Free Motion for Summary Judgment - District Court of Federal Claims - federal

Case 1:05-cv-01030-LSM

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05-1030 T (Judge Margolis)

IN THE UNITED STATES COURT OF FEDERAL CLAIMS ______________

HIGHMARK, INC., SUCCESSOR IN INTEREST TO PENNSYLVANIA BLUE SHIELD AND SUBSIDIARIES, Plaintiff, v.

THE UNITED STATES, Defendant. ______________ UNITED STATES' MOTION FOR SUMMARY JUDGMENT AND BRIEF IN SUPPORT THEREOF ______________ EILEEN J. O'CONNOR Assistant Attorney General DAVID GUSTAFSON W.C. RAPP KAREN SERVIDEA Attorneys Justice Department (Tax) Court of Federal Claims Section P.O. Box 26 Ben Franklin Post Office Washington, D.C. 20044 (202) 616-3423 (202) 514-9440 (Fax)

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TABLE OF CONTENTS Page: Motion for Summary Judgment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Brief in Support of United States' Motion for Summary Judgment . . . . . . . . . . . . . . . . . . . . . . . 3 Questions Presented . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Authorities Involved . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Summary of Argument . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 Argument . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 I. THE FRESH-START BASIS PROVISION DOES NOT APPLY TO THE DEDUCTIONS PLAINTIFF CLAIMS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 A. The Fresh-Start Basis Does Not Give Plaintiff an Adjusted Basis in Its Healthcare Coverage Contracts . . . . . . . . . . . . . . . . . 11 i. Plaintiff's Interpretation Conflicts with the Fundamental Concept of Tax Basis . . . . . . . . . . . . . . . . . 11 Plaintiff's Interpretation Conflicts with the Broader Statutory Framework and Purpose of § 1012 of the Tax Reform Act . . . . . . . . . . . . . . . . . . . . . 14

ii.

B.

The Fresh-Start Basis Provision Applies Only to Gain or Loss Upon the Sale or Exchange of an Asset . . . . . . . . . . . . . . . 16 i. ii. The Provision Does Not Apply to "Any" Loss . . . . . . . . 17 "Gain or loss" Generally Refers to Sales, Exchanges, and Other Dispositions of Property . . . . . . . . . . . . . . . . . 19 The Legislative History Shows That the Fresh-Start Basis Is Available for Only Sales and Exchanges . . . . . . 19 As Interpreted by Plaintiff, the Fresh-Start Basis Provision Would Not Serve the Purpose for Which It Was Enacted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 -i-

iii.

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TABLE OF CONTENTS (CONTINUED) Page: v. Plaintiff's Interpretation of the Fresh-Start Basis Provision Is Inconsistent with the Inapplicability of the Provision to Depreciation Deductions . . . . . . . . . . 23

II.

PLAINTIFF IS NOT ENTITLED TO A REFUND BECAUSE IT MADE AN UNAUTHORIZED CHANGE IN ITS METHOD OF ACCOUNTING . . . . . 26 A. Plaintiff Changed from Treating Its Contracts as One Asset to Treating Them as Discrete Assets . . . . . . . . . . . . . 28 Plaintiff Changed from Expensing to Capitalizing the Costs of Creating Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . 33

B.

Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 Appendix A: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A-1 Internal Revenue Code of 1986 (26 U.S.C.): § 162 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . § 165 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . § 263 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . § 446 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . § 832 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . § 1001 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . § 1011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . § 1012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . § 1016 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A-1 A-1 A-1 A-2 A-3 A-3 A-3 A-4 A-4

Tax Reform Act of 1986, Pub. L. No. 99-514, 100 Stat. 2085: § 1012, 100 Stat. 2085, 2390 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A-5 Deficit Reduction Act of 1984, Pub. L. 98-369, 98 Stat. 494: § 177, 98 Stat. 494, 709 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A-10 Treas. Reg. (26 C.F.R.): § 1.446-1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A-14

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TABLE OF CONTENTS (CONTINUED) Appendix B (Separately Bound): Page:

Declaration of Karen Servidea . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . B-1 Exhibit 1: Plaintiff's Second Amended Response to Defendant's First Set of Requests for Admissions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . B-3 Plaintiff's Second Amended Answers to Defendant's First Set of Interrogatories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . B-33 Excerpt from the 1991 Annual Statement of Pennsylvania Blue Shield ("PBS"), attached to PBS's 1991 tax return . . . . . . . . . . . . . . B-61 Excerpt from the 1993 Annual Statement of PBS, attached to PBS's 1993 tax return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . B-68 Excerpt from the 1994 Annual Statement of PBS, attached to PBS's 1994 tax return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . B-81 IRS Certificate of Official Record for Highmark, Inc., for tax years 1991through 1995 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . B-93 PricewaterhouseCoopers Valuation Report dated September 10, 1998 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . B-120

Exhibit 2:

Exhibit 3:

Exhibit 4:

Exhibit 5:

Exhibit 6:

Exhibit 7:

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TABLE OF AUTHORITIES Cases: Page(s):

Aluminum Castings Co. v. Routzahn, 282 U.S. 92 (1930) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 Capital Blue Cross v. Commissioner, 122 T.C. 224 (2004), rev'd 431 F.3d 117 (3d Cir. 2005) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4, 5 Capital Blue Cross v. Commissioner, 431 F.3d 117 (3d Cir. 2005) . . . . . . . . . . . . . . . . . . . . . . . 5 Dick v. Office of Personnel Mgmt., 216 F.3d 1353 (Fed. Cir. 2000) . . . . . . . . . . . . . . . . . . . . . . 20 Diebold, Inc. v. United States, 891 F.2d 1579 (Fed. Cir. 1989), cert. denied, 498 U.S. 823 (1990) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 Federal Home Loan Mortgage Corp. v. Commissioner, 121 T.C. 129 (2003) . . . . . . . . . . . . . . 25 FPL Group, Inc. v. Commissioner, 115 T.C. 554 (2000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 Golden State Towel & Linen Serv., Ltd. v. United States, 373 F.2d 938 (Ct. Cl. 1967) . . . . . . . 28 INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 In re Johnson, 787 F.2d 1179 (7th Cir. 1986) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d 781 (11th Cir. 1984) . . . . . . . . . . . 27 Newark Morning Ledger Co. v. United States, 507 U.S. 546 (1993) . . . . . . . . . . . . . . . . . . . . . 28 Nixon v. Missouri Municipal League, 541 U.S. 125 (2004) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Orquera v. Ashcroft, 357 F.3d 413 (4th Cir. 2003) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 Pelaez & Sons, Inc. v. Commissioner, 114 T.C. 473 (2000), aff'd 253 F.3d 711 (11th Cir. 2001) (Table) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 Public Citizen v. United States Dep't of Justice, 491 U.S. 440 (1989) . . . . . . . . . . . . . . . . . . . . 21 Public Opinion Publ'g Co. v. Jensen, 76 F.2d 494 (8th Cir. 1935) . . . . . . . . . . . . . . . . . . . . . . . 32 Reves v. Ernst & Young, 494 U.S. 56 (1990) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

