                       122 T.C. No. 11



               UNITED STATES TAX COURT



  CAPITAL BLUE CROSS AND SUBSIDIARIES, Petitioner v.
      COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 13322-01.              Filed March 12, 2004.



     As part of its statutory conversion under sec.
1012(a) and (b) of the Tax Reform Act of 1986, Pub. L.
99-514, 100 Stat. 2390, from a tax-exempt to a taxable
entity, petitioner generally was entitled to step up
its tax basis in its assets to their Jan. 1, 1987, fair
market value.

     Held, among other things, for 1994: (1) The basis
step-up provision of sec. 1012(c)(3)(A)(ii) of the Tax
Reform Act of 1986, Pub. L. 99-514, 100 Stat. 2394, is
not limited to “sale or exchange” transactions; and (2)
because petitioner’s valuation of its health insurance
group contracts did not constitute a contract-by-
contract valuation, did not establish a credible
discrete value for each contract, and is otherwise
deficient, claimed loss deductions under sec. 165,
I.R.C., in the cumulative total amount of $3,973,023
relating to petitioner’s 376 health insurance group
contracts that were terminated in 1994 are not
allowable.
                               - 2 -




     Peter H. Winslow and Samuel A. Mitchell, for petitioner.

     Ruth M. Spadaro, James D. Hill, Robin L. Herrell, and

Adam Trevor Ackerman, for respondent.


                              OPINION

     SWIFT, Judge:   For 1994, respondent determined a deficiency

of $532,192 in petitioner’s Federal income tax.

     The issue for decision involves the allowability of

$3,973,023 (hereinafter rounded to $4 million) in cumulative

total loss deductions claimed under section 165 relating to

petitioner’s health insurance group contracts (group contracts).

     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for 1994, and all Rule

references are to the Tax Court Rules of Practice and Procedure.

     Petitioner, Capital Blue Cross, is the common parent of an

affiliated group of corporations that filed consolidated

corporate Federal income tax returns.    The loss deductions at

issue relate to the business activity of Capital Blue Cross, and

references to “petitioner” in the singular refer only to Capital

Blue Cross.


                            Background

     Some of the facts have been stipulated and are so found.
                                 - 3 -

     In 1938, petitioner was organized under the laws of

Pennsylvania as a “hospital plan corporation” to provide health

insurance to individuals and to sponsoring groups (e.g.,

employers).   Petitioner maintains its corporate office in

Harrisburg, Pennsylvania.

     In 1972, petitioner became licensed as an independent Blue

Cross Association under which license petitioner was authorized

to sell health insurance to individuals and to sponsoring groups

located within a 19-county area of south-central Pennsylvania

under the registered trade name and service mark of the Blue

Cross Association.

     In 1982, the Blue Cross Association merged with the National

Association of Blue Shield Plans to form the Blue Cross Blue

Shield Association (BCBS).   After BCBS was formed in 1982,

petitioner operated as an independent licensee of BCBS and

continued to sell health insurance to individuals and to groups

in south-central Pennsylvania.

     On November 1, 1985, by merger with Blue Cross of Lehigh

Valley, petitioner also acquired the right to sell health

insurance in the two counties located in Lehigh Valley,

Pennsylvania.   Thereafter, under the registered trade name and

service mark of BCBS, petitioner sold health insurance to

individuals and to groups located within a 21-county area in

south-central and in Lehigh Valley, Pennsylvania.
                              - 4 -

     In its service area, petitioner provided (and continues to

provide) health insurance to individuals and to groups who

entered into contracts with petitioner for health insurance

coverage and who paid premiums for the coverage.   Consistent with

its social mission, generally the physical condition of

individuals and of the individual members of the groups applying

for health insurance was not a basis for petitioner to decline to

provide health insurance coverage.

     As of January 1, 1987, not including health insurance

contracts that petitioner had entered into directly with

individuals, petitioner had outstanding 23,526 health insurance

group contracts.1

     Generally, sponsoring organizations for each group contract,

such as employers, as well as the individual members of each

group were to pay premiums to petitioner, and petitioner was to

provide health insurance coverage to the individual members of

each group and, where applicable, to the spouse and to the

dependents of each member.2


     1
        Because a number of groups had entered into more than one
contract with petitioner, the 23,526 group contracts in effect on
Jan. 1, 1987, represented 12,579 separate groups.
     2
        The manner by which the payment of premiums to petitioner
with regard to each group contract was divided between the group
sponsor and its individual members was decided by each group, and
petitioner had no say in that matter. References herein to
“premiums” do not distinguish between the portion thereof to be
paid by a sponsoring group and the portion thereof to be paid by
                                                   (continued...)
                              - 5 -

     Generally, each individual member of a group who purchased

insurance from petitioner could elect the type of insurance

benefit and the type of insurance coverage that would be

applicable.

     We use the word “benefit” herein to distinguish between

insurance that was applicable to an individual only, to an

individual as a parent with one or more dependents, or to an

individual as a parent with a spouse and children (family).

     We use the word “coverage” herein to distinguish between the

different types of medical costs that, as of January 1, 1987,

were reimbursable by petitioner under the various group contracts

as follows.

     Under basic medical, the costs of basic medical services

performed by “professional providers” (e.g., doctors, dentists,

optometrists, and physical therapists) were covered.

     Under basic hospital, the costs of basic hospital services

such as inpatient and outpatient services obtained in hospitals

or in surgical centers were covered.

     Under major medical, major medical services not covered

under basic medical and basic hospital were covered.   Major

medical also covered a portion of the costs of prescription

drugs.



     2
      (...continued)
individual members of each group.
                               - 6 -

     Under comprehensive, the costs of basic medical services,

basic hospital services, and major medical services were all

covered.

     As a hospital plan corporation, the health insurance

premiums charged by petitioner were regulated by the Pennsylvania

Insurance Department (PID).   Petitioner was required annually to

submit for approval to the PID its proposed health insurance

premium rates.

     As of January 1, 1987, total annual premiums charged by

petitioner with respect to each group contract were based on one

of three premium rating methods.


