital losses in the amount of $291 million and asserting additional tax due of approximately $360 million and penalties of approximately $27 million. PLIC paid these amounts and brought a claim for refund in the Court of Federal Claims.
The proper allocation of tax basis among the components of a bifurcated investment arises in various contexts. For example, a series of interest payments (coupons) may be separated from a bond and sold to an investor, or a lessor (property owner) may sell its right to receive rental payments to be received during a number of years. In some cases, the Internal Revenue Code provides a specific rule for the allocation of basis. There is also a general rule in the Treasury Regulations. Reg. § 1.61-6(a) provides in part: “When a part of a larger property is sold, the cost or other basis of the entire property shall be equitably apportioned among the several parts, and the gain realized or loss sustained on the part of the entire property sold is the difference between the selling price and the cost or other basis allocated to such part.” Apart from these authorities, there are a few judicial decisions addressing the allocation of tax basis in certain other fact patterns.
Some advisors believed that this “common law” of tax could be relied upon when a series of dividends payable on a money market fund are separated from the underlying shares and transferred to a third party in order to allocate basis in such a ways as to create a loss for one interest holder. During the period that PLIC engaged in these transactions, some banks and tax advisors marketed such transactions to generate losses. An economically similar transaction could not be done with bonds, because when a bond is stripped of its coupons, section 1286 allocates tax basis between the stripped coupons and the remaining principal and coupons by treating the stripped coupons as a separate debt instrument.
The issues in the case were presented in cross motions for partial summary judgment brought by the parties. In its opinion ruling on the motions, the court considered in detail three of the arguments presented by the government as to why PLIC’s losses should be denied. The first argument was that section 165(a), which allows a deduction for losses, is limited to actual economic losses. The second was that PLIC improperly allocated basis to the carved-out interest that it retained. The final argument was that, as to the Perpetuals transactions, those transactions created a partnership between PLIC and Morgan Stanley, rather than a trust, and that, as a result, the entire tax basis was not allocated to the Interest Certificates. The court found the first argument unconvincing, but agreed with the government on its other two. We focus our discussion on the second and third arguments.
The court was unwilling to find that under the case law, PLIC was entitled to allocate the entire tax basis of its investment to the carved-out interest that it retained. Instead, the court found Reg. § 1.61-6(a) to be controlling. The opinion includes a discussion of various cases in which taxpayers sought to separate dividends or other income from the underlying shares or investment. These cases include Estate of Stranahan v. Commissioner (sale of right to receive dividends respected) and Mapco, Inc. v. United States, (sale of future pipeline revenues treated as a loan). While the transactions in those cases are similar to PLIC’s, the court found those decisions did not address the allocation of tax basis.
The court considered one case decided by the Tax Court, Apex Corp. v. Commissioner which was favorable to PLIC on the basis allocation question, because it limited the basis allocation rule in Reg. § 1.61-6(a) to sales of tracts of a larger parcel of land. However, the court stated “Apex’s holding on this point is simply wrong and cannot be squared with the plain wording of the regulation.” The court also states that the Tax Court in later decisions rejected this limitation on Reg. § 1.61-6(a).
As noted above, the government also argued that, as to the Perpetuals transactions, those transactions created a partnership between PLIC and Morgan Stanley. When that partnership was formed, PLIC and Morgan Stanley acquired the Interest and Principal Certificates with an apportioned basis. (i.e., the entire tax basis in the shares was not allocated to the Interest Certificates as PLIC argued). The court agreed with the government on this point after analyzing the relevant Treasury Regulations, which specify when a trust arrangement having multiple classes of interests is to be respected as a trust for tax purposes or characterized as a business entity.
Under the Sears regulations, an investment trust with multiple classes of interests may be classified as a trust for income tax purposes only if it satisfies two conditions. There must be no power under the trust instrument to vary the investments of the interest holders, and, if there are multiple classes of ownership interests in the trust, these classes must be incidental to the purpose of facilitating a direct investment in the assets of the trust. After analyzing the history and purpose of the regulations, the court concluded that the Interest and Principal Certificates were not “incidental to” facilitating a direct investment in the assets of the trust.
For U.S. income tax purposes, the trust should be treated as a business entity with two owners, i.e. a partnership. Under the partnership formation rules, the tax basis in the money market shares was apportioned between the Interest and Principal Certificates when the partnership was formed. Thus, PLIC did not recognize a loss when it disposed of its Principal Certificates because its basis in its carved-out interest was equal to the value of the interest.
This case provides clarity as to the allocation of tax basis when the right to receive dividends in the future is separated from the underlying shares. The law for basis allocation in a dividend stripping transaction is now in harmony with the law for basis allocation in coupon stripping transactions. It notable that the court reached it decision under a technical analysis of the law and did not see the need to rely on any judicial doctrines, such as economic substance or step transaction.
 Fed. Cl. No. 1:07-cv-00006 (May 9, 2014).
 PLIC was no stranger to the Court of Federal Claims, having successfully sought a tax refund in 2006 with respect to an earlier, unrelated transaction. See Principal Life Insurance Co. v. United States, 97 AFTR 2d 2006-1542, (2006).
 See section 1286 (Tax Treatment of Stripped Bonds); section 305(e) (Stripped Preferred Stock).
 Also during this period, “lease strip” transactions were widely marketed. The IRS responded by making these listed transactions. Notice 2003-55, 2003-34 I.R.B. 395.
 The court refers to “a host of other grounds” that were presented by the government but not discussed in the opinion.
 472 F.2d 867 (6th Cir. 1973).
 556 F.2d 1107 (Ct. Cl. 1977).

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