internal_revenue_service national_office technical_advice_memorandum date number release date index uil no case mis no taxpayer's name taxpayer's address taxpayer's identification no years involved date of conference legend taxpayer sub insurer regulator administrator a administrator b actuary a actuary b analyst p1 p2 year year year year year year year year year year year year year year year year month a month b month c month d month e date date date date date date date date date date date date date state a state b state c number a number b number c number d number e number f number g number h number j dollar_figurea dollar_figureb dollar_figurec dollar_figured dollar_figuree dollar_figuref dollar_figureg dollar_figureh dollar_figurej dollar_figurek dollar_figurem dollar_figuren dollar_figurep dollar_figureq dollar_figurer dollar_figures dollar_figuret dollar_figureu dollar_figurev dollar_figurew dollar_figurex dollar_figurey dollar_figurez dollar_figureaa dollar_figurebb dollar_figurecc dollar_figuredd dollar_figureee dollar_figureff dollar_figuregg dollar_figurehh dollar_figurejj dollar_figurekk a b c d e f g h j k m n p q r s t u v w x issues whether taxpayer’s two broad-based corporate-owned life_insurance coli programs plans p1 and p2 were shams in substance thereby precluding taxpayer from claiming deductions under sec_163 with respect to interest_expenses incurred on policy_loans whether taxpayer paid four of the first seven years’ annual premiums for its coli policies by a means other than indebtedness thereby satisfying the four- out-of-seven safe_harbor set forth at former sec_264 and the accompanying regulations conclusions taxpayer purchased its coli programs pursuant to a plan that lacked objective economic_substance and lacked subjective business_purpose we conclude that taxpayer's broad-based p1 and p2 plans were shams in substance therefore taxpayer is not permitted to claim interest deductions pursuant to sec_163 with respect to interest incurred on the coli policy_loans during the years in issue taxpayer satisfied the four-out-of-seven safe_harbor set forth at sec_264 although taxpayer received refunds_of_premiums with respect to the p2 plan policies this did not result in a substantial increase in premiums that requires the seven-year testing_period to begin anew moreover taxpayer’s receipt of certain experience-based premium refunds with respect to the second through fourth years of the p2 plan policies did not cause borrowing in those years to exceed premiums for purposes of sec_1_264-4 since that provision generally requires that premiums be determined without regard to such experience-based refunds thus no portion of taxpayer’s borrowing in the second through fourth policy years can be allocated to the first policy year lastly the retroactive attachment of the fixed interest rate rider to the p1 plan policies did not change the terms of the policies to a degree sufficient to require a new 7-year testing_period for those policies although we conclude that taxpayer has satisfied the four-out-of-seven safe_harbor taxpayer may not unless otherwise indicated section references are to the internal_revenue_code_of_1986 and the accompanying regulations as amended and in effect during the taxable years at issue in congress redesignated former sec_264 as sec_264 see pub_l_no a 111_stat_788 since the first seven policy years of the p1 and p2 policies occurred prior to we refer to the four-out-of-seven test in former sec_264 deduct interest on policy_loans because the p1 and p2 plans as a whole were shams in substance for purposes of sec_163 facts the taxable years in issue are year sec_11 through during those years taxpayer’s predecessor company was a public_utility organized under the laws of state a and regulated by regulator which regulated public_utilities in state a this case arises out of taxpayer’s participation in a highly leveraged broad-based coli program wherein taxpayer purchased life_insurance policies on the lives of number a of its employees taxpayer purchased the policies as part of two separate plans the p1 plan which taxpayer purchased in month a year comprised of number b policies and the p2 plan which taxpayer purchased in month b year comprised of number c policies taxpayer was the beneficiary of these life_insurance policies background of life_insurance due to the complexity of the p1 and p2 plans we shall first explain the basic principles of life_insurance before discussing the specific facts in this case there are two types of life_insurance policies term_insurance policies which provide a death_benefit for a specified term of years and whole_life_insurance policies which provide a death_benefit throughout the life of the insured insurers determine the premium charged for term_insurance policies on the basis of the actuarially-calculated cost of providing the specified death_benefit during the term of the policy this cost which varies on the basis of the insured’s age and the size of the death_benefit is referred to in the insurance industry as the cost of insurance coi insurers determine the premium charged for whole_life_insurance policies on the basis of the actuarially-calculated cost of providing death_benefits throughout the insured’s life thus the premiums charged for a whole_life_insurance policy during earlier policy years typically involve a prefunding of coi charges for later policy years due to this prefunding of future mortality costs the policyholder of a whole_life_insurance policy may accumulate and invest a portion of its premium payments in an account referred to as the policy’s cash_value in contrast term life_insurance policies typically have no cash values see generally kenneth black jr and harold d skipper jr life_insurance prentice hall 12th ed the insurance_company will increase accumulated cash_value by crediting to the policyholder amounts in the nature of interest in this sense the policyholder’s cash for convenience we refer to both taxpayer and its predecessor company as taxpayer the premiums for both term and whole life policies also include in addition to coi charges amounts to pay for the insurer’s administrative costs and to provide the insurer with a profit value is similar to an interest-bearing bank account the source of these additional credits is the income generated by the insurance company’s investments this additional_contribution to the policyholder’s cash_value is referred to as inside_buildup the owner of a whole life policy may use loans or withdrawals to access the policy’s cash_value during the insured’s lifetime policy_loans are typically structured as a loan from the insurance_company to the policyholder with the policy’s cash_value serving as collateral for the loan the loan is deemed to have been made from the general assets of the insurance_company not as a withdrawal from the accumulated cash_value of the policy if the insured dies before the loan is repaid the amount of the loan and accrued loan interest is deducted from the death_benefit payable under the policy policy withdrawals whereby the policyholder withdraws a portion of the cash_value may similarly reduce the death_benefit however in contrast to policy_loans the policyholder has no obligation to repay amounts withdrawn there are two primary tax benefits arising from the ownership of life_insurance policies taxpayers may defer tax on their policy’s inside_buildup and taxpayers may exclude from income any death_benefits received pursuant to sec_101 in addition policyholders may in certain instances deduct interest incurred on policy_loans this combination of deferral of taxation of inside_buildup the exemption of taxation of death_benefits and the deductibility of interest on policy_loans has historically created the opportunity for tax arbitrage by policyholders by using an asset that produces tax- deferred income as security for a loan a taxpayer is able to deduct interest incurred on the loan while the secured asset increases in value tax free with these concerns in mind congress in enacted limitations on the deductibility of policy loan interest particularly congress amended sec_264 to provide that no deduction is allowed for amounts paid_or_accrued on indebtedness incurred or continued to purchase or carry a life_insurance_contract pursuant to a plan of purchase which contemplates the systematic borrowing of part or all of the increases in the cash_value of such contract sec_264 congress also enacted an exception to this general disallowance rule with respect to interest_paid or accrued on policy_loans incurred or continued as part of a plan whereby no part of of the first annual premiums due on the contract is paid_by means of indebtedness sec_264 this safe_harbor is commonly referred to as the four-out-of-seven safe_harbor legislative_history reflects that congress enacted these provisions with a concern that some insurance_companies were marketing insurance policies to individuals primarily as tax-saving devices s rep no reprinted in c b part congress also explained that it fashioned the four-out-of-seven safe_harbor in part to preserve the value of life_insurance generally by retaining some rights in the individual to borrow on insurance as one could in the case of other assets id pincite congress’ efforts in did not end the use of tax arbitrage associated with life_insurance corporations began purchasing coli on the lives of their employees as a means of generating large policy_loans interest deductions and tax savings congress in attempted to address this perceived abuse by eliminating the interest_deduction on policy_loans to the extent that the aggregate indebtedness exceeds dollar_figure per employee effective date sec_264 the joint_committee on taxation staff in explaining reason for this provision stated congress did not intend to allow these loans to be an unlimited tax_shelter as under prior_law see staff of joint comm on taxation 100th cong 1st sess general explanation of the tax_reform_act_of_1986 comm print in an attempt to circumvent the dollar_figure per policy limitation insurance industry specialists marketed broad-based coli programs in which a corporation purchases insurance on thousands of its non-executive employees regardless of the value of the employees’ services to the corporation thus by increasing the number of policies issued in the coli plan the corporation could increase aggregate policy_loans and loan interest deductions while remaining within the dollar_figure per policy loan limit in congress believing that these broad-based coli programs were inappropriate once again amended sec_264 by entirely eliminating the availability of policy loan interest deductions generated by coli programs except for certain key_person_insurance programs sec_264 d the joint_committee on taxation in explaining the purpose of the legislation particularly noted congress’ concern for transactions in which taxpayers borrow against the value of their policies at an interest rate only slightly higher than the interest rate at which the insurer credits inside_buildup to the policies see staff of joint comm on taxation 104th cong 2d sess general explanation of tax legislation enacted in the 104th congress comm print the joint_committee also explained that congress in amending sec_264 did not intend that taxpayers make inferences concerning the deductibility of policy loan interest_paid or incurred prior to the effective date of the legislation id pincite taxpayer’s coli transactions taxpayer when it began considering the p1 and p2 plans provided life_insurance benefits to its retired employees in the amount of of a retired employee’s salary as of the date of retirement taxpayer paid for these benefits as part of a pay-as-you- in congress also enacted sec_163 which disallows deductions for personal_interest consequently life_insurance tax arbitrage plans were no longer marketed to individual taxpayers after the effective date of this legislation since individuals could no longer deduct interest incurred on policy_loans we note that taxpayer purchased the p1 and p2 plans prior to the date effective date of the dollar_figure per policy limitation nevertheless given the number of policies that taxpayer purchased we consider taxpayer’s coli programs to be broad-based taxpayer also provided death_benefits to employees who died prior to retirement go program administered by administrator a and recovered the cost of the benefits from its customers through the rates set by regulator in year a life_insurance broker broker who was developing taxpayer’s executive compensation plans advised taxpayer that taxpayer faced a large unfunded_liability attributable to the life_insurance benefits provided to its retired employees in year broker estimated the liability at approximately dollar_figurea by the following year broker’s estimate