Community-Rated Group Contracts

     Premiums relating to groups consisting of fewer than 100

individual members (representing approximately 90 percent of all

of petitioner’s group contracts) were “community-rated”, meaning

that annual premiums for each community-rated group were based on

the cumulative claims history or claims experience of all of

petitioner’s community-rated group contracts with the same

benefit type (i.e., individual, single parent with dependents, or

family) and with the same coverage type (i.e., basic medical,

basic hospital, major medical, or comprehensive).   Claims

experience (or claims submitted to petitioner) for the current

year relating to all community-rated group contracts with the

same benefit and coverage type would be reviewed by petitioner
                              - 7 -

and would serve as the basis for the premiums to be charged in

the following year for group contracts with the same benefit and

the same coverage type.

     As indicated, the distinguishing feature of community-rated

group contracts was that the annual premiums and the annual

increase or decrease, if any, in premium rates relating to

community-rated group contracts would be the same for all

community-rated group contracts with the same benefit and the

same coverage type.


Experience- and Cost-Plus-Rated Group Contracts

     Premiums petitioner charged relating to groups with 100 or

more individual members (representing more than half of the total

premiums petitioner received) were either “experience” or “cost-

plus” rated.

     With regard to experience-rated group contracts, total

claims received by petitioner from members of each experience-

rated group would be reviewed and would constitute the basis for

the premiums to be charged to the group in the following year.

Obviously, under this method, premium rate increases or decreases

relating to each experience-rated group contract would be unique.

     Experience-rated group contracts offered by petitioner had

either a “retrospective refund” or a “retrospective credit”

feature (the first providing a cash refund, the second providing

a credit) relating to situations where total premiums received by
                                 - 8 -

petitioner in a year from a group were considered excessive in

light of the total medical claims paid by petitioner during the

year on behalf of the group and its members.

     Cost-plus group contracts simply represented a variation of

experience-rated group contracts.    Premiums on cost-plus group

contracts would be calculated for the following year based upon

claims submitted to petitioner and petitioner’s administrative

costs relating to each group for a year.

     Cost-plus group contracts offered by petitioner had a

retrospective adjustment feature that, where applicable, adjusted

the total premiums received by petitioner for a year to reflect

the group’s actual claims and petitioner’s administrative costs

for the year relating to the group.


Other Matter

     As indicated, the rating formulas used by petitioner to

determine the premium rates for its group contracts were subject

to annual approval by the PID.

     Unless terminated, community-rated group contracts were

automatically renewed with petitioner on a month-to-month basis,

and experience-rated and cost-plus group contracts were

automatically renewed with petitioner on an annual basis.

     Regardless, however, of the nominal renewal terms associated

with petitioner’s group contracts, as a practical matter, all of

petitioner’s group contracts were effectively terminable at will
                                 - 9 -

by each group because at any time a group could stop paying the

premiums owed to petitioner which would result in the

cancellation by petitioner of the contract.

     Groups whose health insurance group contracts with

petitioner were terminated were placed by petitioner on a

prospective customer list that was used by petitioner in

subsequent years to contact the groups and, where appropriate, to

seek renewal of the contracts.

     As of January 1, 1987, in petitioner’s 21-county service

area no other health insurance company maintained a better

provider network (consisting of hospitals, doctors, and other

providers of health care) or offered better health care benefits

at premium rates comparable to those of petitioner, and in its

service area petitioner maintained a dominant share of the

medical health insurance market.

     By 1987, however, the national health insurance marketplace

was experiencing rising health care costs, the emergence of new

health care products, and the continued growth of alternative

health care product delivery services such as Health Maintenance

Organizations (HMOs), Preferred Provider Organizations (PPOs),

and health insurance plans administered by third party

administrators.

     As a result, by 1987, petitioner faced increased competition

from HMOs and from PPOs.
                              - 10 -

     From its organization in 1938 through the time of trial in

March and April of 2003, petitioner has been exempt from

Pennsylvania premium and Pennsylvania income taxes.   See 40 Pa.

Cons. Stat. Ann. sec. 6103(b) (West 1999).

     From its organization in 1938 through December 31, 1986, for

Federal income tax purposes, petitioner operated as a tax-exempt

organization under section 501(c)(4) and its predecessor

statutes.

     Effective January 1, 1987, as a result of enactment of

sections 501(m) and 833 and because petitioner constituted an

existing Blue Cross Blue Shield organization, petitioner became

subject to Federal income tax.   Tax Reform Act of 1986, Pub. L.

99-514, sec. 1012(a) and (b), 100 Stat. 2085, 2390-2394 (TRA

1986).   The basis step-up provision of section 1012(c)(3)(A)(ii)

of TRA 1986 (hereinafter generally cited simply as TRA 1986

section 1012(c)(3)(A)(ii)) was applicable specifically to

petitioner and to other Blue Cross Blue Shield organizations.

This basis step-up provision, in situations about which the

parties dispute, provided generally that Blue Cross Blue Shield

organizations such as petitioner were entitled, for purposes of

determining gain or loss for Federal income tax purposes, to step

up their tax basis in assets owned on January 1, 1987, to the

assets’ January 1, 1987, fair market value.
                             - 11 -

     The conversion of Blue Cross Blue Shield organizations to

taxable status was enacted because Congress believed that the

prior tax-exempt status of these organizations provided the

organizations unfair competitive advantages over taxable

commercial health insurance companies.   H. Rept. 99-426, at 664

(1985), 1986-3 C.B. (Vol. 2) 1, 664.

     Petitioner’s 376 health insurance group contracts in issue

herein for 1994 constituted for petitioner self-created assets.3

     Understandably, because it was exempt from Federal income

tax, from its organization in 1938 through 1986 petitioner did

not reflect in its tax books and records any cost basis relating

to its self-created health insurance group contracts.4

Accordingly, the basis step-up provision of TRA 1986 provides

petitioner with the only ground for establishing a tax basis in

the 376 group contracts.

