Coordinated Issue Paper - Blue Cross Blue Shield Health Insurance Abandonment Losses for Intangible Assets
Effective Date: May 27, 2005
Coordinated Issue Paper
Blue Cross Blue Shield/Health Insurance Industry Life Insurance Industry
Abandonment Losses for Intangible Assets UIL: 165.13-00
This Coordinated Issue Paper reaffirms and updates the positions set forth in Notice 2000-34, 2000-2 C.B. 172 (July 26, 2000), regarding deductions claimed by formerly tax-exempt organizations for abandonment losses of certain intangible assets using the fair market value basis provided in section 1012(c)(3)(A)(ii) of the Tax Reform Act of 1986 (“TRA ‘86”). Specifically:
The Service will continue to challenge abandonment loss deductions under the legal theories in Notice 2000-34, and will continue to carefully scrutinize taxpayer valuations.
If a case was suspended without examination of the loss deductions or any formal or informal claims, the deductions or claims should now be disallowed under the legal theories in Notice 2000-34. In addition the taxpayer’s valuation should be carefully scrutinized and the deductions or claims should be disallowed to the extent they fail to satisfy the standards set forth in Capital Blue Cross v. Commissioner, 122 T.C. 224 (March 12, 2004), appeal docketed, No. 04-2645 (3rd Cir. June 4, 2004).
If a case was suspended after examination, the loss deductions or claims should now be disallowed under the legal theories in Notice 2000-34. However, if the previous examination proposed to allow any portion of a loss based upon a valuation by the taxpayer or the Service prepared prior to the Capital opinion (March 12, 2004), the previous valuation must be reexamined to determine whether it satisfies the standards of the Capital opinion.
The Service will not enter into an Agreement to Extend the Time to Bring Suit (Form 907) and will not further extend any previous Form 907.
If a Blue Cross Blue Shield (BCBS) organization converts from nonprofit to for-profit status, the converted entity will not be considered an “existing Blue Cross or Blue Shield organization” and can not claim the fair market value basis for any transaction after the conversion.
The positions stated in this Coordinated Issue Paper will be applied to similar provisions in the Taxpayer Relief Act of 1997.
TRA ’86 §1012(c)(3)(A)(ii) allows each BCBS organization to use as the adjusted basis of its assets the fair market value as of its first taxable year beginning after December 31, 1986.
BCBS organizations are claiming abandonment loss deductions for individual customer, provider, or employee contracts using aggregate appraisals of the entire customer list, provider network, or workforce in place. Notice 2000-34, 2000-2 C.B. 172, states the Service will be “carefully scrutinizing ” these valuations and will challenge the deductions under legal theories set forth in the Notice.
In many cases, these loss deductions were not reported on the taxpayer’s original return but were filed as a claim for refund, either during an examination or while the return was pending with the Appeals Division. Some returns or claims were examined but the cases were suspended pending the outcome of litigation in the United States District Court and in the Tax Court. Other cases were suspended without examination.
This issue was litigated in Trigon Insurance Co. v. United States, 215 F.Supp. 2nd 687 (E.D. Va. 2002) and Capital Blue Cross v. Commissioner, 122 T.C. 224 (March 12, 2004), appeal docketed, No. 04-2645 (3rd Cir. June 4, 2004). Both courts sustained the disallowance of the deductions and found the taxpayers failed to prove the fair market value of each individual contract allegedly lost during the years in issue.
A significant number of cases remained unresolved pending the outcome of this litigation, including cases where the loss deductions were reported on the taxpayer’s original returns, formal claims for refunds, and informal or protective claims. These examinations should now be completed and the deductions or claims should be disallowed. The Tax Court’s opinion in the Capital case provides the Government with additional grounds to sustain adjustments on this issue which may not have been considered during the initial examination. It is important for the Government to maintain a consistent position on this issue, and accordingly it is important for these additional grounds to be raised in every case in which they are appropriate.
Taxpayer Relief Act of 1997
TRA ’86 was not limited to BCBS organizations but effectively revoked the tax exempt status of any organization if a substantial part of its activities consists of providing commercial-type insurance. Certain organizations were specifically excepted from this provision, and thus retained their tax exemption.
Section 1042(a) of the Taxpayer Relief Act of 1997 (“TRA ‘97”) provides that the exception allowed in TRA ’86 shall not apply to any taxable year beginning after December 31, 1997. Accordingly, the organizations excepted from TRA ’86 are no longer exempt.