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TABLE OF AUTHORITIES (CONTINUED) Cases: Page(s):

Stephens Marine, Inc. v. Commissioner, 430 F.2d 679 (9th Cir. 1970) . . . . . . . . . . . . . . . . . . . 28 Sterling Fed. Sys., Inc. v. Goldin, 16 F.3d 1177 (Fed. Cir. 1994) . . . . . . . . . . . . . . . . . . . . . . . . 13 Trigon Insurance Co. v. United States, 215 F. Supp. 2d 687 (E.D. Va. 2002) . . . . . . . . . . . . . 4, 5 United States v. Gonzales, 520 U.S. 1 (1997) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Statutes: Internal Revenue Code of 1986 (26 U.S.C.): § 162 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32, 33, 34 § 165 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . passim § 167 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 § 172 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 § 263 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33, 34 § 446 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26, 37 § 501 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 § 832 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33-34 § 833 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 § 954 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 § 1001 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 § 1011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11, 19 § 1012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11, 12, 13, 14 § 1016 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11, 34 § 1223 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 § 1231 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 Page(s):

Tax Reform Act of 1986, Pub. L. No. 99-514, 100 Stat. 2085: § 1012, 100 Stat. 2085, 2390 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . passim Deficit Reduction Act of 1984, Pub. L. 98-369, 98 Stat. 494: § 177, 98 Stat. 494, 709 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17, 18

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TABLE OF AUTHORITIES (CONTINUED) Miscellaneous: Page(s):

H.R. Conf. Rep. No. 99-841 (1986), reprinted in 1986 U.S.C.C.A.N. 4075 . . . . . . . . . . . . . . . . . . . . . . 8, 20, 21-22, 25 H.R. Rep. No. 99-426 (1985) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Norman J. Singer, Statutes and Statutory Construction (6th ed. 2000) . . . . . . . . 13, 14, 21 Revenue Procedure 69-29, 1969-2 C.B. 311 (1969) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 Revenue Ruling 90-38, 1990-1 C.B. 57 (1990) . . . . . . . . . . . . . . . . . . . . . . . 27, 29, 34-35 Rules of the Court of Federal Claims: R. 56 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Staff of Joint Comm. on Taxation, 99th Cong., General Explanation of the Tax Reform Act of 1986 (Joint Comm. Print 1987) . . . . . . . . . . 8, 20, 22, 25 Treas. Reg. (26 C.F.R.): § 1.162-4 § 1.167(a) § 1.263(a) § 1.446-1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27, 29, 35

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IN THE UNITED STATES COURT OF FEDERAL CLAIMS ______________ No. 05-1030 T (JUDGE MARGOLIS) HIGHMARK, INC., SUCCESSOR IN INTEREST TO PENNSYLVANIA BLUE SHIELD AND SUBSIDIARIES, Plaintiff, v.

THE UNITED STATES, Defendant, ______________ UNITED STATES' MOTION FOR SUMMARY JUDGMENT ______________

Defendant, the United States of America, pursuant to Rule 56 of the Rules of the Court of Federal Claims ("RCFC"), moves for summary judgment on the grounds that there is no genuine issue as to any material fact and that defendant is entitled to judgment as a matter of law. In support of its motion, defendant relies on the pleadings, the following brief, and defendant's proposed findings of uncontroverted fact.

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Wherefore, defendant prays that the Court grant defendant's motion for summary judgment.

Respectfully submitted,

s/ Karen Servidea KAREN SERVIDEA Attorney of Record United States Department of Justice Tax Division Court of Federal Claims Section Post Office Box 26 Ben Franklin Post Office Washington, D.C. 20044 Voice: (202) 616-3423 Fax: (202) 514-9440 Email: [email protected] EILEEN J. O'CONNOR Assistant Attorney General DAVID GUSTAFSON Chief, Court of Federal Claims Section W.C. RAPP Senior Trial Attorney

February 15, 2007 Date

s/ W.C. Rapp Of Counsel

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IN THE UNITED STATES COURT OF FEDERAL CLAIMS ______________ No. 05-1030 T (JUDGE MARGOLIS) HIGHMARK, INC., SUCCESSOR IN INTEREST TO PENNSYLVANIA BLUE SHIELD AND SUBSIDIARIES, Plaintiff, v.

THE UNITED STATES, Defendant. ______________ BRIEF FOR THE UNITED STATES IN SUPPORT OF ITS MOTION FOR SUMMARY JUDGMENT ______________

This is an action for the recovery of federal income tax paid for the five taxable years ending December 31, 1991, through December 31, 1995, plus statutory interest thereon. QUESTIONS PRESENTED 1. Whether the "fresh-start basis" provision of the Tax Reform Act of 1986 is available to shield income from taxation via artificial loss deductions upon the expiration or cancellation of healthcare insurance contracts in the ordinary course of plaintiff's business. 2. Whether plaintiff made an unauthorized change of accounting method in its treatment of the development and termination of healthcare coverage contracts.

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AUTHORITIES INVOLVED The pertinent portions of the authorities involved are set forth in Appendix A, infra.1 SUMMARY OF ARGUMENT Plaintiff is a Blue Cross/Blue Shield health insurance company. In the instant case, plaintiff claims loss deductions for the termination of various of its insurance contracts. For this purpose, plaintiff claims that, as part of the Tax Reform Act of 1986, plaintiff received a stepped-up basis in the contracts. The Government contends that the basis-adjustment provision invoked by plaintiff does not apply to the claimed deductions, because insurance contracts have no pre-existing cost basis, and because the provision applies only to gain or loss upon the sale or exchange of an asset. The Government also maintains that plaintiff is not entitled to the deductions claimed, because they constitute a change in method of accounting for which plaintiff failed to secure the consent of the Commissioner. Three published court decisions have addressed the types of deductions claimed by plaintiff in this case. See Trigon Insurance Co. v. United States, 215 F. Supp. 2d 687 (E.D. Va. 2002) (holding that, as a legal matter, the taxpayer was entitled to use the basis-adjustment provision for purposes of claiming loss deductions for terminated healthcare coverage contracts but that, as a factual matter, the taxpayer had failed to establish the value of the terminated contracts); Capital Blue Cross v. Commissioner, 122 T.C. 224 (2004), rev'd 431 F.3d 117 (3d Cir. 2005) (holding that the basis-adjustment provision applies to deductions claimed upon the termination of healthcare coverage contracts but that the taxpayer had failed to establish that the