had grown to dollar_figureb broker recommended that taxpayer fund the liability by purchasing coli on the lives of some of its employees naming taxpayer as the beneficiary taxpayer rejected broker’s proposal due to concerns over the proposal’s regulatory treatment and financial feasibility during year broker attempted to reduce taxpayer’s post-retirement life_insurance liability by advising taxpayer to create a new benefits program whereby taxpayer’s employees aged years or older would retain eligibility for post-retirement life_insurance benefits but employees younger than age would not be eligible for such benefits broker further recommended that taxpayer switch the plan_administrator from administrator a to administrator b but continue to pay for the program on a pay-as- you-go basis broker’s goal was to address both taxpayer’s liability and taxpayer’s concerns regarding administrator a’s expenses and customer service problems in conjunction with these proposals broker also offered to taxpayer a new coli plan whereby taxpayer would purchase whole_life_insurance on its employees aged years or older broker suggested that the cost of the coli plan be paid_by taxpayer’s shareholders rather than through taxpayer’s rate base broker requested actuary a an actuarial consulting firm to review broker’s proposal to taxpayer by letter to broker dated date year actuary a explains that the purposes of the proposed coli plan were to fund one-half of the death_benefits payable to active employees aged and over all of the post-retirement death_benefits for current employees aged or older and all of the death_benefits for existing retirees who were nonetheless not lives actually insured under the proposed policies an appendix attached to the letter contains four individual policy illustrations that describe a plan whereby taxpayer pays four out of the first seven annual premiums in cash pays the remaining three premiums through policy_loans borrows heavily from the policies’ cash_value in each policy year after the seventh and deducts policy loan interest for federal_income_tax purposes at a bracket of actuary a concludes that broker’s proposal when viewed as an investment produces a net after-tax rate of return to taxpayer over the life of the policies in the amount of a taxpayer refers to these pay-as-you-go programs as cost plus plans whereby taxpayer pays the administrator for the cost of accrued death_benefits plus administrative expenses this liability fluctuated on the basis of the number of eligible employees and wage inflation specifically actuary a explains the large write-off of the life_insurance program has created a tax savings which substantially reduces the cost of the employee_benefits program taxpayer initially agreed with broker’s advice switching its benefit plan_administrator to administrator b and purchasing a coli plan which it identified as p1 in month a year dollar_figure taxpayer however did not implement broker’s advice to stop providing post- retirement life_insurance benefits for employees aged younger than years the p1 plan was comprised of number b policies insuring employees aged years or older had a total face value of dollar_figurec and an annual premium of dollar_figured the policies were written by insurer a company with a home_office in state b the p1 policies were held by a state b multiple employer trust and taxpayer was issued trust certificates representing taxpayer’s ownership_interest in the policies broker in month c year proposed that taxpayer purchase from insurer an additional coli plan beyond the p1 plan coverage that taxpayer purchased in month a year broker prepared a written proposal dated date year with a supplement dated date year in an attempt to convince taxpayer to purchase the additional insurance the proposal explains that prior to purchasing the p1 plan taxpayer had decided to reduce its potential post-retirement death_benefit liabilities by implementing a new post-retirement benefits program into which all existing employees could opt particularly the proposal notes that prior to purchasing the p1 plan taxpayer had initially agreed with broker’s advice to limit eligibility in the existing benefits program to employees aged and over but eventually decided to allow all existing employees the opportunity to remain in the existing plan due to moral or perhaps legal_age discrimination concerns with respect to taxpayer’s purchase of an additional coli plan broker’s proposal specifically sets forth an estimate of taxpayer’s liability for post-retirement death_benefits based on various assumptions regarding the rate of salary increase attrition and the number of employees electing to forgo post-retirement benefits to join taxpayer’s new post-retirement benefit program a proposed coli plan in which taxpayer will purchase an additional number d policies with an initial face_amount of dollar_figuree each whereby taxpayer will pay premiums in the first fifth sixth and seventh policy years borrow heavily from the policy cash values to pay premiums for the second third taxpayer is unable to locate the original policy illustrations underlying the p1 broker’s projected liability is between dollar_figuref and dollar_figureg with an anticipated liability of plan dollar_figureh fourth and eighth policy years and all policy years thereafter anticipated cash flows from the proposed coli plan projected over years and expressed in terms of after-tax outlays rather than in terms of death_benefits receivable and an internal_rate_of_return analysis of various coli products offered by different companies broker’s proposal does not indicate that the anticipated death_benefits payable from the coli policies would be fashioned to correspond with taxpayer’s liability to pay death_benefits to its retired employees regarding the timing of taxpayer’s proposed purchase of the new coli plan broker’s proposal also recommends that i t would be ideal to wait until the fall of year to exactly measure the liability and increase the reinsurance funding at that time however imminent tax law changes are anticipated in this vein broker’s proposal explains that insurer will allow cancellation of the new coli plan less commissions and pure mortality charges if tax laws are enacted that adversely affect the designed operation of the plan on date year insurer’s senior vice president sent to taxpayer a honeymoon letter regarding pending tax legislation affecting coli the letter states this is to assure you that in the event legislation affecting policyholder taxation is enacted and is effective prior to date year which in the opinion of taxpayer is substantially adverse we will do all in our power to provide an alternate funding vehicle for you if it remains impossible to amend the policy or provide an alternate funding vehicle insurer will allow immediate cancellation p remiums will be refunded at that time to the extent that premiums are in excess of the term cost of providing protection from the effective date of the policies to the date of cancellation soon after receiving broker’s proposal taxpayer purchased an additional coli plan identified as p2 which was comprised of number c policies insuring taxpayer’s employees between the ages of and dollar_figure the policies were written by insurer and had an initial total face value of dollar_figurem and annual premiums of dollar_figuren in similar fashion to the p1 policies the p2 policies were held by a state b multiple employer trust and taxpayer was issued trust certificates representing taxpayer’s ownership_interest in the taxpayer purchased nearly four times more than the number of policies recommended in the proposal broker’s 30-year projected after-tax cash_flow is between dollar_figurej and dollar_figurek depending upon taxpayer’s desired funding level for the proposed plan broker’s low- end estimate of after-tax cash_flow is more than two times greater than dollar_figureg broker’s high-end estimate of taxpayer’s post-retirement death_benefit liability taxpayer is unable to locate the original policy illustrations underlying the p2 plan policies even after purchasing the p1 and p2 plans taxpayer maintained the pay-as- you-go program administered by administrator b features of the p1 and p2 policies the p1 and p2 policies were whole life policies with level premiums until age and an initial face_amount of dollar_figuree for each life the death_benefits payable under the p1 and p2 policies increased annually however the annual death_benefit for the p2 policies increased by approximately b while the annual death_benefit for the p1 policies increased by approximately c moreover the annual death_benefit increases for the p2 policies continued to the end of the contract whereas the death_benefit increases for the p1 policies continued only until age the coi under the p1 and p2 policies was determined on the basis of the age of each participant the monthly cost of insurance rates per dollar_figure of coverage and the guaranteed death_benefit factor set forth on each policy’s data page in addition to the coi charges insurer imposed several other charges including a front-loaded expense charge imposed only during the first ten policy years based on the participant’s age at the inception of the policy with an initial charge imposed during the first policy year and a lower charge imposed during policy years two through ten a percentage expense charge which was a contractually-fixed percentage of the annual premium as stipulated on the data page of each policy and a flat fee for each policy in force at the beginning of the policy year in the amount of dollar_figurer for each p1 policy and dollar_figures for each p2 policy the p2 plan also contained provisions whereby taxpayer could receive premium refunds on the basis of the following a first year policy volume discount equaling k of gross premiums payable for that year a guaranteed mortality profit contribution refund payable for the first five policy years and a fluctuation reserve contingency payment in effect throughout the term of the policies the k volume premium discount reduced the premiums payable for the first policy year from dollar_figuret to dollar_figureu the other two refund provisions were based on the actual claims experience of the p2 policies the guaranteed mortality profits contribution was equal to m of the difference for example a policy covering -year old participant in the p2 plan was subject_to a dollar_figurep monthly expense charge in the first policy year and a dollar_figureq monthly expense charge for policy years two through ten the percentage expense charge for the p1 policies ranged from d to e based on the policy year and age of the participant the percentage expense charge for the p2 policies were solely determined on the basis of policy year as follows f for policy year one g for policy years two through five h for policy years six through ten and j for each year thereafter between the cost of insurance and death_benefits paiddollar_figure the fluctuation reserve contingency payment although involving an elaborate calculation was similarly designed to refund to taxpayer a portion of the excess of actual claims paid over the cost of insurance particularly after the fifth policy year since the p1 and p2 policies were whole_life_insurance policies taxpayer was eligible to obtain policy_loans from insurer and insurer credited the policies’ cash_value with inside_buildup the policies provided for three relevant interest rates the interest rate that taxpayer paid on policy_loans the loaned crediting rate which was the rate at which insurer would credit the portion of the policies’ cash_value that was used to secure policy_loans and the unborrowed crediting rate which was the rate at which insurer would credit the portion of the policies’ cash_value that was not used to secure policy_loans taxpayer could borrow up to n of the cash_value from the p1 policies and p of the cash_value from the p2 policies thus the principal and interest accrued and unpaid on policy_loans could not exceed the policies’ cash_value taxpayer could repay policy_loans at any time but the loans did not have to be repaid until the death of the insured party under the provisions of the policies taxpayer was eligible to choose annually from one of two policy loan interest rate options a variable option and a fixed option under the variable option taxpayer would pay an interest rate on policy_loans determined by the moody’s corporate bond yield average published by moody’s investors service inc as of two months before the plan anniversary if the moody’s rate had not fluctuated more than number f basis points during the policy year then the prior year’s rate would applydollar_figure if taxpayer chose the variable option insurer guaranteed that the loaned crediting rate would be equal