On Appeal from the United States Tax Court, Tax Court No. 26765-83.
Sloviter and Stapleton, Circuit Judges, and Fisher, District Judge.*fn* Sloviter, Circuit Judge, dissenting.
STAPLETON, Circuit Judge.
Gerling International Insurance Company (GIIC) appeals from a grant of summary judgment to the Commissioner of Internal Revenue (IRS), 87 T.C. 679 (1986), following the imposition of sanctions on GIIC for failing to produce certain information and documents which it claims to be unable to obtain. Finding the imposition of sanctions to be error, we will reverse the grant of summary judgment and remand to the Tax Court for further proceedings.
GIIC is a Delaware corporation with assets totalling about $700,000. Its only business, aside from investing its capital, involves a reinsurance contract which it entered into in 1957 with Universale Reinsurance Company, Ltd. (Universale), a Swiss corporation. Under this contract, or treaty, GIIC is to bear 20 % of any losses on the non-life insurance risks assumed by Universale, and GIIC is to receive 20 % of any profits Universale reaps from its non-life insurance risks.*fn1 Universale sends GIIC an annual statement, called the Technical Figures, which contains few details beyond the figures for GIIC's 20 % share of Universale's gross premiums, losses, reserves, expenses, and net profit or loss, together with a check for 20 % of Universale's non-life net profit or a bill for 20 % of Universale's non-life net loss.*fn2 Universale also provides GIIC with its yearly summary of its accounts, called the "Exercise", and with documents published by the Swiss Office of Private Insurance, which inspects Universale's books annually. The treaty between Universale and GIIC includes various other provisions for the rights and responsibilities of the parties, such as a dispute resolution mechanism (arbitration in Switzerland), choice-of-law and choice-of-forum clauses for non-arbitrable disputes (Swiss law and Swiss courts), and access by GIIC (in Switzerland) to Universale's files on the risks covered by the treaty, so GIIC might verify the Technical Figures.*fn3 Additionally, GIIC agreed in the treaty to waive its right to receive a complete list of all the insurance and reinsurance risks assumed by Universale in which GIIC has a 20 % share.*fn4 According to GIIC, requiring a reinsured to compile such a list for a reinsurer is prohibitively expensive and is rarely or never done in the reinsurance business; the number of listings involved in this case would be about 1,400.
When GIIC has been entitled to a net profit under its arrangement with Universale, the profit has never amounted to more than $40,000 for any given year. In only one of the taxable years at issue here, 1976, did the GIIC-Universale agreement result in a net loss to GIIC. GIIC was able to use that loss to reduce its taxable investment income not only for 1976, but also for 1974 and 1973 by means of a net operating loss carryback.
The IRS audited GIIC for taxable years 1959-61. That audit ended happily for GIIC, as the IRS did not demand to look behind the Technical Figures and checks which GIIC had received from Universale. However, the IRS is now auditing GIIC for taxable years 1976-78, and will not so easily be satisfied.
GIIC is subject to tax under Internal Revenue Code § 831, like any other non-life or non-mutual insurance company. Its tax is determined under I.R.C. § 832, which requires use of an annual statement approved by the National Association of Insurance Commissioners (NAIC). The NAIC form is also used by state regulators of the insurance industry. I.R.C. § 832(a) provides that the taxable income of an insurance company such as GIIC is "the gross income as defined in subsection (b)(1) less the deductions allowed by subsection (c)."
Section 832(b)(1) provides that gross income is to be "computed on the basis of" the underwriting and investment exhibits of the NAIC form. The regulations add that:
The underwriting and investment exhibit is presumed to reflect the true net income of the company, and insofar as it is not inconsistent with the provisions of the Code will be recognized and used as a basis for that purpose.
Treas. Reg. § 1.832-4(a)(2). The NAIC form requires a reinsurer in GIIC's position to list as its gross income the full quota share of the gross income of its reinsured, rather than only the net figure actually received from the reinsured. Accordingly, GIIC must include in its gross income 20 % of Universale's gross income from its non-life insurance business. Section 832(b) also requires that various items not listed on the NAIC form, such as gain from the disposition of property, be added to the gross income reported on the relevant exhibits of the form to obtain an insurer's or reinsurer's total gross income.