Unless otherwise noted, the term "I.R.C." followed by either a section symbol ("§") or the word "section" shall refer to the Internal Revenue Code of 1986, codified in Title 26 of the United States Code, as amended and in effect during the relevant period. -4-

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contracts are capable of being valued separately as individual assets); Capital Blue Cross v. Commissioner, 431 F.3d 117 (3d Cir. 2005) (holding that the taxpayer had established that terminated healthcare coverage contracts are capable of separate valuation and that the taxpayer's valuation methodology was reasonable). None of the decisions have addressed the second argument raised in this motion (that plaintiff is not entitled to a refund because it made an unauthorized change in its method of accounting), and, although both trial courts rejected the first argument (that the basis-adjustment provision does not apply to these types of deductions), no appellate court has considered it.2 Moreover, although both trial courts found the plain language of the basis-adjustment provision to encompass the types of deductions claimed by plaintiff, neither court considered the distinction between the phrase "gain or loss" and the phrase "any loss," as used in the Internal Revenue Code (see infra Section I.B.i-ii) or the conflict between plaintiff's interpretation of the provision and the fundamental concept of cost basis (see infra Section I.A). See Trigon, 215 F. Supp. 2d at 696-701; Capital, 122 T.C. at 234-38. Before 1987, organizations such as plaintiff were exempt from federal income taxes as charitable and social welfare organizations. In 1986, Congress determined that changes in the health insurance market had eliminated the basis for exemption of such "Blues," and revoked their exemptions, beginning in 1987, by the passage of the Tax Reform Act of 1986. Congress

The Third Circuit briefly considered and rejected a variation on one of the points raised in the first argument herein. The court dismissed the Commissioner's contention that the freshstart basis provision does not apply to the claimed deductions because of their equivalence to depreciation deductions. See Capital, 431 F.3d at 127 n.3. The court did not consider, however, how that equivalence renders the statute ambiguous with respect to its application to non-sale-orexchange loss deductions. See infra Section I.B.v. -5-

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expected the newly-taxable Blues to compete on an equal footing with other health insurers. To accomplish this, the Tax Reform Act provided for certain transitional rules. One such rule dealt with taxation of gain that had accrued while a Blue had been taxexempt. When a taxpayer sells property its taxable gain is the difference between the amount it receives on the sale, and its tax "basis" in the property (i.e., its cost plus capital expenditures, less depreciation). An organization in plaintiff's position might own real estate, such as a headquarters building or the like, that had been purchased long ago, and which had enjoyed substantial appreciation in value during the time before 1987, when plaintiff was exempt from tax. Believing it to be unfair to tax gains attributable to such pre-1987 appreciation, Congress provided that the basis of such property (for certain purposes, but not others) would be its fair market value as of the date the organization became taxable for the first time. For plaintiff, that magic date was January 1, 1987. As a consequence of this rule, the Blues would pay tax only on appreciation that had occurred after 1986. In the instant case, plaintiff asserts that this provision not only spares plaintiff from tax on pre-1987 appreciation but also gives plaintiff a basis in each and every healthcare contract in force as of January 1, 1987. Plaintiff then claims substantial tax benefits not by overtly deducting that basis upon the sale of one or another of the contracts, nor by claiming depreciation deductions of that basis (a treatment disallowed by the provision). Instead, plaintiff carefully threads this legal needle by claiming deductions of the artificially created basis of each contract when, in the ordinary course of plaintiff's business, the contract ceased to be renewed either by the insured or by plaintiff. Plaintiff claims these deductions as "abandonment losses" under I.R.C. § 165(a).

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The "fresh-start basis" language upon which plaintiff relies provides that "[in] the case of any existing Blue Cross or Blue Shield organization . . . (ii) for purposes of determining gain or loss, the adjusted basis of any asset held on the 1st day of [its first taxable year beginning after December 31, 1986,] shall be treated as equal to its fair market value as of such day."3 Plaintiff contends that this provision operates not just to adjust the basis of property that already had a basis as of January 1, 1987, but also to create basis in property that, because it was neither purchased, nor created via capital expenditures, never had a tax basis. This interpretation of the fresh-start provision conflicts with the fundamental concept that a taxpayer must incur a capital cost to obtain a tax-recognizable basis in an asset. Moreover, by enabling plaintiff to shield substantial amounts of income from taxation via a device unavailable to other health insurers, plaintiff's interpretation undermines Congress's larger purpose in enacting the Tax Reform Act: repealing the Blues' tax exemption. Plaintiff's claim is based also on the premise that the termination of a contract constitutes a "loss" under the fresh-start statute. Interpretation of the phrase "for purposes of determining gain or loss," however, requires resort to the legislative history for two reasons. First, the phrase "gain or loss" is used in the Internal Revenue Code in a variety of contexts, with a variety of particular meanings and applications, and the text of the fresh-start basis provision does not clearly specify one or another of those meanings. Furthermore, the specific reason for the freshstart basis provision ­ to shield pre-1987 appreciation from taxation ­ has no application where the taxpayer has not received potentially taxable consideration in a sale of property. The

Tax Reform Act of 1986 ("TRA 1986"), Pub. L. No. 99-514, § 1012 (c)(3)(A)(ii), 100 Stat. 2085, 2394 (1986) (underlining added). -7-

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legislative history of the "fresh-start" basis provision makes clear that Congress did not intend the anti-competitive windfall claimed by plaintiff. The provision originated in the Conference Committee, which explained that "[t]he basis step-up is provided solely for purposes of determining gain or loss upon sale or exchange of the assets, not for purposes of determining amounts of depreciation or for other purposes." H.R. Conf. Rep. No. 99-841, at II-350 (1986), reprinted in 1986 U.S.C.C.A.N. 4075, 4438; see also Staff of Joint Comm. on Taxation, 99th Cong., General Explanation of the Tax Reform Act of 1986, at 591 (Joint Comm. Print 1987) ("The basis adjustment is provided solely for purposes of determining gain or loss upon sale or exchange of the assets, not for purposes of determining amounts of depreciation or for other purposes"). STATEMENT At all times relevant to this case, plaintiff was a Pennsylvania nonprofit corporation doing business as an independent licensee of the Blue Cross and Blue Shield Association. Def. Proposed Finding (hereinafter "DPF") 1. As a provider of health insurance, plaintiff is party to healthcare coverage contracts with individual and group subscribers. DPF 2. These contracts obligate plaintiff to pay the healthcare costs of the individual or group members in exchange for the subscriber's payment of an insurance premium. DPF 3. In the ordinary course of its business, plaintiff incurs various expenses ­ such as advertising, salaries, actuarial fees to compute premiums, and overhead ­ to induce potential customers to enter into these contracts, and over the life of each contract, incurs additional expenses to keep the policy in place. DPF 4-5. For purposes of its financial accounting (both as a tax-exempt entity and as a taxable entity), plaintiff treats these as current expenses (not capital