to number g basis points less than the policy loan rate for p1 policies and number h basis points less than the policy loan rate for p2 policiesdollar_figure accordingly regardless of the interest rate applicable to policy_loans under the variable option taxpayer’s actual cost of borrowing remained constant because there was a pre-determined spread between the loan interest rate and the loaned crediting rate under the fixed option taxpayer could elect to pay interest on policy_loans at a rate equal to the moody’s corporate bond yield average rate in effect two month prior to the policies’ issue_date but the loaned crediting rate was declared by thus if the cost of insurance charges were dollar_figure and the death_benefits payable was dollar_figure the refund to taxpayer under the mortality profit contribution provision was m of dollar_figure a basis point is equal to one hundredth of one percent the policy forms provided that if any part of the total cash_value is subject_to a loan the interest rate applicable for that part of the total cash_value shall be at a rate which is number g basis points for the p1 plan and number h basis points for the p2 plan less than the loan interest rate in effect insurer and not expressly guaranteeddollar_figure the fixed option was attached as a rider to the p2 policies when those policies were issued and was retroactively attached to the p1 policies at the same time approximately four months after taxpayer purchased the p2 policies broker sent a letter to taxpayer dated date year which explains the tax and regulatory motivations underlying the fixed and variable interest rate options in relevant part the letter provides an insurance_company can only guarantee in the policy the actuarial rates that are used to generate the values of the policy an obvious problem arises when a variable loan interest rate policy is used another constraint is an income-tax issue if for example the moody’s rate at policy issue wa sec_12 and the current rate was how can a taxpayer justify paying the high rate the internal_revenue_service easily could disallow the deduction as simply being for tax purpose sic only why else would you pay more interest than you had to the solution to these issues is an annual option that taxpayer will have option a variable rate option - loan interest rate determined by moody’s - spread on p1 number g basis points - spread on p2 number h basis points or option b fixed rate option - loan interest rate equal to rate in effect at issue - spread not a guaranteed rate but rather a declared rate specifically the policy forms for the fixed rate rider provided that if any part of the total cash_value is subject_to a loan the interest rate credited on that part of the total cash_value shall be an effective rate of interest of q for the p1 plan and c for the p2 plan or any higher rate set by us this solution solves insurer’s dilemma because they are not guaranteeing rates in excess of model law constraintsdollar_figure this solution solves taxpayer’s potential tax issues because you can justify paying the higher loan interest because at the time of your decision you did not have a guarantee of what rate would be credited there was a risk element to justify your higher interest_expense if interest rates rise above the levels at issue the contractual provision will apply option a and option b won’t be necessary although the fixed interest rate option did not expressly guarantee a specific loaned crediting rate due to state regulatory concerns taxpayer and insurer understood that if taxpayer elected the fixed rate option insurer would use a loaned crediting rate that produced the identical pre-determined spread that was expressly available under the variable interest rate option ie number g basis points for the p1 policies and number h basis points for the p2 policies concerning the manner in which insurer intended to exercise its discretion to declare a loaned crediting rate if taxpayer elected the fixed interest rate option broker’s date year letter further explains t he bottom line of all of this is the arbitrage could be reduced if insurer chose to treat taxpayer badly this is extremely unlikely they could only treat taxpayer badly once and on subsequent anniversary taxpayer could choose option a or drop the policy therefore the purpose of the fixed rate rider was to create a floor rather than a ceiling on the rate of interest that taxpayer paid on policy_loans since taxpayer’s actual cost of borrowing was reflected in the pre-determined spread between the policy loan interest rate and the loaned crediting rate taxpayer had no economic incentive to it appears that the model law constraints that broker refers to are those set forth by the national association of insurance commissioners naic model policy loan interest rate bill which the naic first adopted in see proceedings of the national association of insurance commissioners i pp sec_3 of the model bill limits the interest rate charged on policy_loans to the higher of moody’s corporate bond yield average for the calendar_year ending two months before the date on which the policy loan interest rate is determined or the rate used to compute cash surrender values under the policy during the applicable_period plus one percent per annum state b adopted these model bill provisions prior to the issuance of the p1 and p2 policies see state b code number e imposing policy loan interest rate limitations effective prior to year insurer by annually declaring the loaned crediting rate under the fixed rate option ensured that taxpayer could incur a policy loan interest rate that exceeded the moody’s average rate then in effect without violating the model bill reduce the rate of interest imposed on policy_loans to the contrary taxpayer generated more policy loan interest deductions by paying a higher rate if interest rates decreased after the policies were issued taxpayer could elect the fixed rate option thereby generating higher policy loan interest deductions than would be available under the variable option given the interest rates in effect when the policies were issued the fixed rate option ensured the taxpayer would pay interest on p1 policy_loans at no lower than r and on p2 policy_loans at no lower than s taxpayer’s administration of the p1 and p2 policies the following tables summarize taxpayer’s actual cash_flow resulting from the p1 and p2 plans from their inception through the taxable years at issue p1 plan dollars in thousands policy year ending premiums a policy_loans b loan interest c net death_benefits d pre-tax cash_flow b d-a-c tax savings e net after- tax cash_flow b d e-a-c p2 plan dollars in thousands policy year ending premiums a policy_loans b loan interest c net death_benefits d pre-tax cash_flow b d-a- c tax savings e net after- tax cash_flow b d e-a-c the tables reflect that consistent with actuary a’s illustrations concerning the p1 plan and broker’s proposal concerning the p2 plan and in an effort to comply with the four- out-of-seven safe_harbor set forth in sec_264 both the p1 and p2 plans were structured so that taxpayer would pay out-of-pocket for premiums in the first fifth sixth and seventh policy years and borrow from policy cash values to pay premiums for the second third fourth policy years the plans were further designed so that taxpayer could borrow against most of the policies’ remaining cash values in the eighth policy year and all policy years thereafter as of date year taxpayer’s total net equity in the p1 and p2 policies was dollar_figurev representing t of the total gross cash_value of the policiesdollar_figure the term net equity refers to a policy’s cash_surrender_value less any loans or interest accrued on loans secured_by the policy as explained the p2 plan contained provisions whereby taxpayer could receive premium refunds in certain instances taxpayer received the following premium refunds during the first seven years of the p2 policies dollars in thousands policy year ending gross premium volume discount refund net premium guaranteed mortality refund and fluctuation reserve contingency refund after purchasing the p1 and p2 plans taxpayer formed a subsidiary sub for the purpose of holding the ownership certificates for the p1 and p2 policies taxpayer capitalized sub with dollar_figurew in cash and transferred to sub its ownership_interest in the p1 and p2 policies the dollar_figurew payment was in an amount calculated to allow sub to pay for further anticipated premiums and policy expenses through month b year the end of the seventh policy year for the p2 policies after which taxpayer anticipated that the p1 and p2 policies would pay for themselves and provide net excess cash for taxpayer’s use taxpayer did not recover the initial costs of the p1 and p2 policies from its ratepayers thus taxpayer’s shareholders paid the up-front cost associated with the coli plans moreover taxpayer’s shareholders not the ratepayers paid the pay-as-you-go cost of taxpayer’s post-retirement death_benefit program after taxpayer purchased the p1 and p2 plansdollar_figure taxpayer further intended that any after-tax benefits generated by the p1 and p2 plans net of the pay-as-you-go cost of its post-retirement death_benefit program be directed solely to its shareholders as explained infra several years after purchasing the p1 and p2 plans taxpayer began recovering from its ratepayers the cost of providing post-retirement death_benefits on date year less than a year after purchasing the p2 plan taxpayer implemented a new employee_benefits program taxpayer’s new program limited eligibility for post-retirement death_benefits to all of its then active and retired employees this was less restrictive than broker’s initial recommendation which would have limited such benefits to active employees then aged or older nevertheless taxpayer’s new program reduced its projected cost for providing post-retirement death_benefits since the number of participants eligible for post-retirement benefits was fixed as of that date wage inflation was the only factor that could increase taxpayer’s liability taxpayer’s new program further provided its then active employees with an option that would provide an increased two-times salary pre-retirement death_benefit while eliminating post-retirement death_benefits any then active employees who exercised this option further reduced taxpayer’s liability for post-retirement benefits in year broker retained actuary b to perform an actuarial study projecting taxpayer’s post-retirement death_benefit liabilities and comparing them to the projected cash flows from the p1 and p2 plans the study dated month d year indicated that taxpayer in implementing its new employee_benefits program reduced its potential liability for post-retirement death_benefits payable to its then current or retired employees by between u and k additionally the study calculated the after-tax cash flows expected from the p1 and p2 plans under the assumption that taxpayer would borrow heavily from policy cash values and claim federal_income_tax deductions for interest accrued on policy_loans which in turn would generate positive cash_flow for taxpayer by reducing its tax_liability the study sets forth two different illustrations with varying marginal federal_income_tax rates and present_value discount factors the study concludes that as of the beginning of year the potential gain from the p1 and p2 plans determined by subtracting the present_value of future post-retirement death_benefit liabilities from the present_value of future after-tax earnings expected from the p1 and p2 plans is as follows after-tax present_value of p1 and p2 plans including experience refunds present_value of post- retirement group liabilities for current and future retirees net present_value assuming marginal tax_rate and discount rate assuming marginal tax_rate and discount rate according to the actuarial study the present after-tax value of the p1 and p2 plans as of the beginning of year was between and times greater than taxpayer’s projected liability for post-retirement death_benefits in this regard actuary b’s study concludes taxpayer has substantially covered its projected post-retirement liabilities with expected gains from corporate-owned life_insurance as a result taxpayer may want to utilize some of the extra gains for covering the liabilities of other post-retirement programs during the same month in which actuary b prepared its actuarial study broker prepared a document called sub dividend scenarios which explains what taxpayer can do with the positive cash flows generated by the p1 and p2 plans payable to taxpayer in the form of dividends from sub broker suggests that taxpayer in addition to using the dividends to pay for post-retirement death_benefits use the dividends for post-retirement health care