     Because of petitioner’s new taxable status and under

petitioner’s interpretation herein of the basis step-up provision

of TRA 1986, beginning January 1, 1987, petitioner would have



     3
        Apparently, petitioner’s 376 group contracts (which were
terminated in 1994 and to which the loss deductions in dispute
herein relate) do not include any of the Lehigh Valley group
contracts that arguably were “purchased” by petitioner in 1985
when petitioner merged with Blue Cross of Lehigh Valley.
     4
        Also, for the indicated pre-1987 years the evidence does
not indicate that petitioner’s financial books and records
reflected any cost basis in its self-created health insurance
group contracts.
                             - 12 -

been entitled to make adjustments in its tax books and records to

reflect a step up in its tax basis, for purposes of determining

gain or loss, relating to each of its 23,526 group contracts that

were in effect on January 1, 1987 (including the 376 group

contracts at issue herein), from zero to an amount equal to each

contract’s January 1, 1987, fair market value.   During 1987

through 1994, however, in petitioner’s tax books and records no

such tax basis adjustments were made.

     Accordingly, on its originally filed corporate Federal

income tax returns for 1987, 1988, 1989, 1990, 1991, 1992, and

1993, petitioner claimed no loss deductions under section 165

relating to its health insurance group contracts that were

outstanding on January 1, 1987, and that were terminated during

each respective year.

     On its 1994 corporate Federal income tax return, petitioner

first claimed loss deductions under section 165 relating to

terminated health insurance group contracts.

     As filed on approximately September 15, 1995, there was

reflected on petitioner’s 1994 corporate Federal income tax

return loss deductions under section 165 in the cumulative total

amount of $2,648,249 relating to the claimed fair market value of

the 376 group contracts (that were among petitioner’s 23,526
                             - 13 -

group contracts in effect on January 1, 1987, and that were

terminated in 1994).5

     The total $2,648,249 in loss deductions claimed on

petitioner’s 1994 corporate Federal income tax return was based

on a September 10, 1995, valuation report (initial valuation

report) prepared for petitioner by a major accounting firm.    The

initial valuation report calculated a value for all of

petitioner’s 23,526 group contracts that were in effect on

January 1, 1987, by separating the contracts into two blocks --

small groups (with less than 100 individual members) and large

groups (with 100 or more individual members).   The initial

valuation report set forth, as of January 1, 1987, a cumulative

total value for all of petitioner’s small group contracts of

$57.8 million, and a cumulative total value for all of

petitioner’s large group contracts of $105.7 million, for a

combined cumulative total value for both blocks (representing all

23,526 of petitioner’s group contracts in effect on January 1,

1987) of $163.5 million.



     5
        Petitioner has not claimed loss deductions relating to
the termination of any health insurance contracts that it entered
into directly with individuals. Also, where a group entered into
more than one contract with petitioner, petitioner claimed a loss
deduction with regard to its multiple contracts with that group
only in the year in which the group’s last contract with
petitioner was terminated. Because of this last point, the 376
group contracts for which petitioner now claims loss deductions
for 1994 actually represent 698 insurance contracts relating to
376 groups.
                                - 14 -

     The total $2,648,249 in loss deductions claimed on

petitioner’s 1994 corporate Federal income tax return apparently

constituted simply a pro rata share of the valuation reflected in

the initial valuation report of petitioner’s small group

contracts and a pro rata share of petitioner’s large group

contracts.6

     Also, in the fall of 1995, at approximately the same time

that petitioner filed its 1994 corporate Federal income tax

return, petitioner filed amended corporate Federal income tax

returns for 1991, 1992, and 1993 (the years then open under the

applicable refund periods of limitation) in which petitioner

claimed loss deductions under section 165 and tax refunds

relating to the claimed cumulative total fair market value (as

calculated in the initial valuation report) of petitioner’s

health insurance group contracts that were in effect on

January 1, 1987, and that were terminated during each respective

year.

     On audit, in a notice of deficiency dated August 16, 2001,

respondent disallowed completely the $2,648,249 in total

cumulative loss deductions for 1994 relating to the 376 group

contracts terminated in 1994.    Also, petitioner’s claimed refunds



     6
        Because petitioner did not introduce into evidence herein
the initial valuation report, the particular math associated with
the $2,648,249 total valuation reflected therein is not in
evidence.
                               - 15 -

for 1991, 1992, and 1993, relating to group contracts terminated

in those years, were not allowed by respondent.

     In its petition filed herein on November 13, 2001,

petitioner claimed loss deductions under section 165 in the total

amount of $3,342,944 relating to the claimed cumulative total

value of the 376 group contracts terminated in 1994.   No

explanation is provided as to the increase in this amount from

the $2,648,249 in total loss deductions claimed on petitioner’s

1994 corporate Federal income tax return relating to the 376

group contracts.

     Subsequently, and in preparation for trial which was held in

March and April of 2003, petitioner’s trial expert witness

prepared a valuation report dated January 30, 2003, in which he

calculated, as of January 1, 1987, a cumulative total fair market

value of $4 million for the 376 group contracts that were

terminated in 1994 (based on a cumulative total fair market value

of $131,697,202 for all 23,526 of petitioner’s group contracts in

effect on January 1, 1987).7




     7
        The record is unclear as to how, for the 376 group
contracts terminated in 1994, petitioner’s trial expert
calculated a higher cumulative total value ($4 million) than was
calculated in petitioner’s initial valuation report ($2.6
million), even though for all 23,526 of petitioner’s group
contracts in effect on Jan. 1, 1987, petitioner’s trial expert
calculated a lower cumulative total value ($132 million) than the
initial valuation report ($163.5 million).
                              - 16 -

     Accordingly, based on its trial expert’s valuation of the

376 group contracts, petitioner now claims total loss deductions

for 1994 under section 165 in the amount of $3,973,023 (an

increase of $1,324,774 over the $2,648,249 in total loss

deductions claimed therefor on petitioner’s 1994 corporate

Federal income tax return).

     Further, on March 31, 2002, petitioner filed second amended

corporate Federal income tax returns for 1992 and 1993,

increasing for those years the total loss deductions claimed

under section 165 relating to terminated group contracts for

those years.

     For years after 1994, petitioner continued to claim loss

deductions under section 165 relating to the value of

petitioner’s group contracts in effect on January 1, 1987, that

were terminated in each respective year.