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items); and, for purposes of its tax accounting after 1986, plaintiff has treated all these as ordinary expenses (i.e., both its post-1986 expenditures incurred to maintain its pre-1987 contracts, and its post-1986 expenditures incurred to solicit and maintain its post-1986 contracts). DPF 6-7. On plaintiff's income tax returns for the years 1987 through 1994, as originally filed, plaintiff claimed no loss deductions for terminated contracts. DPF 8. Plaintiff claimed such loss deductions for the first time on its amended return for 1991 in September 1995 ­ nine years after the enactment of the "fresh-start" provision. DPF 9. Subsequently, plaintiff filed an amended return for 1992 and informal refund claims for 1993 and 1994, seeking deductions for terminated healthcare coverage contracts, and claimed similar deductions on its original 1995 return. DPF 10-11. At no time between the filing of its original returns for 1987 through 1994 (none of which claimed loss deductions for healthcare coverage contracts) and the filing of its amended 1991 and 1992 returns, 1993 and 1994 refund claims, or original 1995 return ­ each of which claimed loss deductions for terminated healthcare coverage contracts ­ did plaintiff request or secure the consent of the Internal Revenue Service (the "IRS") to this change in its method of accounting. DPF 12-14. On September 29, 2003, the IRS disallowed plaintiff's claimed deductions. Compl. Attach. A. Plaintiff initiated this lawsuit on September 26, 2005. The complaint alleges that "[i]n each tax year 1987 through 1996,4 there were terminations and cancellations of various healthcare coverage contracts that [plaintiff] held on January 1, 1987" and that "[e]ach time one of the healthcare coverage contracts terminated or was canceled, the

Although the complaint mentions contract terminations that occurred in the year 1996, the complaint neither seeks a refund for that year nor seeks to carry back losses from 1996 to any of the years for which the complaint does seek a refund. -9-

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contract became worthless and loss all usefulness in [plaintiff's] business." Compl. ¶ 24. Plaintiff further claims that, for each terminated contract, plaintiff is entitled to a deduction equal to the contract's January 1, 1987, fair market value, as provided by the fresh-start basis provision. Compl. ¶¶ 27-28. The complaint alleges, in particular, that plaintiff is entitled to tax refunds for each of the years 1991 through 1995 for contract terminations that occurred in those years. Compl. ¶¶ 36, 41, 46, 51, 56. In addition, plaintiff seeks to carry forward to 1991 losses from the years 1987 through 1990 arising from contract terminations that occurred during those years. Compl. ¶ 31.

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ARGUMENT I THE FRESH-START BASIS PROVISION DOES NOT APPLY TO THE DEDUCTIONS PLAINTIFF CLAIMS A. The Fresh-Start Basis Provision Does Not Give Plaintiff an Adjusted Basis in Its Healthcare Coverage Contracts

Application of the fresh-start basis provision to plaintiff's healthcare coverage contracts, as to which plaintiff has never incurred a capital cost, would conflict with the fundamental concept of tax basis. It would also undermine Congress's larger purpose in enacting § 1012 of the Tax Reform Act ­ that is, forcing the Blues to compete on a level playing field with commercial insurers by revoking the Blues' tax exemption ­ by enabling plaintiff to shield substantial amounts of income from taxation for decades after Congress repealed its exemption. The Court should therefore find that the statute does not apply to the contracts for which plaintiff claims a deduction in this case. i. Plaintiff's Interpretation Conflicts with the Fundamental Concept of Tax Basis

The fresh-start statute provides an "adjusted basis" for assets held as of January 1, 1987. A taxpayer cannot have an "adjusted basis" in an asset unless the property first has a "basis." § 1011(a) ("The adjusted basis . . . shall be the basis (determined under section 1012 or other applicable sections . . . ), adjusted as provided in section 1016"). As set forth in § 1012 of the Code, the fundamental concept of a tax basis is that the taxpayer has incurred a capital cost for the asset. § 1012 ("The basis of property shall be the cost of such property"). If the fundamental requirement of incurring a capital cost is met, then the fresh-start provision allows the taxpayer to increase, or requires the taxpayer to decrease, the cost basis to allow for pre-1987 appreciation - 11 -

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or depreciation in value ­ i.e., to adjust the cost basis for pre-1987 appreciation or depreciation. The fresh-start basis provision does not apply, however, to assets that had no tax basis in the taxpayer's hands as of January 1, 1987. The nature of plaintiff's costs incurred in connection with the healthcare coverage contracts as self-created assets is such that plaintiff never incurred a capital cost with respect to those contracts. The fresh-start basis provision therefore does not apply to the contracts. The tax basis of an asset is its cost. § 1012. When a taxpayer purchases an asset from another party, the property will have a basis in the hands of the buyer equal to the purchase price. Plaintiff's insurance contracts, however, are "self-created," not purchased, intangibles. DPF 39. The tax basis of a self-created asset is equal to the capital expenditures incurred in creating it ­ that is, the costs of creation that the taxpayer capitalized, rather than deducted as ordinary and necessary expenses. Plaintiff, however, did not incur any capital expenditures in creating its healthcare coverage contracts. Like customer lists, subscriber lists, and the like, the contracts came into being in the ordinary course of plaintiff's business, as a consequence of many small expenditures, none of which is allocable to any particular contract. Each year, plaintiff incurs substantial expenses for advertising, a sales staff, actuaries to compute premiums and the like, all aimed at selling insurance. DPF 4. All of those expenditures are deducted by plaintiff currently, and none are capitalized as the cost of producing any particular insurance contract or all of the insurance contracts entered into by plaintiff in a particular year. DPF 6-7, 40. That is how plaintiff accounts for its insurance contracts and such expenses on an ongoing basis, and that is how plaintiff's never-tax-exempt competitors account for ­ and have always

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accounted for ­ such contracts and such expenses. The contracts for which plaintiff claims a deduction therefore had no pre-existing basis as of January 1, 1987. Plaintiff nonetheless asserts that the fresh-start statute provides plaintiff an adjusted basis in the contracts. The fallacy of plaintiff's argument is that plaintiff interprets the fresh-start provision as providing that the tax basis can consist entirely of pre-1987 appreciation in value, without the taxpayer having any initial capital cost basis in the contracts. In thus misconstruing the fresh-start provision, plaintiff's position would render the fresh-start provision inconsistent with the fundamental concept of a cost basis. See § 1012. It is black-letter law that the provisions of a statute will, if possible, be construed so that they will be consistent, rather than inconsistent, with other statutes dealing with the same subject matter.5 Under plaintiff's construction of the fresh-start provision, it would be inconsistent with § 1012 of the Code. Therefore, plaintiff's construction must be rejected in favor of the Government's construction, under which no basis would be recognized in the healthcare coverage contracts for which plaintiff has no capital cost.