costs executive salary continuation dividends to taxpayer’s shareholders deferred benefits for taxpayer’s directors and other expenses actuary b’s study also sets forth the following -year projection of annual after-tax expected cash flows from the p1 and p2 policies for year sec_2 through assuming a marginal tax_rate and a interest rate a pre-tax cash_flow loan proceeds and net death_benefits received less premiums and interest payable b tax_benefit from interest_deduction c after-tax cash_flow b - a thus the projections indicate that but for the tax benefits derived from policy loan interest deductions taxpayer’s cash_flow from the p1 and p2 plans would result in a loss of dollar_figurex the projections further indicate that except for year sec_4 and the p1 and p2 plans would generate negative pre-tax cash flows for each year between year and year taxpayer has had policy_loans outstanding on the p1 and p2 policies during each policy year after the first policy year taxpayer has chosen the fixed interest rate option each year and the interest rate taxpayer has paid on policy_loans has exceeded market interest rates for most of the time that the p1 and p2 plans have been in effect consistent with broker’s assurance reflected in the letter dated date year insurer declared a loaned crediting rate under the fixed rate option that produced the identical pre-determined spread between the policy loan interest rate and loaned crediting rate as was expressly available under the variable rate option ie number g basis points for the p1 policies and number h basis points for the p2 policies in contrast the unborrowed crediting rate was based on current u s treasury bill rates subject_to a minimum rate therefore since taxpayer first began borrowing from the p1 and p2 policies the unborrowed crediting rate has fluctuated on the basis of market conditions and has always been less than the loaned crediting rate the following chart reflects the p1 and p2 policies’ annual policy loan interest rates annual loaned crediting rates annual unborrowed crediting rates moody’s corporate average monthly bond rates and insurer’s annual portfolio earnings rates unborrowed crediting rate high low p1 loan interest rate loaned crediting rate p2 loan interest rate loaned crediting rate calendar_year in which policy year began the table reflects that during the five taxable years in issue taxpayer paid interest on p1 policy_loans at a rate that was between and greater than moody’s corporate average monthly bond rates and paid interest on p2 policy_loans at a rate that was between and greater than the moody’s rate moody’s corporate avg monthly bond rate high low insurer’s portfolio earnings rate as noted previously the p1 and p2 policies were initially held by a state b multiple employer trust and were subject_to the laws of state b in year however the fixed insurer’s portfolio earnings rate represents insurer’s total net_investment_income divided by the average of the beginning and ending cash and invested asset portfolio balances option policy loan interest rate for the p1 policies exceeded the interest rate permitted under state b’s usury lawsdollar_figure accordingly insurer transferred the master policies to a pre-existing multiple employer trust located in state c where there were no such restrictions on policy loan interest rates taxpayer’s reporting of the p1 and p2 transactions for financial_accounting and regulatory purposes when taxpayer purchased the p1 and p2 plans for purposes of its financial statements it accounted for its post-retirement death_benefit liabilities on a pay-as-you- go basis which was consistent with the manner in which taxpayer paid administrators a and b for those liabilities in date however the financial_accounting standards board fasb issued statement no employers’ accounting for postretirement benefits other than pensions fa sec_106 fa sec_106 which was generally effective for fiscal years beginning after date requires employers to estimate and accrue the expected cost of providing an employee’s post- retirement benefits during the years in which the employee renders the necessary service consequently for financial_accounting purposes taxpayer could no longer accrue post-retirement benefits as they arose but rather had to accelerate the liabilities while the employees were active fa sec_106 also imposed a transition cost attributable to post-retirement liabilities that were deemed accumulated and accrued under fa sec_106 but which had arisen in years prior to implementation of fa sec_106 and had not yet been recorded as an obligation under a pay-as-you-go accounting_method during year and after the issuance of fa sec_106 regulator approved a rate settlement agreement with taxpayer that addressed the accounting and regulatory treatment of taxpayer’s liabilities for post-retirement benefits the agreement and subsequent amended agreements permitted taxpayer to recover the cost of its post- retirement life_insurance liabilities from its ratepayers on a pay-as-you-go basis and permitted taxpayer to amortize and recover from its ratepayers over twenty years any transition costs resulting from the implementation of fa sec_106 accordingly the agreement permits taxpayer to fully recover from its ratepayers the cost of its post- retirement life_insurance program the after-tax cash_flow generated by the p1 and p2 plans although initially allocated in part towards the cost of taxpayer’s post-retirement death_benefit liabilities is no longer needed to pay for such liabilitiesdollar_figure state b’s usury rate is based on the federal reserve average prime lending rate plus v in addition the after-tax cash_flow generated by the p1 and p2 plans continue to be directed to taxpayer’s shareholders rather than being used to reduce the rates charged to its customers regulator reaffirmed this in a year rate case involving taxpayer in which state a’s consumer counsel wanted taxpayer to share sub’s tax benefits with its taxpayer’s ratepayers regulator agreed with taxpayer that the in month e year taxpayer met with several representatives from bond rating agencies to discuss taxpayer’s liabilities for policy_loans relating to the p1 and p2 plans specifically taxpayer was concerned about the treatment of those loans for purposes of its financial ratings analyst taxpayer’s financial analyst who assisted taxpayer in purchasing the p1 and p2 plans prepared a document and provided it to the bond rating agencies the document explains sub’s policy loan interest_expense as follows sub’s coli has been grandfathered under the tax laws in effect before the tax reform act tra of under pre- tra rules interest_paid by corporations for loans drawn against insurance_policy cash values is fully deductible the build-up of value inside the insurance policies is tax deferred and sic since the coli is held until the death of the insured individuals all income becomes tax exempt sub’s coli was designed to take advantage of this imbalance in tax treatment it is most valuable when cash values are routinely borrowed by the policy owner - creating a beneficial tax arbitrage emphasis added the document also states this is very nearly a self-sustaining cycle the loans pay the premium and most of the interest_expense and any out-of-pocket cash needed to make up the difference comes from the tax benefits derived from the interest_expense the tax benefits make the difference between self- sustaining and self-liquidating the only way in which taxpayer’s operations support sub is indirect taxpayer must have sufficient taxable_income to offset sub’s tax benefits taxpayer’s operating income is otherwise entirely available to support taxpayer’s other indebtedness taxpayer also made a slide presentation to the bond rating agencies on date year describing the p1 and p2 policies as insurance designed to be ‘stripped’ with maximum borrowing and maximum interest and tax benefits the slides indicate that the policies will result in pre-tax losses to taxpayer discounted to present_value of dollar_figurey the slides further indicate however that these losses are offset by the present_value of the tax benefits dollar_figurez moreover the slides describe taxpayer’s working strategy in owning the p1 and p2 policies as reducing the tax_liability of taxpayer’s consolidated_group and as producing cash flows that contribute to the gradual growth of taxpayer’s core business and new related business ratepayers should not share the benefits since they did not incur the initial cost of the p1 and p2 plans upon examination of taxpayer’s returns for year sec_11 through encompassing policy years ten through fourteen for the p1 policies and nine through thirteen for the p2 policies the field concluded that taxpayer could not claim as deductions for income_tax purposes the interest that taxpayer incurred on loans secured_by the p1 and p2 policies the field has set forth two reasons for the proposed disallowance the p1 and p2 plans were shams in substance for purposes of sec_163 and taxpayer failed to satisfy the four-out-of-seven test set forth in sec_264 law and analysi sec_1 whether the p1 and p2 plans were shams in substance thereby precluding taxpayer from claiming deductions under sec_163 with respect to interest_expenses incurred on policy_loans at issue in this case is whether taxpayer is entitled to claim deductions under sec_163 with respect to interest incurred on loans secured_by the policies that comprised the p1 and p2 plans sec_163 provides there shall be allowed as a deduction all interest_paid or accrued within the taxable_year on indebtedness court opinions however have established that taxpayers are not entitled to claim interest deductions under sec_163 if the interest is derived from a sham_transaction aimed solely at tax_avoidance see 364_us_361 364_f2d_734 2d cir the sham_transaction doctrine originated in the supreme court in 293_us_465 in gregory the court denied reorganization treatment with respect to a stock_distribution even though the taxpayers had seemingly complied with the code’s requirements concerning reorganizations the court in deciding that the distribution was taxable as a dividend concluded that the structure of the transaction was a mere device for the consummation of a preconceived plan and not a reorganization within the intent of the code id the transaction because it lacked economic_substance was not the thing which the statute intended id courts have recognized two basic types of sham transactions shams in fact and shams in substance 862_f2d_1486 11th cir shams in fact are transactions that occurred only on paper and not in reality whereas shams in substance are transactions that actually occurred but are lacking in economic_substance see 157_f3d_231 ndollar_figure 3rd cir therefore a transaction that lacks economic_substance is not recognized for federal tax purposes and cannot give rise to a deductible expense see 31_f3d_117 3d cir the parties in this case do not dispute whether the p1 and p2 transactions occurred rather they dispute whether the transactions are shams in substance interest payments in particular are not deductible if they arise from transactions lacking purpose substance or utility apart from their anticipated tax consequences goldstein supra pincite the fact that an enforceable debt exists between the borrower and lender is not determinative of whether the debtor may deduct interest arising from that debt see wexler supra pincite rather the transaction as a whole of which the debt is a part must have economic_substance before the debtor may deduct the interest see 113_tc_254 aff’d 254_f3d_1313 11th cir otherwise every tax_shelter no matter how lacking in substance could generate an interest_expense_deduction as long as there was a real creditor in the transaction that demanded repayment in determining whether a transaction constitutes a sham in substance both a majority of the courts of appeals and the tax_court have employed a flexible two-pronged analysis that focuses on two related factors economic_substance apart from tax consequences and business_purpose see acm partnership supra pincite 924_f2d_1018 11th cir 899_f2d_905 10th cir 899_f2d_724 8th cir 868_f2d_851 6th cir kirchman v commissioner supra pincite winn-dixie supra pincite whether a transaction has economic_substance is determined by an objective evaluation of how the transaction alters the taxpayer’s economic position aside from tax benefits see kirchman supra pincite in doing so it is appropriate to analyze the transaction in its entirety rather than isolate any single step id pincite4 whether a transaction has legitimate business_purpose is determined by a subjective analysis of the taxpayer's intent see acm partnership supra pincite three recent court opinions have addressed whether certain broad-based coli transactions had