Opinion ID: 2973232
Heading Depth: 2
Heading Rank: 1

Heading: Inside Buildup

Text: The first basis for the district court’s determination that Dow’s COLI plans had economic substance was its finding that Dow would realize the benefits of the tax-deferred inside buildup of the policies. There were no such benefits in the COLI plans found to be shams in AEP, CM Holdings, and Winn-Dixie. Dow’s pre-purchase projections showed that the plans generated positive cash flows, even in the absence of the interest deductions. The district court noted that although the pre-deduction cash flows were negative for the first 18 years of the plan, positive cash flows, delayed for 18 years, were consistent with Dow’s subjective business purpose of funding retiree benefit expenses in the long term. Dow Chem. Co. v. United States, 250 F. Supp. 2d 748, 806 (E.D. Mich. 2003). I think the district court got it right, in first analyzing each of Dow’s COLI plans as a whole and then correctly concluding that the plans had economic substance, because, among other things, they realized the benefits of inside buildup. That conclusion rested, first, upon the court’s factual finding that Dow intended from the outset to cap policy loans at $50,000, to withdraw funds only to basis, and to invest cash into the Great West and MetLife plans after 17 years. See id. at 802, 809. The district court based this finding not only on the testimony of Dow’s witnesses, but also on contemporaneous documentation introduced by Dow, including Dow’s original 1987 Request for Proposals (RFP) to the insurance industry; analysis of proposals by Dow’s actuarial consultant and his final recommendation; and pre-purchase cash flow illustrations. Id. In addition, the district court noted that a strategy of capping policy loans at $50,000 and withdrawing only to basis was more consistent with Dow’s purpose of producing cash flows to fund future retiree benefit expenses than a minimum-payment strategy because the capped-loan strategy produced higher positive cash flows after 18 years. Id. at 801-02. The capped-loan strategy was also more consistent with Dow’s overall goal of tax avoidance than the minimum payment strategy because interest on loans above $50,000 was not tax deductible, and withdrawing cash above basis would have exposed Dow to taxes that could have been avoided if that cash had been paid out as death benefits. Id.
The district court’s conclusion that Dow’s COLI plans had economic substance because they generated inside buildup was based, in part, upon the court’s acceptance of the net present value (NPV) analysis of Dow’s financial expert. That was a finding of fact, and I am satisfied the court did not commit legal error in accepting Dow’s, rather than the government’s, NPV analysis. Courts have recognized that NPV analysis is an appropriate method to determine the economic effects of transactions designed to yield deferred returns. ACM P’ship v. Comm’r, 157 F.3d 231, 259 (3d Cir. 1998). NPV analysis consists of discounting future earnings by a factor No. 03-2360 Dow Chemical Co. v. United States Page 13 intended to reflect the time value of money. See Dow, 250 F. Supp. 2d at 806. The discount rate used is the rate of return on an alternate investment. The district court accepted the testimony of Dow’s expert, Stewart Myers, who stated that the appropriate discount rate for the NPV analysis of Dow’s delayed cash flows is an “after-tax” Moody’s Corporate Average, which is calculated by multiplying Moody’s Corporate Average by a factor of one minus Dow’s tax rate. This adjusted discount rate reflects the reality that the death benefits from Dow’s COLI plans were not taxable, whereas Dow would have to pay tax on the income from alternate investments. Dow’s actual return from alternate investments would be reduced by its income tax rate, but its return from the COLI plans would not. The government argues that, as a matter of law, the proper discount rate is an unadjusted Moody’s Corporate Average because using a discount rate that reflects the tax-free nature of death benefits conflicts with the “pre-tax” analysis required by this circuit and the Third Circuit, and mistakenly puts Dow in a “world without taxes.” See AEP, 326 F.3d at 743-44; CM Holdings, 301 F.3d at 95. I do not agree with the government’s argument that the “pre-tax” analysis required in this circuit under AEP requires an unadjusted discount rate. As the Third Circuit explained in CM Holdings, this “pre-tax” analysis requires only that there be removed from consideration the challenged deduction and the transaction be evaluated on its merits. CM Holdings, 301 F.3d at 105. It is not necessary, as the government suggests, that we must imagine a “world without taxes,” and we may take into account the reality that some investments are tax favored. Dow’s expert separated Dow’s COLI transactions into their investment and financing components or “legs” and analyzed the cash flows from each leg separately. The “investment leg” cash flows showed the benefits from inside buildup, whereas the “financing leg” cash flows showed the value added from financing—in this case, the interest deductions. The government does not claim that separating the investment and financing legs, as Dow’s expert did, is not standard practice in financial analysis. Dow’s expert concluded that the investment leg of Dow’s MetLife plan had an NPV of approximately $370 million and the investment leg of the Great West plan had an NPV of $76 million at the after-tax discount rate. By analyzing the investment leg separately, Dow’s expert viewed the transaction as a whole—from beginning to end—but removed the challenged deduction from consideration as AEP requires. By using an after-tax discount rate, he recognized the reality that corporations operate in a world with taxes and that some investments are tax favored. Since Dow’s expert’s analysis is a form of the “pre-tax” analysis required by this court in AEP, I am satisfied that the district court did not commit legal error by accepting Dow’s expert’s NPV analysis.