     For 1991 through 2000, the loss deductions claimed by

petitioner under section 165 relating to petitioner’s valuation

of group contracts terminated in each year (that were in effect

on January 1, 1987) total approximately $37 million as set forth

below:
                               - 17 -


                                      Amount of
                  Year          Claimed Loss Deductions
                  1991               $ 7,998,612
                  1992                 7,234,627
                  1993                 4,719,542
                  1994                 3,973,023
                  1995                 2,816,165
                  1996                 3,120,934
                  1997                 1,444,088
                  1998                 1,750,240
                  1999                 2,190,111
                  2000                 1,861,149
                                     $37,108,491


                             Discussion

     The primary issues for decision involve a legal issue and a

factual issue, as follows:   (1) Whether the basis step-up

provision of TRA 1986 is applicable to calculations of gain or

loss relating only to “sale or exchange” transactions and not to

calculations of loss relating to the “termination” of assets; and

(2) whether the specific and discrete fair market value, as of

January 1, 1987, of the 376 group contracts terminated in 1994

has been adequately established by petitioner for purposes of the

claimed loss deductions under section 165.


Construction of TRA 1986

     As explained, supra, in conjunction with their conversion

from nontaxable to taxable status, Congress provided for Blue

Cross Blue Shield organizations a fair market value basis step-up

provision.   The purpose of the basis step-up provision was to

prevent Blue Cross Blue Shield organizations from being taxed on
                               - 18 -

appreciation in the value of assets that had occurred in pre-1987

years when the organizations had not been subject to Federal

income tax.   H. Conf. Rept. 99-841 (Vol. II), at II-350 (1986),

1986-3 C.B. (Vol. 4) 1, 350.   The relevant statutory language of

the basis step-up provision as set forth in TRA 1986 section

1012(c)(3)(A)(ii), 100 Stat. 2394, provides as follows:


     for purposes of determining gain or loss, the adjusted
     basis of any asset held on the 1st day of * * * [the
     1st taxable year beginning after Dec. 31, 1986], shall
     be treated as equal to its fair market value as of such
     day.


     Respondent argues that because the above statutory language

fails to state expressly the kinds of losses to which the basis

step-up provision is intended to apply, the statutory language

should be regarded as ambiguous and the legislative history of

TRA 1986 section 1012(c)(3)(A)(ii) should be controlling.    In the

legislative history, it is stated that the basis step-up

provision is limited to “sale or exchange” transactions.    The

relevant language from the conference report is underscored

below:


     the basis of assets of * * * [BCBS] organizations is
     equal, for purposes of determining gain or loss, to the
     amount of the assets’ fair market value on the first
     day of the organization’s taxable year beginning after
     December 31, 1986. Thus, for formerly tax-exempt
     organizations utilizing a calendar period of accounting
     and whose first taxable year commences January 1, 1987,
     the basis of each asset of such organization is equal
     to the amount of its fair market value on January 1,
                              - 19 -

     1987. 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. Conf. Rept. 99-841 (Vol. II), at II-349-
     II-350, 1986-3 C.B. (Vol. 4) 1, 349-350; emphasis
     added.]


     Petitioner argues that the statutory language is not

ambiguous and provides no limitation on the types of transactions

to which the basis step-up provision applies and therefore that

the limiting language in the legislative history is irrelevant.

     In interpreting a statute, we look first to the language of

the statute, and we look only to legislative history to learn the

purpose of the statutory language or to resolve ambiguities in

the statutory language.   Robinson v. Shell Oil Co., 519 U.S. 337,
340 (1997); Consumer Prod. Safety Commn. v. GTE Sylvania, Inc.,

447 U.S. 102, 108 (1980); Valansi v. Ashcroft, 278 F.3d 203, 209

(3d Cir. 2002); Fed. Home Loan Mortgage Corp. v. Commissioner,

121 T.C. 129, 134 (2003); Wells Fargo & Co. v. Commissioner, 120

T.C. 69, 89 (2003); Allen v. Commissioner, 118 T.C. 1, 7 (2002).

     If the language of a statute is plain, clear, and

unambiguous, the statutory language is to be applied according to

its terms, United States v. Ron Pair Enters., Inc., 489 U.S. 235,

241 (1989); Burke v. Commissioner, 105 T.C. 41, 59 (1995), unless

a literal interpretation of the statutory language would lead to
                               - 20 -

absurd results.   Green v. Bock Laundry Mach. Co., 490 U.S. 504,

509 (1989); Idahoan Fresh v. Advantage Produce, Inc., 157 F.3d

197, 202 (3d Cir. 1998); Gen. Dynamics Corp. v. Commissioner, 108

T.C. 107, 121 (1997).    As the Court of Appeals for the Third

Circuit has explained:


     Where the statutory language is plain and unambiguous,
     further inquiry is not required, except in the
     extraordinary case where a literal reading of the
     language produces an absurd result. * * * [Idahoan
     Fresh v. Advantage Produce, Inc., supra at 202.]


     Recently, in Trigon Ins. Co. v. United States, 215 F. Supp.

2d 687 (E.D. Va. 2002), supplemented at 234 F. Supp. 2d 581 (E.D.

Va. 2002), the precise legal question before us as to the

interpretation of TRA 1986 section 1012(c)(3)(A)(ii) and its

application to Blue Cross Blue Shield organizations was

addressed.   Trigon Ins. Co. also involved claimed loss deductions

under section 165 relating to the termination of health insurance

group contracts that were in effect on January 1, 1987.   The

District Court agreed with the taxpayer (and with petitioner’s

legal position herein) that the language of TRA 1986 section

1012(c)(3)(A)(ii) was clear and unambiguous and therefore that,

in spite of the limiting language in the legislative history, the

statutory basis step-up provision was not limited to gains or

losses realized only on sale or exchange transactions, and the

basis step-up generally was applicable to the group contracts

terminated in each year.   The District Court explained as

follows:
                               - 21 -


            The introductory clause of sec. 1012(c)(3)(A)(ii)
       articulates that * * * [the basis step-up provision] is
       to be used “for purposes of determining gain or loss.”
       The statutory text imposes no limit on the kind of gain
       or loss to which the * * * [basis step-up provision]
       applies. The common usage of the words “gain or loss,”
       without limitation, plainly includes any gain or loss.
       * * * Thus, the statutory language at issue, given its
       ordinary meaning, is plain and unambiguous. * * *

       * * * the inconsistency relied on by the United States
       is created not by the text of statute but by a passage
       in the legislative history * * *. [Id. at 699.]


       We agree with the District Court and with petitioner herein

as to the interpretation of TRA 1986 section 1012(c)(3)(A)(ii).