Norman J. Singer, Statutes and Statutory Construction § 46.05 at 175-76 (6th ed. 2000) ("The general rule is followed that prior and later statutes dealing with the same subject matter although in apparent conflict, should as far as reasonably possible be construed in harmony with each other so as to allow both to stand and to give force and effect to each" (internal footnote omitted)); see, e.g., Orquera v. Ashcroft, 357 F.3d 413, 422 (4th Cir. 2003) (rejecting a statutory interpretation that would have created a conflict between the provision in question and a separate statute on the same subject); In re Johnson, 787 F.2d 1179, 1181 (7th Cir. 1986) ("Where two statutes deal with the same subject matter, they are to be read in pari materia and harmonized when possible"); c.f. Sterling Fed. Sys., Inc. v. Goldin, 16 F.3d 1177, 1185 (Fed. Cir. 1994) ("[A] basic rule of statutory construction is that the whole of the statute should be considered in ascertaining the meaning of language therein"). - 13 -

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ii.

Plaintiff's Interpretation Conflicts with the Broader Statutory Framework and Purpose of § 10126 of the Tax Reform Act

Plaintiff's attempt to apply the fresh-start provision to its healthcare coverage contracts conflicts, not only with the fundamental concept that a taxpayer must incur a capital cost to receive basis in an asset, but also with the remainder of § 1012 of the Tax Reform Act.7 The congressional purpose in enacting § 1012 of the Tax Reform Act was to repeal the Blues' tax exemption and make their income subject to taxation. Not only is the statute entitled "Repeal of Tax-Exempt Status for Certain Organizations Providing Commercial-Type Insurance," but the first two of the statute's three subsections amend the Internal Revenue Code to subject the Blues to taxation,8 leaving the third subsection to address more technical implementation rules, such as the effective date of the statute, organization-specific exemptions, and the basis adjustment at issue here. Coincidentally, the cost-basis rule and the fresh-start basis rule share the same section number (§ 1012) ­ the former refers to the Internal Revenue Code, however, while the latter refers to the Tax Reform Act of 1986. Norman J. Singer, Statutes and Statutory Construction § 46.05 at 174-75 (6th ed. 2000) ("[T]he general purpose, intent or purport of the whole act shall control, and . . . all the parts be interpreted as subsidiary and harmonious to its manifest object, and if the language is susceptible of two constructions, one which will carry out and the other defeat such manifest object, it should receive the former construction" (internal footnote omitted)); see, e.g., Reves v. Ernst & Young, 494 U.S. 56, 63 (1990) ("[T]he phrase `any note' should not be interpreted to mean literally `any note,' but must be understood against the backdrop of what Congress was attempting to accomplish in enacting the Securities Acts"). Subsection (a) amends I.R.C. § 501 as follows: "An organization described in paragraph (3) or (4) of subsection [501] (c) shall be exempt from tax under subsection (a) only if no substantial part of its activities consists of providing commercial-type insurance." TRA 1986, Pub. L. No. 99-514, § 1012(a), 100 Stat. 2085, 2390 (codified as I.R.C. § 501(m)(1)). Subsection (b) adds a new § 833 to the I.R.C., providing that "any existing Blue Cross or Blue Shield organization" shall be "taxable . . . in the same manner as if it were a stock insurance company." TRA 1986, Pub. L. No. 99-514, § 1012(b), 100 Stat. 2085, 2391 (codified as I.R.C. § 833(a)(1), (c)(1)(A)). - 14 8 7 6

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The legislative history makes clear this purpose of the statutory framework: The committee is concerned that exempt charitable and social welfare organizations that engage in insurance activities are engaged in an activity whose nature and scope is so inherently commercial that tax exempt status is inappropriate. The committee believes that the tax-exempt status of organizations engaged in insurance activities provides an unfair competitive advantage to these organizations. The committee further believes that the provision of insurance to the general public at a price sufficient to cover the costs of insurance generally constitutes an activity that is commercial. In addition, the availability of tax-exempt status under present law has allowed some large insurance entities to compete directly with commercial insurance companies. For example, the Blue Cross/Blue Shield organizations historically have been treated as tax-exempt organizations described in sections 501(c)(3) or (4). This group of organizations is now among the largest health care insurers in the United States. Other tax-exempt charitable and social welfare organizations engaged in insurance activities also have a competitive advantage over commercial insurers who do not have tax-exempt status. H.R. Rep. No. 99-426, at 664 (1985). It is apparent that the overriding objective of Congress in passing § 1012 of the Tax Reform Act was to eliminate the competitive imbalance that existed between tax-exempt insurers, such as the Blues, and commercial health insurers. Plaintiff's interpretation of the fresh-start basis provision would thwart the accomplishment of that objective by enabling plaintiff to shield substantial amounts of income from taxation, by using a device unavailable to its competitors. As interpreted by plaintiff, the fresh-start basis provision would provide plaintiff with millions of dollars of deductions, rendering that much of plaintiff's post-1986 income untaxed. As explained above, plaintiff's use of the fresh-start basis accomplishes this by transforming plaintiff's group healthcare coverage contracts from self-created property, with a zero basis, into assets with a basis of over $303 million. See DPF 15. Before application of the fresh-start basis provision, the amount of plaintiff's deduction for the termination of a contract would be zero, since § 165(b) limits the

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deduction to the adjusted basis of the property. By invoking the fresh-start basis provision, and by claiming that its group healthcare coverage contracts had a January 1, 1987, fair market value of $303 million, and then claiming loss deductions in that amount spread over the lives of those contracts, plaintiff is able to shield $303 million of post-1986 income from tax. By way of comparison, plaintiff's average taxable income during the period 1991 through 1995 was $88 million per year. DPF 16. Thus, plaintiff's interpretation of the fresh-start basis enables it to shield over three years' worth of income from taxation. Of course, by effectively postponing the day when plaintiff becomes fully taxable, on a basis equivalent to its always-taxed competitors, allowance of plaintiff's claim in this case perpetuates plaintiff's competitive advantage with respect to those competitors, the very advantage Congress sought to eliminate by enacting § 1012 of the Tax Reform Act of 1986. This competitive advantage will continue until all of the contracts held by plaintiff in 1987 lapse or are terminated. Plaintiff's experts seem to suggest that this may not occur until after 2025. DPF 17. Thus, plaintiff will have contrived to preserve a tax advantage over its competitors for four decades after Congress thought it had imposed tax parity. B. The Fresh-Start Basis Provision Applies Only to Gain or Loss Upon the Sale or Exchange of an Asset