TRA ’86 § 1012(c)(3)(A)(ii) provided a “basis step-up” for BCBS organizations. TRA ’97 § 1042(b)(2) provided a basis step-up using language identical to TRA ’86.
The taxpayer has the burden of proving both the legal and factual basis for any deduction claimed. New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). In Notice 2000-34 the Service informed BCBS organizations that it would challenge abandonment loss deductions for intangibles and set forth various legal theories that would be raised. Notice 2000-34 also indicated the Service would be “carefully scrutinizing” taxpayer valuations in these cases, but did not provide further guidance on this aspect of the issue. The Capital opinion significantly affects how this aspect of the issue should be developed.
In most of these cases, there is a basic inconsistency between the taxpayer’s initial valuation, which was prepared at the aggregate level, and its alleged loss deductions, which were claimed at the level of individual contracts. In many cases, the taxpayer’s expert appraisal merely shows the aggregate valuation, but does not show how the taxpayer determined that a loss occurred in any particular year, the nature and identity of the specific item or items lost in that year, or how the aggregate value was allocated to those items. In other words, the taxpayer has not produced any proof that a loss in fact occurred. As the Tax Court emphasized in the Capital case, an aggregate valuation merely establishes that subscriber contracts can be valued in the aggregate; it does not establish that such contracts can be valued as individual assets.
In many cases, a Service engineer was requested to review and analyze the taxpayer’s aggregate appraisal. The engineer was not assigned to investigate how the taxpayer determined that a loss occurred, or to identify the items lost, or to determine whether the method used by the taxpayer for its aggregate appraisal would be appropriate for valuing the specific items lost, since none of those issues were part of the taxpayer’s aggregate appraisal. Accordingly, the only determination made by the engineer was that the taxpayer’s aggregate appraisal was too high.
In the absence of a closing agreement, the fact that the examining agent or the Service engineer did not initially challenge the taxpayer’s aggregate valuation method does not constitute a concession by the Government or an agreement that the taxpayer’s method is correct. See Botany Worsted Mills v. United States, 278 U.S. 282 (1929). Levin v. Commissioner, T.C. M 1990-226. The Tax Court’s opinion in the Capital case must be taken into account in examining this issue.
Even before the Capital opinion, the Service could make a strong argument that an aggregate workforce, or the individual employees that make up that workforce, cannot be accurately valued for tax purposes. In Ithaca Indus., Inc. v. Commissioner, 17 F.3d 684, 690 (4th Cir. 1994), aff’g 97 T.C. 253 (1991), the Court of Appeals noted:
An employee is not a subscription; indeed, a workforce consisting of human beings perhaps could be no better described than as “composed of constantly fluctuating components.” We note in this regard that the record discloses no predetermined limits of any sort, contractual or otherwise, upon the relationship between Ithaca and its employees. This means that in contrast to a subscription, which is susceptible mainly to the influences affecting one actor, the subscriber, a single employment relationship is susceptible to changing influences affecting two actors, the employer and the employee.
We are not persuaded that Ithaca can control for these influences.
In the Capital opinion the Tax Court cited the Ithaca case in support of its conclusion that “These human elements associated with petitioner's group contracts created a significant element of unpredictability with regard to the useful life of petitioner's group contracts.” 122 T.C. at 257.
On August 9, 2002, the District Court issued its opinion in the Trigon case. The factual, valuation issue was decided in favor of the Government. No deductions were allowed. The petitioner in the Capital case had the advantage of reviewing the Trigon opinion before the Capital case was tried and attempted to meet the factual problems identified by the Trigon court. Nevertheless, when the Tax Court issued its opinion in the Capital case, it decided the factual valuation issue in favor of the Government.
In both cases, the Government made legal arguments that the fair market value basis adjustment did not apply to periodic, annual losses claimed under I.R.C. § 165. The text of TRA ’86 states that the basis step-up is “for purposes of determining gain or loss.” The Government’s legal arguments were based in part on the Conference Committee Report, which states that the fair market value basis adjustment was provided “solely for purposes of determining gain or loss upon the sale or exchange of the assets, not for purposes of determining amounts of depreciation or for other purposes.” H.R. Conf. Rept. 841, 99th Cong., 2d Sess. II-350 (1986). Both the District Court and the Tax Court found that the statutory language was plain and unambiguous and rejected the Government’s legal arguments.
The Service continues to believe that the legal theories set forth in Notice 2000-34 are correct and that these abandonment loss deductions should be challenged on the basis of those theories.
In addition, in both the Trigon case and the Capital case the courts found the taxpayers failed to prove the fair market values of each of the contracts allegedly lost during the years in issue.