sufficient economic_substance and business_purpose to permit the owners of the underlying policies to deduct interest incurred on policy_loans under sec_163 in each case the court concluded that the coli plans at issue lacked economic_substance and business_purpose the first of the three courts that have recently addressed broad-based coli transactions is the united_states tax_court see winn-dixie supra in winn-dixie the taxpayer purchased a coli plan comprised of big_number policies on the lives of its employees the taxpayer purchased the plan pursuant to a pre-arranged scheme whereby the taxpayer would systematically borrow from the policies in order to pay premiums the taxpayer paid an interest rate of on policy_loans and the insurer provided the taxpayer with a loaned crediting rate of on leveraged cash values thereby producing a fixed spread of basis points in contrast the insurer provided the taxpayer with a crediting rate of percent on unborrowed cash values the promoters of the coli plan in winn-dixie provided the taxpayer with detailed projections of costs and benefits expected from the plan over a 60-year period particularly the projections indicated that during each policy year the plan would generate a pre-tax loss and a significant after-tax profit attributable to deductions for policy loan interest and administrative fees the plan contemplated that the taxpayer would maintain little net equity in the policies relative to the size of the plan the court in winn-dixie first addressed whether the coli plan possessed sufficient objective economic_substance the taxpayer argued that the coli plan could produce tax-independent benefits if the insureds died earlier than anticipated thereby producing unexpected death_benefits the court recognized that life_insurance may be legitimate even where its predictable cost exceeds its predictable benefits if the policy protects the beneficiary against the financial consequences of the insured’s untimely death the court however found that the taxpayer did not purchase the plan to provide death_benefit protection noting the large number of geographically dispersed insureds and the fact that the employees remained insured even after their employment was terminated id pincite the court further observed that although there would be some variation between the anticipated and actual mortality of the big_number insureds such variations were not expected to significantly affect the plan viewing the coli plan as a whole and noting the annual discrepancy between pre-tax losses and after- tax profits set forth in the promotional material the court found that the plan’s only function was to reduce the taxpayer’s income_tax liabilities id pincite thus the court concluded the plan lacked economic_substance the court in winn-dixie next addressed whether the taxpayer had a sufficient subjective business_purpose for entering into the coli transaction the taxpayer argued that its business_purpose for entering into the transaction was to generate funds to pay for the increasing cost of its employee_benefits program which included limited death_benefits the court rejected this argument explaining that there was no indication that the coli policies were tailored to fund the taxpayer’s employee_benefit_plan and that employees remained insured after they left the taxpayer’s employ id pincite in addition the court explained that even if the taxpayer had earmarked the coli plan’s tax savings to fund its employee_benefits that would not be sufficient to breathe substance into the transaction otherwise reasoned the court every sham tax_shelter device might succeed id pincite moreover the court noted that the taxpayer was offered an exit strategy to terminate the plan if new legal limitations were imposed upon taxpayer’s interest deductions thereby suggesting that the purported business_purpose for the plan was not sufficient to maintain the plan without the plan’s tax benefits id pincite thus the court concluded that the coli plan served no business_purpose for the taxpayer other than to reduce its taxes the next two opinions that addressed broad-based coli transactions were in re c m holdings inc 254_br_578 d del and 136_fsupp2d_762 s d ohio which involved similar coli transactions based upon policies issued by the same insurer in c m holdings and a e_p the taxpayers purchased coli plans comprised of big_number and approximately big_number policies respectively the coli plans in c m holdings and a e_p in similar fashion to the coli plan in winn-dixie contemplated a scheme whereby the taxpayers would systematically borrow from the policies to pay premiums the taxpayers in c m holdings and a e_p before purchasing the coli plans received financial illustrations indicating that the coli plans would generate annual pre-tax losses and significant after-tax profits primarily attributable to deductions for policy loan interest the courts in both cases described the features of the plans as follows high policy value on the first day of the policy maximum policy_loans used to pay high premiums during the first three policy years zero net equity and maximum borrowing at the end of each policy year perfected through the use of computer programs a variable interest rate provision whereby the taxpayer could choose the interest rate that it paid on policy_loans a fixed spread between the policy loan rate and the loaned crediting rate with the counterintuitive result that the higher the loan interest rate paid_by the taxpayer the greater the cash_flow due to increased tax deductions and extremely high expense load components for the fourth through seventh policy years which were used to create policyholder dividends that could be used to pay premiums a e_p supra pincite c m holdings supra pincite in addressing whether the coli plans at issue lacked objective economic_substance the courts in c m holdings and a e_p compared the plans’ economic effects on a pre- tax and after-tax basis the courts first noted that according to the financial illustrations provided to the taxpayers before they purchased the coli plans the plans were projected to generate negative pre-tax cash flows and positive after-tax cash flows over the life of the plansdollar_figure the courts further explained that the taxpayers did not expect to derive material economic gain from the non-tax beneficial components of the coli plans ie tax deferred inside build-up and tax-free death_benefits specifically the courts reasoned that inside build-up was not a motivating factor since the coli policies were designed to have zero net equity at the end of each policy year a e_p supra pincite c m holdings supra pincite the courts further noted that the fixed spread between the policy loan interest rate and loaned crediting rate precluded the taxpayer from receiving any non-tax economic benefit from inside build-up despite the fact that the policy loan rates themselves were variabledollar_figure a e_p supra pincite c m holdings supra pincite in concluding that the taxpayers did not purchase the coli plans with an expectation of receiving death_benefits the courts reasoned that the the court in c m holdings particularly observed that even assuming that the taxpayer’s coli plan were to generate positive pre-tax cash flows in the fifty-third through eighty-first years of the plan it would not confer economic_substance upon the transaction because the taxpayer failed to establish that the aggregate present_value cash_flow from the plan provided a reasonable return in the absence of loan interest deductions see c m holdings supra pincite the court in a e_p explained that although the policy loan interest rate was variable which in turn varied the amount of tax savings derived from the transaction that fact did not imbue the plan with economic_substance a e_p supra pincite policies were designed to be mortality neutral insofar as the parties expected that the cumulative coi charges paid_by the taxpayers would equal the cumulative death_benefits that the taxpayers would receive a e_p supra pincite c m holdings supra pincite in addition to addressing whether the taxpayer sought to generate inside build-up and receive death_benefits in excess of cost the court in a e_p expressed particular concern that the parties in designing the policies’ interest rate provisions exploited a loophole in the naic model bill discussed supra at n in an attempt to ensure that the taxpayer would always pay a policy loan interest rate in excess of the moody’s corporate average rate a e_p supra pincite in so doing the court stated when a transaction is structured so that the borrower actually benefits from a higher loan interest rate and the borrower is permitted to choose its own interest rate from a range of rates that begins with a rate that far exceeds the industry maximum the interest rate component of the transaction lacks economic_substance id pincite thus the courts in c m holdings and a e_p concluded that the coli plans lacked economic_substance the courts in c m holdings and a e_p next addressed the parties’ subjective business_purpose for entering into the coli transactions the taxpayer in c m holdings argued that it entered into the coli transaction for the legitimate purpose of providing for the increasing cost of its employees’ medical benefits whereas the taxpayer in a e_p argued that it entered into the coli transaction for the legitimate purpose of offsetting the cost of implementing fa sec_106 both courts rejected the taxpayers’ arguments emphasizing that the business_purpose test is whether the underlying transaction has a legitimate purpose not whether the taxpayer has a legitimate use for the after-tax cash flows generated by the transaction a e_p supra pincite c m holdings supra pincite the court in c m holdings particularly noted the taxpayer’s concern with pending tax legislation manifested by a honeymoon letter and an attempt to execute the transaction before congressional hearings on coli began as further indication that the coli plan’s critical feature was its ability to generate interest deductions c m holdings supra pincite thus finding that the earnings generated by the coli plans were tax-driven the courts concluded that the plans served no legitimate business_purpose a whether the p1 and p2 plans had objective economic_substance we now address whether the p1 and p2 transactions at issue in this case have sufficient objective economic_substance apart from their tax benefits viewing the transaction as a whole unlike the parties involved in the three published coli opinions the parties in this case did not submit precise plan illustrations issued contemporaneously with the issuance of the p1 and p2 plans nevertheless other materials dated prior to or recently after issuance of the p1 and p2 plans indicate that the primary purpose of the plans was to generate after-tax cash flows for taxpayer through the use of policy loan interest deductions actuary a’s illustration dated just prior to issuance of the p1 plan refers to the plan as an investment based on the after-tax rate of return generated by the large write-off of the life_insurance program broker’s date year proposal with respect to the p2 plan similarly refers to the benefits of the proposed plan in terms of after-tax outlays with benefits generated by policy loan interest deductions in this regard the proposal also assures taxpayer of insurer’s willingness to unwind the transaction in the event that congress enacts adverse tax legislation as indicated by the honeymoon letter dated date year subsequently provided to taxpayer by insurer most significantly actuary b’s study of the p1 and p2 plans dated month d year sets forth the anticipated pre-tax and after- tax effects of the plan and projects negative pre-tax cash flows from the plans for all but two of the years between year and year particularly actuary b’s study projects that over a -year period the p1 and p2 plans will result in combined pre-tax losses of dollar_figurex and positive after-tax cash flows of dollar_figureaa this wide difference is primarily due to the interest deductions generated by policy loan interest deductions the projections in actuary b’s study are consistent with taxpayer’s year description of the plans to bond rating agencies as insurance designed to by ‘stripped’ and as possessing maximum interest and tax benefits the wide difference in this case between anticipated pre-tax losses and positive after-tax cash flows indicates that the p1 and p2 plans lacked economic_substance apart from tax benefits see a e_p supra pincite c m holdings supra pincite winn-dixie supra pincite the policies’ interest rate provisions further indicate that policy loan interest deductions were the primary feature of the plan broker’s date year letter to taxpayer explains that insurer fashioned the policies