Even if the fresh-start provision were to apply to basis-less property like plaintiff's healthcare coverage contracts, it would not be available for the type of "loss" deductions plaintiff claims. The text of the fresh-start basis provision does not clearly specify for what purposes it applies. Plaintiff's claim at bar is premised on the proposition that the word "loss" in the freshstart phrase "gain or loss" refers to the same events and transactions that fall within § 165(a), which provides that "[t]here shall be allowed as a deduction any loss sustained during the taxable - 16 -

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year and not compensated for by insurance or otherwise." Alleging that the termination of healthcare coverage contracts generates a loss deductible under § 165(a), plaintiff claims deductions equal to the fair market value of each terminated contract as of January 1, 1987. Whatever its superficial appeal, plaintiff's argument ignores the various ways in which Congress has used the word "loss," as well as the congressional purpose behind the transition rules. i. The Provision Does Not Apply to "Any Loss"

Section 165(a), upon which plaintiff relies for its claimed deductions, modifies the word "loss" with the word "any." § 165(a). The fresh-start basis provision refers, instead, to "gain or loss." Given the generally expansive meaning of the word "any," the different phrasing suggests that Congress did not intend the fresh-start basis provision to be co-extensive with § 165(a). See United States v. Gonzales, 520 U.S. 1, 5 (1997) ("Read naturally, the word `any' has an expansive meaning"). Had Congress intended to provide a fresh-start basis for all events that are deductible under § 165(a), it could have done so less ambiguously by including the phrase "any loss" in the fresh-start basis provision. Indeed, legislation passed just two years before the Tax Reform Act of 1986 shows Congress not only could have done so, but that Congress has done so with respect to other extraordinary basis adjustment rules, enacted in a context identical to that of the Tax Reform Act of 1986. Before 1984, the Federal Home Loan Mortgage Corporation (the "FHLMC") was exempt from federal income taxation. See 12 U.S.C. § 1452(d) (1983) (repealed 1984). In 1984, as it would with respect to the Blues in 1986, Congress subjected the FHLMC to taxation for the first time after determining that the rationale for its exemption no longer existed. Deficit Reduction Act of 1984, Pub. L. 98-369, § 177(a)(1), 98 Stat. 494, 709 (1984). As it repealed the FHLMC's

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tax exemption, however, Congress was concerned ­ as it was when it enacted the provision at issue in this case ­ about the tax treatment of assets acquired before the repeal. To address that concern, Congress gave the FHLMC a fair-market-value basis in its property held on the day it became taxable. That basis-adjustment provision states: (2) Adjusted Basis of Assets. ­ (A) In General. ­ Except as otherwise provided in subparagraph (B), the adjusted basis of any asset of the Federal Home Loan Mortgage Corporation held on January 1, 1985, shall­ (i) for purposes of determining any loss, be equal to the lesser of the adjusted basis of such asset or the fair market value of such asset as of such date, and (ii) for purposes of determining any gain, be equal to the higher of the adjusted basis of such asset or the fair market value of such asset as of such date. Pub. L. 98-369, § 177(d)(2)(A), 98 Stat. 494, 711 (not codified) (emphasis added). The difference in wording between the Blues' fresh-start basis provision and the FHLMC provision is noteworthy. By providing the FHLMC basis adjustment for purposes of determining "any loss" ­ the exact term used in § 165(a) ­ Congress strongly suggested that the basis adjustment applies to all § 165(a) events, not just sales and exchanges. By contrast, when it addressed the same concerns upon the repeal of the Blues' exemption, Congress chose different language, providing a basis adjustment for purposes of determining "gain or loss," not "any loss." This difference not only highlights the ambiguity of the provision at issue here as applied to the deductions claimed by plaintiff, but also suggests that Congress intended to provide the Blues with a more limited basis adjustment than one that would apply to "any loss" deductible under § 165(a).

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ii.

"Gain or Loss" Generally Refers to Sales, Exchanges, and Other Dispositions of Property

The term "loss" in the fresh-start basis provision is part of the phrase "determining gain or loss," which connotes a narrower application than that of § 165(a). The Internal Revenue Code normally uses the phrase "gain or loss" in the context of sales, exchanges, or other dispositions of property, that is, in the context of transactions that ­ by their nature ­ may produce either a gain or a loss. See, e.g., § 954(c)(1) (referring to "gains and losses" from the "sale or exchange" of property); § 1231(a) (same); § 1223(2) (referring to "gain or loss from a sale or exchange"); § 172(d)(4)(A) (referring to "gain or loss" from the "sale or other disposition" of property); § 1001(e)(1) (same); § 1011(a) (same); § 1001 (using the heading "Determination of Amount of and Recognition of Gain or Loss" to refer to gain or loss "from the sale or other disposition of property" or "the sale or exchange of property"); § 1011 (using the heading "Adjusted Basis for Determining Gain or Loss" to refer to gain or loss "from the sale or other disposition of property"). If Congress intended the phrase "gain or loss" in the fresh-start basis provision to refer only to gains or losses generated by sales and exchanges, then plaintiff's instant claim must fail. Plaintiff's claimed losses arose when its healthcare contracts lapsed by their terms, and were not renewed, or were cancelled by plaintiff or an insured, again pursuant to the contract terms. In no instance has plaintiff claimed a deduction arising from a transaction that involved a sale or exchange. iii. The Legislative History Shows That the Fresh-Start Basis Is Available for Only Sales and Exchanges

The purpose of the foregoing analysis is not to persuade the Court that the Government's interpretation of the phrase "gain or loss" in the fresh-start basis provision is the only possible

