Opinion ID: 2973232
Heading Depth: 4
Heading Rank: 1

Heading: Pre-Deduction Cash Flows

Text: In each prior case addressing the economic substance of a COLI plan, the court found that, without the benefit of the claimed interest deductions, the plan generated negative cash flows. AEP, 326 F.3d at 742; CM Holdings, 301 F.3d at 103; Winn-Dixie, 254 F.3d at 1316. Indeed, we have called a COLI plan’s negative pre-deduction cash flows (that become positive when the benefit of interest deductions is considered) a “hallmark[] of an economic sham.” AEP, 326 F.3d at 742. The district court found that the Great West and MetLife plans would generate negative prededuction cash flows during their first eighteen and seventeen years, respectively. Unlike the COLI plans in AEP, CM Holdings, and Winn-Dixie, however, Dow’s plans were not projected to be cashflow negative for their entire durations. The district court found that Dow intended to infuse large sums of cash into the plans during their middle years,9 which would make the plans cash-flow positive in their later years. Because the plans were projected to have both cash-flow-negative and cash-flow-positive years, the district court applied a NPV analysis to determine the overall cash flow.10 Finally, the district court credited the discount rate utilized by Dow’s experts and found that the NPV of each plan was positive. 1991); Bryant v. Comm’r, 928 F.2d 745, 748 (6th Cir. 1991). Although there may appear to be some tension between Ratliff and our subsequent cases, we recognized in AEP that the Ratliff panel “did not specifically hold that the ultimate question of whether a transaction is a sham is to be reviewed under the clearly erroneous standard.” AEP, 326 F.3d at 742. Furthermore, employing different standards of review for the factual and ultimate questions is more consistent with the Supreme Court’s teaching that “[t]he general characterization of a transaction for tax purposes is a question of law subject to review. The particular facts from which the characterization is to be made are not so subject.” Frank Lyon Co. v. United States, 435 U.S. 561, 581 n.16 (1978). Both parties agree that although factual findings are reviewed for clear error, the ultimate question of whether the transaction is an economic sham is reviewed de novo. Appellant’s Br. at 33; Appellee’s Br. at 38. 9 The district court did not specify how large this infusion would have had to be in order to make the COLI plans profitable. Based on the following evidence and findings, however, we can infer that the figure was quite large indeed — about $315 million. With respect to the Great West plan, Dow asserts that it relied on two illustrations (Cash Flow #1 and #2) in making its purchase decision. Appellee’s Br. at 12. The district court credited “Dow’s intention to cap loans at $50,000 and withdraw only to basis,” Dow I, 250 F. Supp. 2d at 802, which reflects only Cash Flow #1, Appellee’s Br. at 9. This illustration shows cash infusions of about $30 million during the middle years. Joint Appendix (“J.A.”) at 1711. With respect to the MetLife plan, the district court credited Dow’s assertion that it relied on an illustration called Case #23. Dow I, 250 F. Supp. 2d at 809; Appellee’s Br. at 16. This illustration shows cash infusions of about $285 million during the middle years (after multiplying the illustration’s per-insured infusion by the 17,800 employees that Dow projected to be covered by the plan, Dow I, 250 F. Supp. 2d at 784-85; Appellee’s Br. at 15). J.A. at 898. 10 “In transactions that are designed to yield deferred rather than immediate returns, present value adjustments are, as the courts have recognized, an appropriate means of assessing the transaction’s actual and anticipated economic effects.” ACM P’ship v. Comm’r, 157 F.3d 231, 259 (3d Cir. 1998) (citing cases). No. 03-2360 Dow Chemical Co. v. United States Page 6 The government objects to the district court’s finding that Dow intended to inject large amounts of cash into the plans in their middle years. Reversing this finding would have a domino effect favorable to the government: it would undermine the finding that the plans would generate positive cash flows in their later years, which would in turn preclude the finding that each plan had a positive NPV. Review of this factual finding for clear error is only necessary, however, if such highly-contingent cash flows are relevant as a matter of law to the economic-sham analysis. Unfortunately, the prior COLI-plan decisions are unhelpful in resolving this legal question because in each case the court found the pre-deduction cash flow to be negative for every year of the plan, and there was no possibility of future profitability upon the materialization of some contingency.11 The Supreme Court has, however, provided useful guidance. In Knetsch v. United States, 364 U.S. 361 (1960), the Court reviewed a transaction involving the