We find the statutory language of TRA 1986 to be clear and

unambiguous.    Reliance on the language in the legislative history

to the contrary is not necessary and would not be appropriate

other than to understand the purpose of the statute.

       Further, the plain meaning of TRA 1986 section

1012(c)(3)(A)(ii) is consistent with the purpose of the statute

-- namely, in years after 1986 to allow Blue Cross Blue Shield

organizations to avoid tax on appreciation that had occurred in

years when such organizations were not subject to Federal income

tax.

       The limitation on the basis step-up provision sought by

respondent would frustrate the above purpose and the overall

statutory scheme of TRA 1986 section 1012(c)(3)(A)(ii).    An

example set forth in petitioner’s posttrial brief illustrates

this point.
                              - 22 -

     If petitioner sold an office building on January 1, 1994,

for a price equal to the building’s fair market value on

January 1, 1987, petitioner would not realize gain or incur tax

on the sale of the building because petitioner would have been

allowed to step up the building’s tax basis to its January 1,

1987, fair market value.   Under respondent’s interpretation,

however, if on January 1, 1994, the building was uninsured and

was totally destroyed by fire, and if petitioner claimed a

deduction under section 165 relating to the casualty loss

associated with the fire, petitioner would not be allowed to

utilize the January 1, 1987, stepped-up basis in the building

because such loss was caused by a fire, not by a sale or

exchange.   This latter result (in which petitioner, as a taxable

entity for 1994, would be taxed on the pre-1987 appreciation in

the building) would be inconsistent with the overall purpose of

TRA 1986 section 1012(c)(3)(A)(ii) to not tax such appreciation.8

     We conclude that the basis step-up provision of TRA 1986

section 1012(c)(3)(A)(ii) applies not just to sale or exchange


     8
        We also note that respondent’s legal position is contrary
to one of respondent’s own legal advice memoranda. In Tech. Adv.
Mem. 95-33-003 (Aug. 18, 1995, and not since revoked or
withdrawn), the language of the basis step-up provision of TRA
1986 sec. 1012(c)(3)(A)(ii) is construed by respondent as not
limited by the “sale or exchange” language of the legislative
history and as including an “abandonment” of computer software.

     Also, in Field Service Advice 2000-01-002 (Jan. 7, 2000),
respondent reiterated the same legal interpretation of TRA 1986
sec. 1012(c)(3)(A)(ii) and concluded generally that the basis
step-up provision was not limited to sale or exchange
transactions.
                             - 23 -

transactions but also to other types of transactions generating

losses, such as the contract terminations involved herein.   Our

conclusion is supported by a plain reading of TRA 1986 section

1012(c)(3)(A)(ii) and is consistent with and does not frustrate

the overall purpose of TRA 1986 section 1012(c)(3)(A)(ii).


The Valuation of Petitioner’s
Health Insurance Group Contracts

     Before discussing the evidence before us relating to the

valuation of petitioner’s health insurance group contracts, we

discuss legal precedent particularly relevant to the valuation of

customer-based intangible assets where tax deductions and losses

are claimed with regard thereto.   The court opinions typically

frame the issue as whether a taxpayer’s evidence, valuation, and

(where relevant) useful life determination relating to the

intangible assets are adequate to support the separate and

discrete tax treatment claimed.    Where the taxpayer’s evidence is

found to be lacking, the intangible assets may be referred to as

“mass assets”.

     In Houston Chronicle Publg. Co. v. United States, 481 F.2d

1240 (5th Cir. 1973), the Court of Appeals for the Fifth Circuit

upheld a District Court’s opinion that allowed a newspaper

publisher to depreciate the cost of subscription lists that had

been purchased from another publisher.   In reaching its

conclusion in Houston Chronicle Publg. Co., the Court of Appeals

discussed at length and generally rejected the general argument

made by the Government therein that the “mass asset” or
                             - 24 -

“indivisible asset” rule, as a matter of law, prevents

depreciation deductions for customer-based intangible assets

where such assets are linked to goodwill and where the intangible

assets possess some of the same qualities as goodwill.     Id. at

1249-1250.

     The Court of Appeals, however, provided general guidance as

to the burden of proof where tax deductions relating to

intangible assets are claimed:


     we are convinced that the “mass asset” rule does not
     prevent taking an amortization deduction if the
     taxpayer properly carries his dual burden of proving
     that the intangible asset involved (1) has an
     ascertainable value separate and distinct from
     goodwill, and (2) has a limited useful life, the
     duration of which can be ascertained with reasonable
     accuracy. [Id. at 1250.]


     In Newark Morning Ledger Co. v. United States, 507 U.S. 546

(1993), with its purchase of a commercial newspaper, a taxpayer

acquired subscriber contracts.   The Supreme Court, before

deciding whether the taxpayer could depreciate the value assigned

to the subscriber contracts, explained the mass asset or

indivisible asset rule and why certain customer-based

intangibles, as a factual matter, may be nondepreciable

thereunder, as follows:


          When considering whether a particular customer-
     based intangible asset may be depreciated, courts often
     have turned to a “mass asset” or “indivisible asset”
     rule. The rule provides that certain kinds of
     intangible assets are properly grouped and considered
     as a single entity; even though the individual
     components of the asset may expire or terminate over
                                - 25 -

     time, they are replaced by new components, thereby
     causing only minimal fluctuations and no measurable
     loss in the value of the whole. * * * [Id. at 557.]


     The Supreme Court explained further that customer-based

intangible assets relating to the expectancy of continued

business may be depreciated provided the taxpayer is able to

satisfy its evidentiary burden of establishing with reasonable

accuracy that the intangible asset is capable of being valued and

that the intangible asset diminishes in value over an

ascertainable period of time.    Id. at 566.   Whether taxpayers

satisfy this dual burden (affecting the separate tax treatment of

discrete customer-based intangible assets) constitutes a question

of fact.   Id. at 564.

     In Newark Morning Ledger Co., because the Supreme Court

concluded that the taxpayer therein had satisfied its burden of

establishing the value and useful life of the subscriber

contracts, the taxpayer was allowed the claimed depreciation

deductions for the value assigned to the contracts.     The Supreme

Court cautioned, however, that with regard to tax deductions

relating to customer-based intangibles a taxpayer’s burden of

proof “often will prove too great to bear.”     Id. at 566.