Section 832(c), besides allowing as deductions such usual items as interest and taxes,*fn5 allows the deduction of "all ordinary and necessary expenses incurred as provided in § 162 (relating to trade or business expenses)" and of "losses incurred as defined in subsection (b)(5) of this section". These provisions, in combination with definitions of "expenses incurred" and "losses" supplied by § 832(b), work out to allow GIIC to deduct the 20 % of Universale's expenses and losses allocable to it, as well as expenses it has itself incurred in conducting its business.*fn6
In its tax returns for each of the years at issue, GIIC has not filled in the spaces for gross income, deductions from gross income, or any other items which are listed above taxable income and which serve as the basis for calculating taxable income. Instead, GIIC has written, across all of those lines, "See Copy of Annual Report to Insurance Dept. of Delaware Attached Hereto." App. at 440, 473, 517. Presumably, GIIC did this because it did not in those years receive any income not reflected in the relevant exhibits on the NAIC form, and because the NAIC forms it completed contained figures for the losses and expenses passed on by Universale to GIIC plus all the allowable deductible expenses GIIC itself incurred. Despite GIIC's failure to fill in the relevant lines of its tax return, the fact is that it included in its deductions from its gross income the 20 % of Universale's losses and expenses allocated to it. The Tax Court found that:
Petitioner's obligation as a U.S. taxpayer was to report the activities relating to its reinsurance treaty with Universale in the same manner as it was required to report the same to the insurance regulatory authorities, i.e., on the basis of an annual statement approved by the National Association of Insurance Commissioners. Sec. 1.832-4(a)(1) and (2), Income Tax Regs. It appears that petitioner, in its report to the regulatory agency of the State of Delaware, was required to report, and in fact did report, its share of the premiums, losses and expenses of the reinsurance business of Universale covered by the treaty.
Memorandum sur order, App. at 416-17.
The IRS, while accepting the figure supplied by GIIC for its 20 % share of Universale's gross income, has disallowed the deduction by GIIC of the 20 % of losses and expenses allocated by Universale to GIIC's share of the gross, on the grounds that GIIC has not substantiated the deductibility of those losses and expenses as ordinary and necessary, made for the purposes claimed, and allocable in fact to GIIC's 20 % share rather than Universale's 80 % share. The IRS has also challenged whether the deductions were allocated to the appropriate tax year. This disallowance puts GIIC's tax deficiency, according to the IRS, at $1,439,676 for 1976, $1,917,174 for 1977, and $2,503,934 for 1978. The loss carrybacks from 1976 are also challenged, resulting in a claimed deficiency of $885 for 1973 and $2,043 for 1974. GIIC filed this suit petitioning for a redetermination of its tax liability.
The situation is complicated by the uncommunicative Mr. Robert Gerling. Gerling founded GIIC in 1951 and has always been its president, as well as a director and stockholder. Until June of 1973, Gerling was GIIC's sole stockholder. In 1976, however, Gerling owned only 10.82 % of GIIC's stock. At that time, the rest of GIIC's stock was held by Eden Corporation, a Swiss company, which owned 52.3 %, and four individuals, each of whom owned 9.22 %. In response to IRS interrogatories, GIIC claimed to be unable to discover the identities of any owners of Eden, which is no longer in existence; according to GIIC, no shareholders of GIIC, including Gerling, would answer GIIC's request for information about whether they had ever owned stock in Eden. Gerling later represented to GIIC that he has never owned any stock in Eden. From 1977 on, Gerling has owned only 8.82 % of GIIC, continuing to be only a minority stockholder although remaining president and a director. Since 1977 there has been a total of eleven stockholders in GIIC, each of whom owns a little over or a little under 9 % of the company. Gerling resides in Switzerland, and has done so for some time, though he remains a U.S. citizen and thus must pay U.S. tax on his worldwide income. According to GIIC, Gerling has not visited GIIC's offices since the 1950s and does not participate actively in the management of GIIC.
Gerling is Chairman of the Board of Directors of Universale, and one of its stockholders. The record does not disclose the extent of Gerling's stock ownership in Universale. GIIC reports that Universale has refused to provide information about its stockholders and has claimed that to do so would violate Swiss law.
In the Tax Court, the IRS first served interrogatories soliciting, inter alia, the identity of Universale's stockholders. When GIIC responded that it did not have that information and had been unable to obtain it through reasonable inquiry, the IRS moved for sanctions under Tax Court Rule of Practice 104(c).*fn7 The court imposed a sanction in the form of a conclusive presumption that, from January 1, 1976 to the present, Gerling owned substantially all of the stock of Universale and, by virtue of that ownership and his ...