with fixed and variable interest rate options so that the interest that taxpayer paid on policy_loans would never decrease after the policies were issued the fixed rate option was available if interest rates decreased and the variable rate option was available if interest rates increased the fixed interest rate rider in particular exploited a loophole in the naic model bill regarding policy loan interest limitations by doing so taxpayer was able to pay interest on policy_loans at a rate that far exceeded market interest rates while taxpayer paid high interest rates on policy_loans insurer annually declared a loaned crediting rate under the fixed rate option in an amount that created the same pre-determined spread between the loaned crediting rate and policy loan interest rate as was available under the variable rate option accordingly both taxpayer’s cost of borrowing and insurer’s profit were fixed regardless of the rate of interest taxpayer paid on policy_loans the higher policy loan interest_deduction generated by higher policy loan interest charges coupled with the fixed cost of borrowing led to the counter-intuitive result that taxpayer actually benefitted more from the transactions on an after-tax basis as policy loan interest rates increased see c m holdings supra pincite not surprisingly when the usury laws of state b threatened to limit policy loan interest rates the policies were transferred to a_trust administered in state c where no such limitations existed as explained by the court in a e_p supra pincite the interest rate component of a transaction lacks economic_substance where the borrower actually benefits from a higher loan interest rate and the borrower is allowed to choose its own interest rate including those that far exceed the current market rates taxpayer argues that the p1 and p2 plans had economic_substance for four reasons taxpayer first argues the transactions materially changed its economic position because taxpayer had significant cash values in the p1 and p2 policies and had the expectation of receiving significant death_benefits specifically taxpayer argues that it paid dollar_figurebb out-of-pocket for premiums during four of the first seven policy years taxpayer further argues that at the end of the seventh policy years the policies had accumulated death_benefit protection of dollar_figurecc and net equity of dollar_figuredd taxpayer also contends that if everyone insured in the p1 and p2 plans died in the same year it was entitled to receive death_benefits from the policies net of policy_loans of dollar_figureee in the first policy year increasing to dollar_figureff during the sixteenth policy year additionally taxpayer maintains that unlike the plans set forth in c m holdings and a e_p the p1 and p2 plans were not designed to be mortality neutral because taxpayer expects to receive dollar_figuregg in death_benefits in excess of the coi for the policies taxpayer further argues that had it not leveraged the policies it would receive total death_benefits less expenses in the net amount of dollar_figurehh taxpayer correctly asserts that the expectation of inside build-up and death_benefits are two non-tax benefits associated with owning life_insurance nevertheless we disagree with taxpayer that the p1 and p2 plans provided taxpayer with any economic benefits aside from generating tax deductions turning first to taxpayer’s expectation of accumulating inside build-up we note that although taxpayer temporarily accumulated cash_value by paying cash for four of the first seven years’ premiums taxpayer broker and insurer assumed from the inception of the plans that taxpayer would have little or no net equity in the policies after the seventh policy year economic_substance is determined on the basis of the p1 and p2 transactions as a whole viewed in the aggregate over the life of the plans we are required to weigh the fact that there was some economic benefit during any one year of the plan against the economic consequences of the plan over its duration see c m holdings supra pincite given the anticipated pre-tax losses that the p1 and p2 plans were expected to generate over their duration the fact that taxpayer generated cash_value in the seventh policy year does not imbue the plans with economic_substance regarding taxpayer’s expectation of receiving death_benefits from the p1 and p2 plans actuary b’s study projects that the p1 and p2 plans including expected net death_benefits received will result in negative pre-tax cash flows of dollar_figurex over years we agree with taxpayer that in some instances it is inappropriate to analyze the economic benefits of life_insurance in terms of pre-tax profit expectations because the predictable cost of maintaining life_insurance may exceed predictable death_benefits and nevertheless be justified by the financial protection that insurance provides against the insured’s untimely death what taxpayer actually argues then is that its need for financial protection against the untimely death of its employees justifies the expected pre-tax cost of the p1 and p2 plans in this case however taxpayer purchased insurance on a large number of non-executive employees who remained covered even after leaving taxpayer’s employ thus there was little likelihood that expected cash flows from the plan would be significantly affected by discrepancies between the insureds’ actuarially anticipated mortality used to determined the coi and the insureds’ actual mortality see winn-dixie supra pincite for that reason whether taxpayer could have generated a windfall from death_benefits if many insureds died in the same year is irrelevant since the likelihood of such an event is remote similarly although the p1 and p2 plans are not mortality neutral in the same manner as the plans in c m holdings and a e_p it is improbable that the actual mortality experience of the p1 and p2 plans will be sufficient to justify the plan’s projected pre-tax costdollar_figure accordingly we disagree with taxpayer that its expectation of receiving death_benefits confers economic_substance upon the p1 and p2 plans we also disagree with taxpayer’s assertion that because it would receive death_benefits in the amount of dollar_figurehh had it not borrowed from the p1 and p2 policies the p1 and p2 plans possessed economic_substance taxpayer attempts to analyze the economic effects of the transactions by assuming that the policy_loans never occurred this is inconsistent with the economic_substance analysis performed by the three courts that have addressed coli transactions the proper economic_substance analysis of a coli transaction as set forth by the courts is to examine the objective economic effects of the entire transaction absent its tax benefits this contemplates comparing the pre-tax and after-tax consequences of the transaction including the cost of paying interest on policy_loans a e_p supra pincite c m holdings supra pincite winn- dixie supra pincite accordingly we reject taxpayer’s analysis in this respect which is based upon a non-existent set of facts taxpayer’s second of four arguments is that it had a legitimate non-tax motivation for electing the fixed rate loan provision even when it resulted in an interest rate on policy_loans that far exceeded current market rates specifically taxpayer contends the p2 policies purchased in year offered a fixed rate rider that would permit taxpayer to opt for a constant rate of interest over time this feature could eliminate nearly all uncertainty from the funding capability of the product and the feature was then added as a rider to the p1 policies we also note that the guaranteed mortality profit refund and fluctuation reserve contingency payments set forth in the p2 policies will reduce any mortality fluctuations with respect to those policies we disagree taxpayer’s actual cost of borrowing was the same under either the fixed or variable rate option ie the pre-determined spread of number g basis points for the p1 policies and number h basis points for the p2 policies we fail to see how the fixed rate option provided taxpayer with more certain funding in comparison to the variable rate option unless one considers the certainty of tax benefits generated by policy loan interest_paid at a fixed rate regardless of current market conditionsdollar_figure indeed a fixed loan rate provision would serve a non-tax purpose for example if it protected the borrower from subsequent interest rate increasesdollar_figure in this case however taxpayer derived greater cash_flow on an after-tax basis as policy loan interest rates increased for that reason broker’s date year letter to taxpayer indicates that the policies’ fixed rate option was fashioned to protect taxpayer in case interest rates subsequently decreased thereby maintaining taxpayer’s after-tax rate of return without regard to market interest rate fluctuations it is not surprising therefore that taxpayer was entitled to annually elect either the fixed or variable rate option and never chose the variable rate even though market interest rates decreased after the policies became effective accordingly contrary to taxpayer’s assertions the fixed rate provision was purely tax motivated taxpayer’s third of four arguments is that a revenue_ruling and applicable case law support its position that the p1 and p2 plans have economic_substance taxpayer taxpayer’s description of the fixed rate option as providing certain funding for the plan is also inconsistent with the terms of the fixed rate rider which permits insurer to annually declare the loaned crediting rate this is further indication that taxpayer and insurer understood that the annually declared loaned crediting rate under the fixed rate option would produce the identical spread as was expressly available under the variable rate option taxpayer cites the blue_book explanation of certain amendments to sec_264 in as indication that congress approved of fixed loan interest rate provisions with respect to contracts purchased prior to date see staff of joint comm on taxation 104th cong 2d sess general explanation of tax legislation enacted in the 104th congress comm print specifically congress in imposed limitations upon the policy loan interest rate that taxpayers could use to generate interest deductions and set forth in sec_264 an exclusion from such limitations for certain contracts with fixed rate provisions purchased prior to date in providing this exclusion however congress did not intend to permit interest deductions under sec_163 for transactions that otherwise lacked economic_substance and business_purpose see winn-dixie supra pincite explaining that we are not persuaded that congress by enacting and amending sec_264 intended to allow interest deductions under sec_163 based on transactions that lacked either economic_substance or business_purpose thus we must determine whether the p1 and p2 transactions as a whole are substantive shams before turning to the legislative_history underlying sec_264 maintains that revrul_71_309 1971_2_cb_168 where the service concluded that interest incurred on policy_loans was deductible is controlling the ruling is similar to the facts in this case in that the taxpayer in the ruling satisfied the four-out-of-seven test set forth in sec_264 and intended to pay the premiums for the eighth and all succeeding policy years under a plan that contemplated the systematic borrowing of part or all of the increases in the cash_value of the policy nevertheless we consider the ruling to be inapposite the ruling involved one life_insurance_policy with the policyholder’s wife and children designated as beneficiaries in contrast the facts in this case involve broad-based plans comprising many insured lives where it is contemplated that pre-tax cash flows net of expected death_benefits will be negative over the duration of the plans the ruling also assumes that except for the policy_loans no other taxpayer- adverse factors were present by comparison in this case additional factors not present in the ruling indicate that the p1 and p2 plans lack economic substancedollar_figure taxpayer also contends that the fifth circuit’s economic_substance analysis in 377_f2d_688 5th cir is applicable to the facts in this case we disagree in cen-tex the taxpayer was a family-owned_corporation that purchased leveraged life_insurance policies on the lives of its employee-stockholders on the basis of the parties’ stipulation that the insurance policies in issue were purchased to meet the taxpayer’s deferred_compensation obligations and to provide insurance on its key employees the court concluded that the transaction possessed economic_substance because the transaction produced benefits other than tax benefits the court in winn-dixie in rejecting the argument that cen-tex was controlling distinguished winn-dixie’s