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interpretation. Instead, we seek to make the more limited point that plaintiff's interpretation is not the only meaning that the phrase can possibly have, and that the statute is therefore not clear on its face, as plaintiff contends. Because the statute is susceptible of multiple interpretations ­ with differing consequences ­ it is appropriate to consult the legislative history to resolve the ambiguity. See, e.g., Dick v. Office of Personnel Mgmt., 216 F.3d 1353, 1356 (Fed. Cir. 2000) ("Since the statute is ambiguous with respect to its application in this case, we have reviewed the legislative history of the amendment"). Section 1012 of the Tax Reform Act was inserted in the House Bill under consideration by the Conference Committee. The committee explained: The basis step-up is provided solely for purposes of determining gain or loss upon sale or exchange of the assets, not for purposes of determining amounts of depreciation or for other purposes. The basis adjustment is provided because the conferees believe that such formerly tax-exempt organizations should not be taxed on unrealized appreciation or depreciation that accrued during the period the organization was not generally subject to income taxation. H.R. Conf. Rep. No. 99-841, at II-350 (1986), reprinted in 1986 U.S.C.C.A.N. 4075, 4438; see also Staff of Joint Comm. on Taxation, 99th Cong., General Explanation of the Tax Reform Act of 1986, at 591 (Joint Comm. Print 1987) ("The basis adjustment is provided solely for purposes of determining gain or loss upon sale or exchange of the assets, not for purposes of determining amounts of depreciation or for other purposes"). Thus, while the statutory language is ambiguous, the legislative history could not be clearer: Congress intended the "fresh-start basis" provision to apply only to sales or exchanges, and not for "other purposes," such as the losses claimed by plaintiff at bar. Plaintiff's claim must therefore fail.

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iv.

As Interpreted by Plaintiff, the Fresh-Start Basis Provision Would Not Serve the Purpose for Which It Was Enacted

Plaintiff argues that the text of the fresh-start basis provision unambiguously refers to all events that fall under § 165(a). As demonstrated above, that contention does not withstand scrutiny. But plaintiff's interpretation of "gain or loss" should be rejected on the additional independent ground that, as interpreted by plaintiff, the provision fails to serve a rational purpose, and leads to inconsistent results. Application of the fresh-start basis to contract terminations would fail to serve the purpose for which the provision was enacted ­ that is, to protect pre-1987 appreciation and depreciation from taxation. In contrast to the application of the fresh-start basis provision when a taxpayer sells property (as Congress intended), application of the fresh-start basis provision to the deductions claimed here would never have the intended effect of avoiding taxation of pre-1987 appreciation or depreciation.9 The Conference Committee explained the reason for the fresh-start basis provision: "The basis adjustment [was] provided because the conferees believe[d] that such formerly tax-exempt organizations should not be taxed on unrealized appreciation or depreciation that accrued during the period the organization was not generally subject to income taxation." See H.R. Conf. Rep.

Norman J. Singer, Statutes and Statutory Construction § 46.05 at 173 (6th ed. 2000) ("The presumption is that the lawmaker has a definite purpose in every enactment"); see, e.g., Nixon v. Missouri Municipal League, 541 U.S. 125, 133 (2004) ("We think that the strange and indeterminate results of using federal preemption to free public entities from state or local limitations is the key to understanding that Congress used `any entity' with a limited reference to any private entity when it cast the preemption net"); Public Citizen v. United States Dep't of Justice, 491 U.S. 440, 454 (1989) ("Where the literal reading of a statutory term would compel an odd result, we must search for other evidence of congressional intent to lend the term its proper scope. The circumstances of the enactment of particular legislation, for example, may persuade a court that Congress did not intend words of common meaning to have their literal effect" (internal quotation marks and citations omitted)). - 21 -

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No. 99-841, at II-350, reprinted in 1986 U.S.C.C.A.N. at 4438 (emphasis added); see also Staff of Joint Comm. on Taxation, 99th Cong., General Explanation of the Tax Reform Act of 1986, at 591 (Joint Comm. Print 1987) ("The basis adjustment is provided because Congress concluded that such formerly tax-exempt organizations should not be taxed on unrealized appreciation or depreciation that accrued during the period the organization was not generally subject to income taxation" (emphasis added)). In other words, Congress wanted to tax the Blues on only the changes in the value of their assets that occurred after the Blues became taxable. As an example, assume that plaintiff had purchased real estate in 1950 for $100,000; that, by 1987, the property had appreciated in value to $150,000; and that, in 1991, plaintiff sold the property for $250,000. Pursuant to the fresh-start basis provision, plaintiff's basis in the property at the time of the sale would be $150,000. Thus, plaintiff would pay tax on only the $100,000 of appreciation accruing between 1987 and 1991. The $50,000 of pre-1987 appreciation would remain tax-free, because it accrued during the time when plaintiff was tax exempt. Congress's goal of shielding pre-1987 appreciation and depreciation from taxation is applicable, however, only when a Blue Cross organization receives something of value upon the disposition of an asset and not, as here, when an insurance contract lapses in the ordinary course of plaintiff's business. Such an event, by its nature, cannot give rise to gain, and thus there can never be any gain that ­ for fairness sake ­ must be shielded from tax. Thus, Congress's concern to avoid taxing the Blues on pre-1987 appreciation and depreciation is never implicated in the type of "loss" (contract lapses) that forms the basis of plaintiff's claims. Application of the fresh-start basis to plaintiff's claimed deductions would therefore fail to serve the purpose for which the provision was enacted.

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v.

Plaintiff's Interpretation of the Fresh-Start Basis Provision Is Inconsistent with the Inapplicability of the Provision to Depreciation Deductions

Oddly, while plaintiff claims deductions for the termination of individual healthcare coverage contracts, there is no evidence that plaintiff has ever bought or sold such a property; plaintiff has never accounted for contracts that way (about which, see below); and, in this very case, plaintiff has not valued individual contracts. In fact, plaintiff has always treated its contracts consistent with their being one mass asset. As a consequence, plaintiff's "loss" deductions are indistinguishable from depreciation of the mass asset comprised of plaintiff's subscriber base, and allowance of such deductions therefore contravenes the express congressional intent to preclude application of the fresh-start basis provision to depreciation deductions. To begin, the serial nature of deductions for terminated contracts and plaintiff's method of valuing the contracts demonstrate that the real "asset" at issue is plaintiff's subscriber base, and that the loss deductions plaintiff claims are functionally equivalent to the depreciation of such asset. Plaintiff is presently claiming a § 165(a) deduction for each group subscriber that existed as of January 1, 1987, whose contract terminated in the years 1987 through 1995. Compl. ¶¶ 24-31. Plaintiff plans to continue claiming such deductions in the years that the remaining contracts that existed on January 1, 1987, terminate. DPF 18. Thus, the § 165(a) deductions plaintiff claims will eventually span the same period of time that would have constituted the useful life of the aggregate group subscriber base. Moreover, the total value of the individual § 165(a) deductions will be equivalent to the fair market value of the aggregate subscriber base as of January 1, 1987 ­ in other words, the same as the fresh-start basis of the aggregate subscriber base. At the end of the day, plaintiff will have taken its insurance contracts - 23 -