The Trigon court noted that “[W]hen the income approach alone is the basis for valuation, it is critically important that the data used in applying that approach be accurate. . . [T]he income approach, depending on the inputs, can result in a ‘large range of numbers.’” 215 F.Supp. 2nd at 725.
The record here fully bears out this problem. For instance, although the income approach has been used by other experts to estimate the value of subscriber contracts owned by other Blue Cross/Blue Shield organizations, the use of that approach has produced widely varied results for other plans with premium income similar to Trigon’s. . . . This is in stark comparison to Wierwille’s valuation of Trigon’s contracts at $384 million, or even Wierwille’s revised figure of $308 million. . . .
The most dramatic variance in the application of the income approach, however, appears in two different valuations of the subscriber contracts here at issue. . . .Arthur Andersen, using the same approach as Wierwille and valuing the same contracts, concluded that the subscriber contracts had a value of $1,325,543,000 -- more than three times the value assigned by Wierwille. . . .
The fact that Arthur Andersen and Wierwille reached such divergent results applying the same approach to the same contracts calls into serious question both results. That is especially true where, as here, Wierwille did not explain why his valuation was so widely divergent from the one used by Trigon to support its claim initially. Indeed, absent such an explanation, there is justification for rejecting both valuations.
However, that disparity and the previously explained deviations from the valuation obtained by applying the income approach to other similarly situated Blue Cross/Blue Shield plans demonstrates quite clearly that valuation results will only be reliable if the inputs are accurate. Hence, the lifing and income stream components, as well as any other adjustments included or omitted from the calculus, must be closely scrutinized, because any deviation will multiply the inaccuracy of the final result.
Id. at 725-726.
In the Capital case the Court began its analysis of the valuation of petitioner’s health insurance group contracts with a discussion of the “legal precedent particularly relevant to the valuation of customer-based intangible assets.” 122 T. C. at 238. The Court noted that in Newark Morning Ledger Co. v. United States, 507 U.S. 546 (1993), the Supreme Court had cautioned that with regard to tax deductions relating to customerbased intangibles a taxpayer’s burden of proof “’often will prove too great to bear.’” 122 T.C. at 239.
Turning to the evidence, the Court asserted that TRA ’86 “anticipated” taxpayers would identify assets, make valuations as of January 1, 1987, and record the valuations on their tax books and records. Id. 247. “[S]uch a valuation of petitioner’s health insurance group contracts was not attempted until sometime in 1995, 8 years after enactment of TRA 1986, which 1995 valuation was then discarded by petitioner and replaced with an unexplained valuation done in 2001 and later by a valuation done in 2003. The 2003 valuation on which petitioner now relies was not completed until 16 years after the relevant valuation date.“ Id. at 247. The Court noted petitioner’s “significant effort to cure” the evidentiary deficiencies identified by the Trigon Court. Id. at 249, fn. 12.
The Court rejected “formula” appraisals of customer-based intangibles for tax purposes, even if such methods are accepted in the industry. Id. at 243-245. Petitioner’s formula method was deficient because it did not take account of “contract-specific” information. See id. at 251, fn. 13; 253 and 254. Use of a formula method does not cure information deficiencies; rather use of such method is evidence of those deficiencies. Id. at 245. “What is required to support petitioner’s claimed loss deductions under section 165 are valuations of the group contracts that reflect a value for each contract as a separate and discrete contract.” Id. at 251. “[A]ll petitioner has done is establish that the group contracts are capable of being valued in blocks. Petitioner has not, however, established that the group contracts are capable of being valued separately and independently as individual assets.” Id. (emphasis added).
Finally, the Court emphasized the importance and difficulty of properly taking into account the “human elements” affecting the useful life of these contracts, which are effectively terminable at will for any number of reasons . The Court rejected the taxpayer’s appraisal in part because it ignored these human elements. Id. at 257.
In summary, in both cases, the taxpayers did not file claims until years after the valuation date. The taxpayers’ initial valuations were revised for trial, and Capital tailored its trial appraisal based on the Trigon opinion. The disparities between these multiple appraisals, and in the Trigon case between appraisals by similar BCBS organizations, undermined the credibility of the trial appraisal and o f the income approach. Both courts emphasized the importance of accurate data in applying the income approach.
In the Capital opinion, the Tax Court expanded on the standard of proof in valuing customer-based intangibles. Where, as in these cases, taxpayers are claiming loss deductions under I.R.C. § 165 for each “separate and discrete contract” the Court rejected the use of “formula” appraisals and required “contract-specific” information. Furthermore, in determining the life of the income stream for each contract, the appraisal must take into account the human elements.