taxpayer’s purchase of $4 million worth of 30-year bonds and his simultaneous borrowing against them, which generated hundreds of thousands of dollars in interest deductions in just two years. Id. at 362-63. The taxpayer terminated the transaction after three years: he surrendered the bonds (now worth $4,308,000), his loan (now worth $4,307,000) was cancelled, and he received the difference ($1,000). Id. at 364. The Court upheld the IRS’s disallowance of the taxpayer’s loan-interest deductions as the product of a sham transaction. Id. at 366. Two aspects of the Court’s opinion shed light on the current inquiry. First, the Court observed that if, instead of terminating the transaction, the taxpayer had held the bonds to maturity and continued to operate as he had done for the first three years, he would have received an annuity worth $1,000. Id. at 364. Second, the Court summarily rejected the taxpayer’s argument that the transaction would have become profitable in ten years if he paid off the original $4 million loan. Id. at 366 n.3. The first statement demonstrates that potential future profitability can be relevant in assessing whether an ongoing transaction is an economic sham. The contrast between the first and second statements reflects a more nuanced lesson. Courts may consider future profits contingent on some future taxpayer action, but only when that action is consistent with the taxpayer’s actual past conduct. Courts should be skeptical, however, when the asserted future profits hinge on future taxpayer action that seriously departs from past conduct, especially where such departure involves the expenditure of large sums of money.12 These principles have obvious relevance to the instant case. It was proper for the district court to consider whether Dow’s plans would be profitable in the future; indeed, in each prior COLIplan case, the court looked to future cash flows. The same cannot be said, however, for the district court’s consideration of positive cash flows that were contingent on Dow’s eventual spending of significant amounts of cash. Like the transaction in Knetsch, the instant COLI plans would become profitable only upon the taxpayer’s large future outlay of additional cash, and, considering that Dow had heretofore made no similar cash infusions, such additional spending would be a drastic departure 11 Beyond the COLI-plan context, courts have disfavored the deduction of interest paid on investments with contingent benefits. See, e.g., Coleman v. Comm’r, 87 T.C. 178, 208-09 (1986), aff’d, 833 F.2d 303 (3d Cir. 1987); Rice’s Toyota World, Inc. v. Comm’r, 752 F.2d 89, 92-93 (4th Cir. 1985); Smoot v. Comm’r, 61 T.C.M. (CCH) 2897, 1991 WL 97650 (1991); Goldwasser v. Comm’r, 56 T.C.M. (CCH) 606, 1988 WL 118617 (1988); Zegeer v. Comm’r, 54 T.C.M. (CCH) 1203, 1987 WL 49205 (1987). 12 The dissent objects to our reading of Knetsch, asserting that the Court simply “determined that the taxpayer did not intend to make the greater future investment by paying off the loan, and therefore, the potential future cash flows were not relevant to the economic substance analysis.” Dissent at 11. Our reading of Knetsch is consistent with this statement. What the dissent ignores (and we recognize) is the reason behind the Court’s determination: the large future investment would be altogether inconsistent with his past conduct. This is what made paying off the loan “wholly unlikely.” Knetsch, 364 U.S. at 366 n.3. No. 03-2360 Dow Chemical Co. v. United States Page 7 from the taxpayer’s past conduct.13 Moreover, there was no contractual provision requiring Dow to make substantial cash infusions in the future. In light of the teachings of Knetsch, the district court erred in including in its cash-flow analysis the highly-contingent positive cash flows projected for later years.14 When the future infusion of cash is properly removed from the analysis, only negative cash flows remain. Therefore, without the benefit of the interest deductions, the COLI plans were cash-flow negative for all relevant periods, which is a “hallmark[] of an economic sham.” AEP, 326 F.3d at 742. Our holding that the future positive cash flows should have been ignored makes it unnecessary to reach the government’s appeal of the district court’s (i) choice of discount rate to credit in the NPV analysis and (ii) exclusion of Dow’s tax protest letters under Rule 408 of the Federal Rules of Evidence. First, the removal of the highly-contingent positive cash flows from the analysis leaves only negative cash flows, which of course yield a negative NPV no matter what the discount rate. Second, the government offered the tax protest letters to cast doubt on Dow’s intent to inject large amounts of cash into the plans in the future, which is irrelevant in light of our holding that this putative additional outlay (or, more precisely, the profits contingent on such spending) should be disregarded as a matter of law.