     In the same Newark Morning Ledger Co. opinion, the Supreme

Court made a number of similar statements regarding a taxpayer’s

evidentiary burden with regard to customer-based intangible

assets (in the context of claimed tax deductions relating

thereto), quoting in part from earlier court opinions and
                              - 26 -

emphasizing the importance of the taxpayer’s evidentiary basis to

support tax deductions relating to customer-based intangible

assets (even though some of the referenced opinions allowed the

deductions in dispute as did the Supreme Court in Newark Morning

Ledger Co.).   We quote below these additional statements from the

Supreme Court’s opinion in Newark Morning Ledger Co.:


     (1) “The courts that have found these assets depreciable
     have based their conclusions on carefully developed factual
     records.” * * * [Id. at 560];

     (2) “The * * * [Court of Claims in Richard S. Miller & Sons,
     Inc. v. United States, 210 Ct.Cl. 431, 537 F.2d 446 (1976)]
     concluded that the taxpayer had carried its heavy burden of
     proving that the expirations had an ascertainable value
     separate and distinct from goodwill and had a limited useful
     life * * *.” [Id. at 560];

     (3) “The Tax Court [in Citizens & S. Corp. v. Commissioner,
     91 T.C. 463 (1988), affd. 919 F.2d 1492 (11th Cir. 1990)]
     rejected the Commissioner’s position, concluding that the
     taxpayer had demonstrated with sufficient evidence that the
     economic value attributable to the opportunity to invest the
     core deposits could be (and, indeed, was) valued * * *.”
     [Id. at 562];

     (4) “The * * * [Tax Court in Co. Natl. Bankshares v.
     Commissioner, T.C. Memo. 1990-495, affd. 984 F.2d 383 (10th
     Cir. 1993)] specifically found that the deposit accounts
     could be identified; that they had limited lives that could
     be estimated with reasonable accuracy; and that they could
     be valued with a fair degree of accuracy.” * * * [Id. at
     563];

     (5) “The Court of Appeals [in Newark Morning Ledger Co. v.
     United States, 945 F.2d 555 (3d Cir. 1991), revd. 507 U.S.
     546 (1993)] concluded further that in ‘the context of the
     sale of a going concern, it is simply often too difficult
     for the taxpayer and the court to separate the value of the
     list qua list from the goodwill value of the customer
     relationships/structure.’ [Id. at 568.] We agree with that
     general observation. It is often too difficult for
     taxpayers to separate depreciable intangible assets from
     goodwill. But sometimes they manage to do it. And whether
                             - 27 -

     or not they have been successful in any particular case is a
     question of fact.” [Id. at 564];
     (6) “Although we now hold that a taxpayer able to prove that
     a particular asset can be valued and that it has a limited
     useful life may depreciate its value over its useful life
     regardless of how much the asset appears to reflect the
     expectancy of continued patronage, we do not mean to imply
     that the taxpayer’s burden of proof is insignificant.”
     * * * [Id. at 566].


     Subsequent to the Supreme Court’s 1993 opinion in Newark

Morning Ledger Co. v. United States, supra,9 court opinions

consistently have made similar statements and consistently have

placed a heavy burden on taxpayers seeking tax deductions

relating to intangible assets.   In Ithaca Indus., Inc. v.

Commissioner, 17 F.3d 684 (4th Cir. 1994), affg. 97 T.C. 253

(1991), the Court of Appeals for the Fourth Circuit explained

that the Supreme Court’s holding in Newark Morning Ledger Co.

“subsumes the mass asset rule under a broader inquiry aimed at

determining whether the asset can be valued”.   Id. at 688 n.8.

“[M]ost of the cases purporting to apply the ‘mass asset’ rule

involve evidentiary failures on the part of the taxpayer”.     Id.

at 689 n.11 (quoting Houston Chronicle Publg. Co. v. United

States, 481 F.2d at 1249).


     9
        We note generally that in 1993 sec. 197 was added to the
Code to allow for amortization of goodwill and other intangible
assets (including customer-based intangibles) purchased after
Aug. 10, 1993. Omnibus Budget Reconciliation Act of 1993, Pub.
L. 103-66, sec. 13261(g), 107 Stat. 312, 540. Sec. 197, however,
expressly excludes most self-created intangible assets from
amortization treatment thereunder, and petitioner herein makes no
argument that it should be entitled under sec. 197, for 1994 or
any other year, to amortize any cost basis in the group
contracts.
                             - 28 -

     In Globe Life & Accident Ins. Co. v. United States, 54 Fed.

Cl. 132 (2002), the Court of Federal Claims explained that in

order for a taxpayer to be entitled to amortization deductions

relating to intangible assets, the taxpayer would have to prove:


     (1) that the asset wastes over time, including that the
     asset is not a regenerating mass asset;

     (2) a reasonably accurate estimate of the period in
     which the asset wastes, meaning the asset’s useful
     life; and

     (3) a reasonably accurate estimate of the value of the
     asset over its useful life. A taxpayer’s failure to
     prove any of the three prongs is fatal to its claim.
     [Id. at 136.]


     In FMR Corp. & Subs. v. Commissioner, 110 T.C. 402 (1998),

in disallowing amortization deductions relating to expenditures

incurred in launching a number of regulated investment companies,

we explained that the availability of an amortization deduction

relating to an intangible asset “is primarily a question of fact”

with the taxpayer bearing the burden of proof.   Id. at 430

(citing Newark Morning Ledger Co. v. United States, 507 U.S. at

560, 566).

     In Meredith Corp. & Subs. v. Commissioner, 102 T.C. 406

(1994), in disallowing claimed amortization deductions relating

to an employment contract, we explained that the taxpayer’s

burden of proof was “not insignificant and ‘that burden often

will prove too great to bear.’”   Id. at 436 (quoting in part

Newark Morning Ledger Co. v. United States, supra at 566).
                                - 29 -

     In Turner Outdoor Adver., Ltd. v. Commissioner, T.C. Memo.

1995-227, in concluding that a group of leasehold interests did

not constitute a depreciable intangible asset, we explained that

“The critical question is the overall value of the leasehold

interests, and that amount must be shown with ‘reasonable

accuracy’.”   Id. (quoting in part Newark Morning Ledger Co. v.