coli transaction by emphasizing the plan’s predictable negative cash_flow absent its tax benefits winn-dixie supra pincite likewise the court in c m holdings distinguished cen-tex by noting that the plan in cen-tex was purchased to provide the taxpayer with insurance protection from financial losses in the event that its key employees died c m holdings supra pincite similar to the plans in winn-dixie and c m holdings the p1 and p2 plans in this case are expected to generate predictable pre-tax losses over their duration and are broad-based plans that are not targeted towards taxpayer’s key employees accordingly we conclude that cen-tex is not controlling in this case in addition taxpayer cites 916_f2d_1414 9th cir as instructive shirar is distinguishable from the facts in this case because the facts in shirar involved one policy purchased to fund potential estate_tax liabilities and the the ruling does not provide that every leveraged life_insurance transaction that satisfies the four-out-of-seven test has economic_substance per se cf winn- dixie supra pincite explaining that while the parties agree that the taxpayer’s coli plan meets the four-out-of-seven test sec_264 does not confer a right upon the taxpayer to take the deduction that would not otherwise be allowable under sec_163 taxpayer’s plan of purchase contemplated the accumulation of cash_value and an expectation of receiving death_benefits in excess of the cost of the policies taxpayer’s last argument is that the service cannot use taxpayer’s pattern of borrowing which it claims satisfies sec_264 as a basis for concluding that the p1 and p2 plans lack economic_substance for purposes of sec_163 although taxpayer acknowledges that compliance with sec_264 does not ensure deductibility of policy_loans under sec_163 taxpayer contends that the service cannot use taxpayer’s decision to borrow heavily from policy values in the eighth policy year as a negative factor in analyzing the economic_substance of the p1 and p2 plans taxpayer further argues that sec_264 represents congress’ decision to draw a clear line between abusive and permissible borrowing against life_insurance policies we disagree sec_264 only applies to what is otherwise allowable under sec_163 thus a transaction lacking economic_substance and business_purpose does not generate deductible_interest under sec_163 regardless of whether it meets the requirements of sec_264 see c m holdings supra pincite winn-dixie supra pincite as indicated by revrul_71_309 transactions generating policy loan interest may possess sufficient economic_substance for purposes of sec_163 although the taxpayer intends to pay the premiums for the eighth and all succeeding policy years by borrowing from increases in the policy’s cash_value nevertheless an analysis of that transaction’s tax-independent economic_substance must take such borrowing into account because the borrowing will typically affect the transaction’s non-tax economic consequences by increasing interest costs and reducing net cash values and net death_benefits therefore we consider it appropriate to consider taxpayer’s decision to borrow from the p1 and p2 policies’ cash values during the eighth and all succeeding policy years in analyzing the economic_substance of the plans moreover other factors apart from taxpayer’s particular pattern of borrowing indicate that the p1 and p2 plans lack economic_substance including anticipated aggregate pre-tax losses and the policy loan interest rate provisions accordingly we conclude that taxpayer’s p1 and p2 plans lack objective economic_substance apart from generating tax benefits b whether the p1 and p2 plans had a legitimate subjective business_purpose we now address whether taxpayer had a subjective business_purpose for engaging in the p1 and p2 transactions other than tax_avoidance taxpayer alleges that before entering into the p1 and p2 transactions it had become concerned with the increasing pay-as-you-go costs associated with its post-retirement death_benefit program and that it decided to implement the p1 and p2 plans as a means of paying for such costs particularly taxpayer contends that if left unchecked its undiscounted future liabilities for post-retirement death_benefits as of mid-year could have totaled a maximum of dollar_figurejjdollar_figure indeed both actuary a’s date year letter and broker’s date year proposal indicate that taxpayer purchased the p1 and p2 plans in part to fund its post- retirement death_benefit liabilities despite taxpayer’s assertions however there is no documentation indicating that the anticipated death_benefits payable from the p1 and p2 policies were tailored to fund those liabilities rather it appears that taxpayer structured the plans in order to pay for its post-retirement death_benefit liabilities through tax savings rather than death_benefits we first note that the policies remained in effect even if individual insureds left taxpayer's employ prior to retirement moreover actuary b’s projections of cash flows from the plans completed only one year after taxpayer purchased the p2 plan indicate that the p1 and p2 policies’ anticipated death_benefits and net cash values alone would not satisfy taxpayer's premium and policy loan obligations only when the tax benefits of the interest deductions are taken into account do the plans generate cash_flow to pay for taxpayer’s liabilities the honeymoon letter which allowed taxpayer to terminate the p2 policies in the event congress enacted new legal restrictions on interest deductions further indicates that the p2 policies would not provide taxpayer with satisfactory cash_flow absent the tax benefits derived from policy loan interest deductions see c m holdings supra pincite winn-dixie supra pincite in this vein broker’s date year proposal presented to taxpayer before it purchased the p2 plan sets forth after- tax cash-flow projections for coli plans issued by various insurers so that taxpayer could compare the cumulative net after-tax effects of each plan furthermore actuary b’s study also projects that the p1 and p2 plans will generate tax savings to times greater than was needed to fund taxpayer’s post-retirement death_benefit liabilities and recommends that taxpayer utilize some of the extra gains for covering the liabilities of other post-retirement programs similarly broker’s document sub dividend scenarios suggests that taxpayer in addition to paying for its retired employee’s death_benefits use the after-tax cash_flow from the p1 and p2 plans to pay for post-retirement health care costs executive salary continuation dividends to taxpayer’s shareholders deferred benefits for taxpayer’s directors and other expenses in addition although the p1 and p2 plans were expected to generate more than enough after-tax cash_flow to provide for taxpayer’s cost of providing post- retirement death_benefits taxpayer subsequently began recovering that cost from its ratepayers thereby allowing taxpayer to use all of the cash_flow from the plans for purposes other than its initial ostensible purpose these are further indications that taxpayer’s maximum liability is based on a year study which assumes that all current and future employees would be eligible to receive post-retirement death_benefits accordingly the study sets forth various scenarios depending upon employee population growth rate attrition and wage inflation taxpayer made little effort to tailor the p1 and p2 plans in an effort to meet its post- retirement death_benefit liabilities we also note that even after purchasing the p1 and p2 policies taxpayer separately maintained a plan operated by administrator b that administered taxpayer’s post- retirement death_benefit program on a pay-as-you-go basis thus taxpayer maintains that it paid insurer for insurance in order to fund future payments to administrator b for coverage of the same liabilities taxpayer therefore incurred redundant administrative expenses by maintaining two separate insurance plans to pay coverage for the same liability ie the lives of its retired employees were the p1 and p2 policies primarily designed to fund taxpayer’s liability for its employee’s post-retirement death_benefits we doubt that taxpayer would have needed to maintain its plan with administrator b taxpayer argues that actuary b’s year study does not accurately reflect taxpayer’s liabilities for post-retirement death_benefits as they existed when taxpayer purchased the p1 and p2 plans specifically taxpayer contends that actuary b’s estimates of taxpayer’s liabilities are not helpful because those estimates incorporate cost-reducing changes that taxpayer implemented in its benefit program on date year subsequent to the date in which taxpayer purchased the p1 and p2 plans taxpayer maintains that its own year study where it estimated its maximum liability at dollar_figurejj is more accurate than actuary b’s study because taxpayer’s study projects liabilities on the basis of taxpayer’s employee benefit program as it existed when taxpayer purchased the p1 and p2 policies we disagree broker’s date year proposal to taxpayer indicates that prior to purchasing the p1 and p2 plans taxpayer had decided to implement a new employee benefit program that would reduce taxpayer’s liabilities the proposal further explains that prior to purchasing the p1 plan taxpayer decided to limit eligibility in its existing program to employees aged and over but decided to allow all existing employees the opportunity to stay in the program due to moral or perhaps legal_age discrimination concerns accordingly when taxpayer purchased the p1 and p2 plans taxpayer was also contemplating various cost-reducing changes in its employee_benefits program actuary b’s study is the most accurate estimate available of taxpayer’s post-retirement death_benefit liability because that study incorporates cost- reducing changes similar to those that taxpayer was considering at the time that it purchased the p1 and p2 plans given that taxpayer was anticipating reducing employee eligibility for post-retirement death_benefits when it purchased the p1 and p2 plans we also doubt the reliability of taxpayer’s own calculated estimates completed in year which assume that all current and future employees will continue to receive such benefitsdollar_figure in addition a letter by broker to taxpayer dated date year indicates that approximately g of taxpayer’s employees did not participate in its group_life_insurance program even prior to the implementation of taxpayer’s new program on therefore we conclude that taxpayer purchased the p1 and p2 plans to fund its employee death_benefit liabilities and other unrelated liabilities with the plans’ positive after-tax cash_flow which was solely generated by policy loan interest deductions accordingly taxpayer’s liability for post-retirement employee_death_benefits is no different than the employee_death_benefits discussed in winn-dixie winn-dixie supra pincite that a taxpayer has a valid use for the after-tax gains generated from a transaction does not confer upon the transaction a valid business_purpose see a e_p supra pincite winn-dixie supra pincite the possibility that the tax benefits from the p1 and p2 plans could have been used as a general source of funds for taxpayer's post-retirement death_benefit obligations or any other business_purpose does not alter the fact that the p1 and p2 plan served only to reduce taxpayer’s income_tax liabilities accordingly we conclude that taxpayer did not engage in the p1 and p2 transactions with a legitimate business_purpose other than tax_avoidance on the basis of all the aforementioned considerations we find that taxpayer purchased the p1 and p2 policies pursuant to a plan the only function of which was to generate interest deductions in order to offset income from other sources and thereby significantly reduce its income_tax_liability we conclude that taxpayer's broad-based p1 and p2 plans were shams in substance accordingly taxpayer is not permitted to claim interest deductions pursuant to sec_163 with respect to interest incurred on p1 and p2 policy_loans for year sec_11 through whether taxpayer paid four of the first seven years’ annual premiums for the p1 and p2 policies by a means other than indebtedness thereby satisfying the four-out-of-seven safe_harbor set forth at sec_264 and the accompanying regulations the parties dispute whether taxpayer met the requirements of the four-out-of-seven safe_harbor set forth in sec_264 with respect to taxpayer’s premium payments for the p1 and p2 policies since we have concluded that taxpayer may not claim deductions for the interest incurred on policy_loans because the p1 and p2 plans are substantive shams for purposes of sec_163 our determination of whether taxpayer satisfied the four-out-of-seven test will not affect our ultimate conclusion