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in force ­ its primary income-producing asset as of January 1, 1987 ­ and will have invoked the fresh-start provision to deduct (via loss deductions as the contracts terminate) their entire fair market value, spread over their useful life. Had plaintiff instead claimed entitlement to amortization deductions (explicitly forbidden in Congress's intent), plaintiff would have deducted their fair market value as of January 1, 1987, over the useful life of all of the contracts: There is no difference between these approaches. The one apparent difference between the § 165(a) deductions claimed by plaintiff and depreciation deductions is that the timing of the individual § 165(a) deductions is controlled by the actual terminations of individual contracts, as opposed to a standardized depreciation schedule. Even that apparent difference, however, is meaningless in light of plaintiff's methodology for valuing the contracts. While plaintiff claims that each healthcare coverage contract was a discrete intangible asset that had an ascertainable fair market value as of January 1, 1987, see Compl. ¶ 26, plaintiff actually derived those "discrete" values, not through an analysis of the unique characteristics of each contract, but rather by gathering and averaging data from all (or broad categories) of its contracts. DPF 19-32. The lack of contract-specific data used in its valuation means that the value plaintiff is claiming for each individual contract termination is less a measure of that actual contract's actual value than it is a certain percentage of the value of all of the contracts that existed on January 1, 1987 ­ just as the amount of a depreciation deduction represents a percentage of the value of the wasting asset. Thus, the timing of individual contract terminations amounts to nothing other than a depreciation schedule for the entire subscriber base asset, and the deductions plaintiff is claiming upon the termination of individual contracts are the functional equivalent of depreciation deductions.

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This functional equivalence is problematic for plaintiff in the instant case, because no amount of stretching can possibly make the phrase "for purposes of determining gain or loss" encompass depreciation deductions.10 And, as a matter of fact, the legislative history makes plain that Congress had no intention of allowing such deductions. The Conference Committee report confirms that the inapplicability of the provision to depreciation deductions was a deliberate decision, not an inadvertent oversight. The report states clearly: "The basis step-up is provided . . . not for purposes of determining amounts of depreciation." H.R. Conf. Rep. No. 99841, at II-350, reprinted in 1986 U.S.C.C.A.N. at 4438; see also Staff of Joint Comm. on Taxation, 99th Cong., General Explanation of the Tax Reform Act of 1986, at 591 (Joint Comm. Print 1987) ("The basis adjustment is provided . . . not for purposes of determining amounts of depreciation"). Plaintiff's interpretation of the fresh-start basis provision would therefore lead to the odd result that, although taxpayer would not be able to use the basis step-up for depreciating an asset, taxpayer would be able to achieve the same tax effect by dividing the asset into smaller parts and deducting the "discrete" value of each part as it expires.

In Federal Home Loan Mortgage Corp. v. Commissioner, 121 T.C. 129 (2003), the court held that the basis adjustment provided to the Federal Home Loan Mortgage Corporation applied for purposes of determining depreciation amounts. In reaching that decision, however, the court distinguished the provision at issue here on the grounds that (1) the two basisadjustment provisions use different wording and (2) the legislative history to the Blue Cross and Blue Shield provision expressly prohibits the use of the basis adjustment for depreciation. See id. at 141-42. - 25 -

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II PLAINTIFF IS NOT ENTITLED TO A REFUND BECAUSE IT MADE AN UNAUTHORIZED CHANGE IN ITS METHOD OF ACCOUNTING A taxpayer must maintain a consistent method of accounting for its income and deductions. Section 446(e) provides that "a taxpayer who changes the method of accounting on the basis of which he regularly computes his income in keeping his books shall, before computing his taxable income under the new method, secure the consent of the Secretary." § 446(e). In 1995 (nine years after the statute was enacted), plaintiff, for the first time, claimed deductions for the termination of individual healthcare coverage contracts. This constituted a change in accounting method requiring the consent of the Commissioner. Plaintiff did not request the consent of the Commissioner to this change at any time between the filing of its original 1987 through 1994 income tax returns (none of which claimed these deductions), and the filing of its refund claims for 1991 through 1994 or its original return for 1995, on which plaintiff claimed the deductions at issue in this case. DPF 12-14.11 The purpose of requiring a taxpayer to obtain the Service's consent before changing its method of accounting is to enable the IRS to determine whether the change results in distortions

At the same time that it filed its original 1987 return, plaintiff did file an application for a change in accounting method for that year to take advantage of § 1012(c)(3)(A)(i) of the Tax Reform Act of 1986, Pub. L. No. 99-514, 100 Stat. 2085, 2394. (Plaintiff's Second Amended Response to Defendant's First Set of Requests for Admissions Nos. 29-30 and attachment (Def. Ex. 2, App. B at B-9 - B-10, B-24 - B-32). That section authorized Blue Cross and Blue Shield organizations to change accounting methods in 1987 from their pre-1987 financial accounting methods without penalty. Both of the changes in accounting method at issue in this case, however, occurred after 1987. That is, plaintiff adopted a method of accounting on its original 1987 through 1994 returns and then changed from that method without securing the Commissioner's consent. The changes at issue therefore do not fall within the terms of plaintiff's 1987 application. - 26 -

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of the taxpayer's income or deductions ­ such as the omission of items from income, or the doubling of deductions or exclusions ­ and to make the necessary adjustments to avoid those results. Diebold, Inc. v. United States, 891 F.2d 1579, 1583 (Fed. Cir. 1989), cert. denied, 498 U.S. 823 (1990). Thus, even a change from an incorrect method to a correct method requires consent. Id.; 26 C.F.R. § 1.446-1(e)(2)(i) (1995). The question, therefore, is whether plaintiff's treatment of its healthcare coverage contracts constituted a "method of accounting" that it changed without consent. The term "method of accounting" includes not only the overall method of accounting of the taxpayer but also the accounting treatment of any material item. 26 C.F.R. § 1.4461(e)(2)(ii)(a) (1995). A material item is any item that involves the proper timing for the inclusion of income or the taking of a deduction. Id.; see also Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d 781, 799 (11th Cir. 1984) (holding that a taxpayer's rebate reserve method was a "material item," because it determined when income would be taxed). The treatment of a material item in the same way in two or more consecutively filed tax returns constitutes a method of accounting. Rev. Rul. 90-38, 1990-1 C.B. 57 (1990). This is true even if the consistent treatment was erroneous. Id. For this reason, courts look to a taxpayer's tax returns to determine the taxpayer's method of accounting . See, e.g., Aluminum Castings Co. v. Routzahn, 282 U.S. 92, 99 (1930) (relying on "[t]he use of inventories, and the inclusion in the returns of accrual ite