United States, supra at 566).

     Some further discussion is appropriate with regard

specifically to claimed section 165(a) loss deductions relating

to intangible assets.   Section 165(a) allows an ordinary

deduction for a business loss sustained during a year where the

loss is not compensated for by insurance or otherwise.    The

amount of a loss deduction under section 165(a) is limited to the

taxpayer’s adjusted tax basis in the asset lost.   Sec. 165(b).

     The relevant regulations under section 165 make it clear

that loss deductions are allowable not just for losses relating

to tangible, depreciable property, but also for losses relating

to nondepreciable property.   Section 1.165-2(a), Income Tax

Regs., provides in part as follows:


     A loss incurred in a business or in a transaction
     entered into for profit and arising from the sudden
     termination of the usefulness in such business or
     transaction of any nondepreciable property, in a case
     where such business or transaction is discontinued or
     where such property is permanently discarded from use
     therein, shall be allowed as a deduction under section
     165(a) for the taxable year in which the loss is
     actually sustained. * * * [Emphasis added.]
                              - 30 -

     Generally, to be entitled to loss deductions under section

165(a) the losses must be evidenced by closed and completed

transactions, fixed by identifiable events, and sustained during

the year in which the deductions are claimed.   Sec. 1.165-1(b),

(d), Income Tax Regs.   As explained in United Dairy Farmers, Inc.

v. United States, 267 F.3d 510 (6th Cir. 2001), the event that

identifies the loss of an asset “must be observable to outsiders

and constitute ‘some step which irrevocably cuts ties to the

asset.’”   Id. at 522 (quoting Corra Res., Ltd. v. Commissioner,

945 F.2d 224, 226-227 (7th Cir. 1991), affg. T.C. Memo. 1990-

133); JHK Enters., Inc. v. Commissioner, T.C. Memo. 2003-79.

     In A.J. Indus., Inc. v. United States, 503 F.2d 660, 664

(9th Cir. 1974), the Court of Appeals for the Ninth Circuit,

citing section 1.165-1(b) and (d), Income Tax. Regs., stated that

“A loss is not sustained and is not deductible because of mere

decline, diminution or shrinkage of the value of property”.

     A number of court opinions decided prior to the Supreme

Court’s opinion in Newark Morning Ledger Co. v. United States,

supra, involved loss deductions claimed under section 165 and

attempted valuations of customer-based intangible assets, and we

believe them still to have relevance in the context of the

instant case.

     In Skilken v. Commissioner, 420 F.2d 266 (6th Cir. 1969),

affg. 50 T.C. 902 (1968), upon its purchase of a vending machine

business, a taxpayer purchased contract rights for the placement

of cigarette vending machines on different properties.   These
                               - 31 -

contract rights were terminable at will and were affected by the

taxpayer’s ongoing relationship with the owners of the properties

on which the vending machines were located.     Id. at 267.

     The Court of Appeals for the Sixth Circuit concluded, among

other things, that because the taxpayer in Skilken v.

Commissioner, supra, had not valued each contract right

separately no loss deduction was allowable.     Id. at 270-271.    The

Court of Appeals was not persuaded by the fact that the

taxpayer’s valuation method represented a recognized method in

the industry for valuing contract rights associated with a

vending machine business.   The Court of Appeals stated as

follows:


          The rule of thumb employed by [the] taxpayer no
     doubt is an accurate reflection of the average value of
     vending machine locations in such circumstances. It is
     not an accurate reflection, however, of the value of
     any particular location. * * * [Id. at 270.]


     In Sunset Fuel Co. v. United States, 519 F.2d 781 (9th Cir.

1975), a taxpayer purchased from a distributor of fuel oil a

group of customer accounts.    The taxpayer valued each account

based on a formula of 4 cents for each gallon of fuel oil

purchased by the customer during the prior 12-month period.       As

individual customers canceled their accounts with the taxpayer,

the taxpayer claimed loss deductions under section 165 based on

the above valuation formula.    Id. at 782.   Because the taxpayer

did not adequately establish a basis in each separate account,

the court denied the claimed loss deductions under section 165
                             - 32 -

relating to the cancellation of the individual customer accounts.

The Court of Appeals for the Ninth Circuit explained as follows:


     the indivisible asset rule prevents a loss deduction
     when the nature of the purchased asset is such that
     individual accounts cannot be accurately valued. A
     taxpayer must be able to establish reasonably
     accurately a basis in the particular account on which
     the loss is claimed. Segregating out the goodwill is
     only the first step. The taxpayer must then prove the
     portion of the total purchase price allocable to the
     particular account lost. * * * [Id. at 783.]


     The Court of Appeals in Sunset Fuel Co. concluded that the

taxpayer’s “rule of thumb” valuation of assets for loss deduction

purposes was inadequate and that loss deductions had to be based

on the value of the separate assets.   The court explained

further:


     The * * * [value] of a particular account is a function
     of the [expected] flow of future income * * *
     discounted by the risk of discontinuance or nonpayment
     of that particular account * * * a risk peculiar to
     each account depending on the nature of the customer
     and his future plans and prospects. Application of the
     indivisible asset rule reflects the fact that, when a
     relatively fungible mass of accounts is purchased, the
     taxpayer cannot determine the value of each account and
     establish a basis in it, but rather determines the
     value of the whole using some rule of thumb technique
     which discounts the income to be expected from the
     whole by the risk of discontinuance [which] experience
     has indicated inheres in the mass as a whole (thereby
     averaging out the unique and indeterminable risks of
     each account). [Id. at 783-784; fn. ref. omitted.]


     In Ralph W. Fullerton Co. v. United States, 381 F. Supp.

1353 (D. Or. 1974), affd. 550 F.2d 548 (9th Cir. 1977), a

taxpayer purchased a group of insurance accounts as part of its
                              - 33 -

purchase of an ongoing general insurance agency.   The taxpayer

argued that the group of insurance accounts constituted separate

assets with respect to which loss deductions under section 165

should be allowed as the accounts were terminated in amounts

equal to the alleged cost of the accounts.   Id. at 1354.   The

court concluded that because the taxpayer failed to make an

adequate factual showing that it had valued each customer account

separately, no loss deductions were allowable on termination of

the separate contracts.   Id. at 1355.