that the interest incurred on the p1 and p2 policy_loans is not deductible nevertheless we shall address whether taxpayer satisfied the four-out-of-seven test on the assumption that the policy loan interest was otherwise legitimate sec_264 generally disallows deductions for interest_paid or accrued on loans taken against a life_insurance_policy pursuant to a plan of purchase which contemplates the systematic direct or indirect borrowing of part or all of the increases in the cash_value of the policy sec_264 provides an exception to this general date year rule specifically sec_264 provides that if no part of any four annual premiums due in the first seven-year period of an insurance_contract is financed by means of indebtedness then the general_rule of sec_264 will not apply the flush language of sec_264 further provides that for purposes of applying the four-out-of-seven test if there is a substantial increase in premiums on the contract a new 7-year period with respect to such contract shall commence on the date the first such increased premium is paid see also sec_1_264-4 the legislative_history of sec_264 indicates the congressional intent underlying sec_264 and the flush language in relevant part the legislative_history provides the interest_deduction is to be allowed if there is no borrowing with respect to any four of the annual premiums payable on the insurance_contract in the first years of the contract however to prevent avoidance of this provision by taking out a contract with very low premiums for the first years with the premiums being substantially greater thereafter the bill contains a rule relating to situations of this type it is provided that the 7-year period referred to above is to commence again at any time there is substantial increase in the premiums payable under the insurance_contract s rep no reprinted in c b part thus the flush language contemplates situations whereby a taxpayer attempts to circumvent the meaning of the four-out-of-seven test by paying four very low annual premiums without borrowing while paying substantially higher premiums for other years with borrowing the parties in this case first dispute the effect of the p2 policies’ volume discount upon the application of the four-out-of-seven test since taxpayer received a volume discount refund of dollar_figurekk with respect to the first policy year of the p2 policies the parties dispute whether the first policy year’s premium should be measured on a basis net of the volume discount for purposes of the four-out-of-seven test assuming that the first policy year’s premium is measured on a net_basis the parties also differ as to whether net_premiums for the second policy year represent a substantial increase from the net_premiums payable in the first policy year thereby triggering a new four-out-of-seven testing_period commencing in the second policy year since taxpayer borrowed from the p2 policies during the second third fourth and eighth policy years taxpayer would not satisfy the four-out-of-seven test if the second policy year’s net_premiums represented a substantial increase from the first policy year’s net_premiums given the facts of this case even if we were to accept the argument that it is appropriate to measure premiums on a net_basis in applying the four-out-of-seven test there would not be a substantial increase in premiums from the first to second policy years the second year’s premiums net of the guaranteed mortality and fluctuation reserve contingency refunds represent only a w increase over the net_premiums for the first policy year there are no similar increases in the net_premiums for subsequent years and the premium refunds under the policies are not payable or determinable until the end of each policy year therefore the w increase in net_premiums from the first to second policy years is not a substantial increase under sec_264 accordingly we reject the argument that the volume discount payable with respect to the first policy year of the p2 policies precludes the taxpayer from meeting the four-out-of-seven test the parties next dispute whether the guaranteed mortality and fluctuation reserve contingency refunds paid with respect to the second through fourth policy years of the p2 policies should be used to allocate a portion of the loans in those years to the first policy year sec_1_264-4 provides in part for purposes of subdivision i of this subparagraph if during a 7-year period referred to in such subdivision the taxpayer borrows with respect to more than one annual premium on a contract such borrowing shall be considered first attributable to the premium for the current policy year and then attributable to premiums for prior policy years beginning with the most recent policy year an example in the regulations indicates that this provision contemplates situations where a taxpayer borrows from a policy an amount in excess of that policy’s annual gross premium in the year of the borrowing see sec_1_264-4 ex in such an instance the loan is first considered attributable to the current year’s premiums and any excess borrowing is deemed attributable to prior years’ premiums taxpayer’s p2 policy_loans for the second through fourth policy years were equal to the gross annual policy premiums for those years but less than the premiums actually paid net of the guaranteed mortality and fluctuation reserve contingency refunds thus if we consider the annual premiums for the second through fourth policy years on a net_basis the loans for such years would exceed such premiums and the excess would be deemed as borrowing attributable to the first policy year’s premium taxpayer therefore would be deemed to have borrowed from the policy for the first four policy years and thereby fail the requirements of the four-out-of-seven safe_harbor we disagree that the premiums for the second through fourth policy years of the p2 policies should be viewed net of the guaranteed mortality and fluctuation reserve contingency refunds for purposes of sec_1_264-4 example set forth at sec_1_264-4 of the regulations suggests that premiums should be viewed on a gross basis for purposes of sec_1_264-4 this is also consistent with sec_1_264-4 which measures certain premium fluctuations in terms of stated annual premiums due on a contract these provisions in the regulations were not intended to measure premiums net of experience-based refunds or dividends otherwise a taxpayer attempting to comply with sec_264 could not be certain that future contingent refund payments would cause policy_loans to fail the four-out-of- seven testdollar_figure we also note that the guaranteed mortality and fluctuation reserve contingency refunds for the second though fourth policy years represented only x of the gross premium due during those years this is not akin to the situation contemplated in example of the sec_1_264-4 where a taxpayer pays the first four policy premiums without borrowing and essentially borrows from those premiums in the fifth policy year by borrowing far in excess of the fifth year’s gross annual premium accordingly we reject the argument that premiums for the p2 policies should be viewed on a net_basis for purposes of applying sec_1 d ii lastly the parties dispute whether the fixed policy loan interest rate rider attached to the p1 policies in year number j months after the policies were issued results in a new four-out-of-seven testing_period for the p1 policies beginning in the second policy year particularly the parties dispute whether the rider constitutes such a substantial change in the p1 policies that the policies should be deemed reissued in year since taxpayer borrowed from the p1 policies during the second third fourth and eighth policy years taxpayer would not satisfy the four-out-of-seven test if the p1 policies were deemed reissued in year the parties dispute the applicability of cases supporting the principle that for purposes of sec_1001 changes in the interest rates of a debt_instrument may result in a taxable_exchange of that debt_instrument see eg 166_f2d_27 2nd cir holding that exchange of bonds for new bonds with lower interest rates and extended maturity dates was a taxable_event in this case however the issue is not whether the p1 policy_loans were exchanged for new loans upon the effective date of the fixed rate rider rather the issue is whether the p1 policies used to secure policy_loans changed so substantially as to commence a new 7-year testing_period for purposes of sec_264 accordingly the cases cited by the parties concerning exchanges of debt instruments are not applicable in the present case the legislative_history underlying the enactment in of the dollar_figure per policy loan limitation presently set forth at sec_264 is helpful as previously discussed the dollar_figure per policy limitation is not applicable to policies issued prior to date the following colloquy between senator dole and senator packwood addresses whether a policy issued prior to date will be subject_to the dollar_figure per policy limitation when certain changes to the policy are implemented after that date mr dole section of h_r limits the interest_deduction on indebtedness in excess of dollar_figure per insured under certain life this is distinguishable from a situation where a premium refund is a pre- arranged factual sham see c m holdings supra pincite explaining that the premium for purposes of the four-out-of-seven test is determined net of loading dividends that were determined to be factual shams insurance policies the limitation applies only to indebtedness under contracts purchased after date concern has been expressed about whether this provision will apply to a policy purchased on or before date if the policy is changed in a way that was contemplated by the parties and is customary with respect to such insurance i would appreciate confirmation of my understanding that none of the following changes to a policy would be treated as the purchase of a new policy a change in the owner of the policy the exercise of an option or a right granted under a contract as originally issued -- including the substitution of insured but excluding conversion to term_insurance -- or a change in administrative provisions loan rates or any other item that does not affect the major terms of the policy however a policy exchanged for a policy issued by a different insurance_company would be treated as a new policy mr packwood your understanding is correct cong rec s13956-57 date emphasis added commenting on this colloquy chairman rostenkowski further added with respect to the colloquies between senator dole and senator packwood i am particularly concerned by statements which seem to validate the ability to substitute insureds under a policy and qualify under the grandfather provisions this issue was never discussed and therefore never agreed to by the conferees in addition i would like to clarify that certain factual determinations under this provision would be made by the internal_revenue_service and the courts cong rec e3391 date the legislative_history suggests that changes in a life_insurance_policy will not cause the policy to be considered reissued for purposes of sec_264 unless those changes affect the fundamental terms of the policy in this case the retroactive attachment of the fixed rate rider was solely intended to ensure that the p1 policies would generate policy loan interest deductions at a rate no lower than the applicable moody’s rate in effect when the policies were issued taxpayer and insurer understood that the spread between the loaned crediting rate and the policy loan interest rate would be identical under either the variable or fixed rate option thus taxpayer did not generate higher net cash values for any particular year by choosing the fixed rate option over the variable rate option therefore the fixed rate option was not designed to affect taxpayer’s net cash_value in the policies or increase its net death_benefits receivable although the fixed rate rider may have been tax-motivated it was not fashioned to avoid the particular requirements of the four-out-of-seven test accordingly we conclude that the retroactive attachment of the fixed interest rate rider to the p1 policies did not result in a new 7-year testing_period for purposes of sec_264 on the basis of the aforementioned considerations we conclude that taxpayer satisfied the requirements of the four-out-of-seven safe_harbor with respect to its payment of premiums for the p1 and p2 policies nevertheless because we also conclude that the p1 and p2 plans were shams in substance taxpayer is not permitted to claim interest deductions on policy_loans during the taxable years at issue caveat s a copy of this technical_advice_memorandum is to be given to the taxpayer s sec_6110 of the code provides that it may not be used or cited as precedent