Court Opinion

ID: 9496000
Source: CourtListenerOpinion
Date Created: 2023-08-05 16:15:06.574695+00
Date Added: 2024-06-11T17:57:18.395398
License: Public Domain

DAVID A. NELSON, Circuit Judge,
concurring.
I fully concur in the judgment and in Judge Gilman’s opinion. My only purpose in writing separately is to comment on a couple of matters that arose during the oral argument.
Counsel for AEP was asked at argument whether this case could be distinguished from In re CM Holdings, Inc., 301 F.3d 96 (3d Cir.2002). In his response, counsel pointed out that the record before us here contains expert witness testimony that was not available to the CM Holdings court.
The testimony in question was provided by a well-qualified economist and tax expert, Dr. Charles D. McLure, Jr. The central theme of Dr. McLure’s testimony was that whether or not corporate-owned life insurance is purchased with borrowed funds, the tax advantage of such insurance is attributable to the fact that the “inside buildup” in the value of the insurance is *746exempt from taxation. Implicit in this testimony, as I understand it, is the proposition that where Congress has created such a tax preference — as it has done in exempting from taxation the interest paid on municipal bonds, for example — taxpayers should be free to accept Congress’ implied invitation to cash out on the preference.
I have no quarrel with this proposition, which is consistent, I believe, with Woodson-Tenent Laboratories, Inc. v. United States, 454 F.2d 637 (6th Cir.1972), and the two cases on which that decision rested, Campbell v. Cen-Tex, Inc., 377 F.2d 688 (5th Cir.1967), and Priester Machinery Co. v. United States, 296 F.Supp. 604 (W.D.Tenn.1969). In all three of those cases the taxpayers used the proceeds of policy loans (loans that carried a four percent interest rate) in prepaying premiums on “key-man” insurance policies. The insurance policies had substantial net cash values that increased over time, and the insurance benefits payable on the deaths of the named insureds were substantially greater than the amounts of the loans. See, e.g., Priester, 296 F.Supp. at 608. The owners of the insurance policies could in a sense capture the value of the inside buildup by cashing the death benefit checks they received when the insured employees died,1 and there was a meaningful chance that the policy owners would realize non-tax economic gains through premature employee deaths.
In the case at bar, by contrast, AEP paid interest rates that bore no relation to the market for secured policy loans and were roughly three times as high as the rate paid in the earlier cases.2 Because of a contractual linkage between the policy loan interest rates and the rates credited to the values by which the loans were secured, AEP maximized the inside buildup by electing to pay artificially high loan interest rates.
As Dr. McLure conceded on cross-examination, AEP’s higher inside buildup did not translate into cash flows when insured individuals died. Indeed, AEP never accessed any material part of the inside buildup through direct payments from the insurance company. AEP kept its insurance costs as low as possible by maximizing its use of withdrawals and policy loans while the insured individuals were alive, and it realized no significant mortality gains when the individuals died. This was because the insurance program required AEP to pay increased annual charges if the company realized death benefits that exceeded the insurer’s actuarial projections.
Unlike the taxpayers in Woodson-Ten-ent, Cen-Tex, and Priester Machinery, AEP had no net equity in the insurance at the end of any policy year and, viewed from a long-term program-wide standpoint, the company did not stand to realize any gain upon the deaths of insured employees. In economic terms, I believe, the entire value of the inside buildup was converted into tax deductions for the artificially high interest AEP was paying. If I am correct in this, it does not seem to me that Dr. McLure’s testimony can carry the day for AEP; the program at issue lacked the kind of economic substance that was necessary for it to pass muster under Knetsch v. *747United States, 364 U.S. 361, 81 S.Ct. 132, 6 L.Ed.2d 128 (1960).
A second point discussed at oral argument involved the consequences of a hypothetical catastrophe killing huge numbers of AEP personnel. If such a catastrophe would enable AEP to receive death benefits substantially in excess of its expenditures, that fact could lend economic substance to a program that would otherwise appear to lack substance. As I now understand it, however, not even catastrophic losses of AEP personnel could trump the requirement that the cost of insurance charges be adjusted to reflect AEP’s actual mortality experience.3 In any event, there is no evidence, and it has not been argued, that a desire to insure against such a catastrophe played any part in AEP’s decision to purchase the COLI program.
In summary, it looks to me as though AEP’s sole purpose in purchasing the program was to buy tax deductions. Under Knetsch, as Judge Gilman’s opinion explains, such a purchase must be treated as a sham transaction for tax purposes. And the fact that the tax savings AEP hoped to realize from the sham would have been used for perfectly legitimate business purposes cannot legitimize the transaction itself.

. Death benefits are not geared to inside buildup, of course, but Dr. McLure accepted a suggestion by the government that death benefits represent one way in which "the cash value and the inside buildup within the cash value can translate into cash flows....” Trial transcript p. 2416.

. As government expert James Hoag explained, insurance companies can afford to charge low interest rates for policy loans because the loans, being secured by the policies themselves, carry no credit risk.

. In addition to requiring adjustment of the cost of insurance charges, the COLI program provided for the payment of “mortality dividends” as a means of implementing “mortality neutrality." This is one respect in which AEP’s program differed from the program at issue in Dow Chemical Co. v. United States, 250 F.Supp.2d 748, 780 (E.D.Mich.2003) (noting the absence of mortality dividends from the challenged program).