The Capital opinion calls into question the application of the income approach to the valuation of individual contract relationships. An aggregate valuation merely establishes that subscriber contracts can be valued in the aggregate; it does not establish that such contracts can be valued as individual assets and it does not establish a value for each individual asset.
1. This coordinated issue paper reaffirms the positions set forth in Notice 2000-34. The Service will continue to carefully scrutinize the valuations presented by taxpayers and will continue to challenge the loss deductions under the legal theories set forth in the Notice.
2. In any case in which these loss deductions have not been examined, either where the deductions were reported on the original return or were filed as a formal or informal claim for refund, the facts regarding the loss deductions should be fully developed. In both the Trigon case and the Capital case the factual valuation issue was decided in favor of the Government. There should be no further delay in developing these cases pending the appeal of the Capital case or any other litigation. These issues are highly factual. Even where the alleged abandonments occurred in years currently under examination, the basis step-up requires the development of information of value on January 1, 1987, which generally must be based upon information from years prior to 1987. Further delay in developing the facts of these cases could jeopardize the Government's position.
There must be consistency between the asset being abandoned and the asset being valued. Accordingly, examining agents should carefully develop the facts regarding how the taxpayer determined that an abandonment had occurred. Examining agents should be particularly sensitive to the difference between a valuation of intangibles on an aggregate basis, and a valuation of each “separate and discrete” intangible.
For example, most taxpayers prepared an aggregate valuation of their entire subscriber base, and then allocated a portion of that value to each separate contract. A loss was claimed as each contract terminated, using an allocable portion of the aggregate valuation. Under the reasoning of the Capital opinion, a valuation at an aggregate level does not establish the value of each separate and discrete contract. If the taxpayer contends that the contracts are being “lost” one by one, then the contracts must also be valued one b y one. Allocating a portion of an aggregate valuation of a block of contracts does not establish the separate value of each contract included in that block.
Examining agents should disallow these loss deductions under the legal theories in Notice 2000-34. In addition, the taxpayer’s valuation should be carefully scrutinized and appropriate adjustments should be made consistent with the standards of the Capital opinion. The relevant information is not limited to the taxpayer's valuation of the aggregate assets and the Government's rebuttal of that valuation, but should also include the following:
- The taxpayer’s method for determining that an abandonment has occurred. In other words, what is the event of abandonment?
- Based on the taxpayer’s method for determining that an abandonment has occurred, what is the specific asset being abandoned?
- The taxpayer’s method for determining the value of each separate and discrete contract that was abandoned. The valuation must be based upon information which is specific for each contract, rather than “formula” or average information.
Examining agents should consult with the Technical Advisor, BCBS/Health Insurance, for further guidance in developing this issue and in applying the principles of the Capital opinion.
3. In any case in which these loss deductions or claims for refunds were previously examined the deductions or claims should now be disallowed under the legal theories in Notice 2000-34. However, if the previous examination proposed to allow any portion of a loss based upon a valuation by the taxpayer or the Service prepared prior to March 12, 2004, the date of the Capital opinion, the previous valuation must be reexamined to determine whether it satisfies the standards of the Capital opinion.
4. In many cases the loss deductions were filed as claims for refunds after the examination of the original returns had been completed or while the cases were pending with the Appeals Division. Taxpayers in these refund cases resisted examination of the claims pending the outcome of the Trigon and Capital cases. In many cases the claims were simply disallowed and the parties executed an Agreement to Extend the Time to Bring Suit (Form 907).
The Service will no longer enter into a Form 907 in cases where the taxpayer has filed a claim for these losses. In cases where a Form 907 has been executed, the Service will not enter into any further Form 907. It is the taxpayer’s responsibility to timely bring suit before the expiration of any extended period.
5. TRA ’86 § 1012(c)(3) provides special rules for existing BCBS organizations as defined in I.R.C. § 833(c)(2). Those special rules include the fair market value basis provided in TRA ’86 §1012(c)(3)(A)(ii). In cases where a BCBS organization has converted from a nonprofit organization to a for-profit stock entity, the converted entity will not be considered an existing BCBS organization and will not be eligible to claim the fair market value basis for any transaction after the conversion.
6. The position stated in this Coordinated Issue Paper shall be applied to taxpayers claiming deductions for the loss of intangible assets using the fair market value basis provided in section 1042(b)(2) of the Taxpayer Relief Act of 1997.
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