     In affirming the District Court’s decision, the Court of

Appeals for the Ninth Circuit in Ralph W. Fullerton Co. v. United

States, 550 F.2d 548 (9th Cir. 1977), concluded that the formula

used by the taxpayer was designed to value the aggregate and was

inadequate to value separate accounts.   The court stated as

follows:


     valuation of customer accounts by resort to a formula
     applied indiscriminately to all accounts does not
     sufficiently establish the portion of the purchase
     price allocable to the individual accounts so as to
     avoid application of the mass asset rule. Indeed,
     resort to a formula * * * [is] an indication that the
     individual value of the accounts cannot satisfactorily
     be ascertained. * * * [Id. at 550 (citing Sunset Fuel
     Co. v. United States, supra).]


     As indicated, supra, recently in Trigon Ins. Co. v. United

States, 215 F. Supp. 2d 687, 720 (E.D. Va. 2002), claimed losses

relating to health insurance group contracts similar to those

involved herein were not allowed because the taxpayer had not
                             - 34 -

adequately established the fair market value (i.e., basis) of its

health insurance group contracts as of January 1, 1987.

     In regard to the nature of the evidence needed to establish

the amount of loss deductions under section 165, Mertens, Law of

Federal Income Taxation, provides generally as follows:


          Often, in proving the amount of actual loss, the
     taxpayer must demonstrate not only the value of what
     the taxpayer may have left after the loss but his cost
     or other basis in the item on which loss is sustained.
     This phase of the problem requires essentially a
     factual demonstration. Estimates and crude
     approximations are not sufficient. [7 Mertens, Law of
     Federal Income Taxation, sec. 28.04, at 25 (2001 rev.);
     fn. ref. omitted.]10


     10
        The concept that different valuation contexts may call
for different valuation approaches is not a novel or new
proposition. As stated in a leading valuation treatise: “an
asset’s value for one federal tax purpose may be different from
its value for another federal tax purpose.” Bogdanski, Federal
Tax Valuation, par. 2.03, at 2-169 (1996). An asset’s value may
differ depending on the valuation context because “both the
concepts of value and the technique of its proof are decidedly
influenced by the specific purpose for which the valuation is
made.” 1 Bonbright, The Valuation of Property, at 4-5 (photo.
reprint 1965) (1937); see also, Smith & Parr, Valuation of
Intellectual Property and Intangible Assets, ch. 5, at 140-142
(2d ed. 1994) (the value of an asset may be impacted by the
underlying purpose for the valuation of the asset).

     Courts have recognized that in the estate tax context the
valuation approach used to calculate the value of a gross estate
(e.g., a grouping of the assets together) may be different from
the approach used to calculate the value of a deduction from the
gross estate. Ahmanson Found. v. United States, 674 F.2d 761
(9th Cir. 1981); Estate of Chenoweth v. Commissioner, 88 T.C.
1577 (1987). In Ahmanson Found., the Court of Appeals for the
Ninth Circuit stated as follows:

     there are compelling considerations in conflict with
     the initially plausible suggestion that valuation for
                                                   (continued...)
                             - 35 -


     10
      (...continued)
     purposes of the gross estate must always be the same as
     valuation for purposes of the charitable deduction.
     When the valuation would be different depending on
     whether an asset is held in conjunction with other
     assets, the gross estate must be computed considering
     the assets in the estate as a block. * * * The
     valuation of these same sorts of assets for the purpose
     of the charitable deduction, however, is subject to the
     principle that the testator may only be allowed a
     deduction for estate tax purposes for what is actually
     received by the charity -- a principle required by the
     purpose of the charitable deduction. [Ahmanson Found.
     v. United States, supra at 772.]


See also Estate of Chenoweth v. Commissioner, supra at 1589,
where an asset was to be valued differently for gross estate
purposes than it was to be valued for marital deduction purposes;
and see 15 Mertens, Law of Federal Income Taxation, sec. 59.54,
at 154 (2002 rev.), which provides as follows:

     for estate tax valuation purposes a block of stock may
     be treated as a single controlling block of stock, even
     though the block is bequeathed to the decedent’s
     survivors and his spouse in separate parts. * * *
     However, for purposes of the estate tax marital
     deduction valuation, the portion of the same decedent’s
     interest in the company that passes to his surviving
     spouse should be treated as a separate minority
     interest and discounted accordingly. [Fn. refs.
     omitted.];

and Lavoie, 831-2d Tax Mgmt. (BNA), “Valuation of Corporate
Stock”, at A-62 (1998), which provides as follows:

          If a decedent dies owning a controlling interest
     in a corporation, then the stock is valued as a
     controlling interest irrespective of the number or
     identity of the decedent’s legatees. However, per share
     value determined for purposes of inclusion in the
     decedent’s gross estate does not necessarily control
     the value assigned to shares for purposes of
     determining allowable deductions to the estate. * * *
     [Fn. ref. omitted.]
                              - 36 -

and further with regard specifically to loss deductions and

intangible assets, Mertens provides:


     When an asset is composed of individual accounts which
     cannot be accurately valued, the asset is treated as an
     indivisible asset and termination of any individual
     account merely diminishes the value of the indivisible
     asset. Unless the taxpayer can prove with reasonable
     accuracy the basis in the particular account lost, the
     indivisible asset rule prohibits a loss deduction,
     since the requirement that the loss be evidenced by a
     closed and completed transaction is not met. * * *
     [7 Mertens, Law of Federal Income Taxation, sec. 28.15,
     at 49-50 (2001 rev.).]


     Petitioner herein acknowledges that loss deductions under

section 165(a) are allowable only on an asset-by-asset basis, not

on the basis of some cumulative diminution in the fair market

value of an aggregate group of assets of which the lost asset is

a part.   Accordingly, petitioner agrees that under section 165(a)

it is only the amount of a taxpayer’s specific tax basis in

separate and discrete assets that constitutes an allowable loss

deduction.   Accordingly, petitioner argues, as indeed it must,

that the $4 million (in claimed loss deductions for 1994 relating

to petitioner’s group contracts) represents the cumulative total

of 376 separate loss deductions, reflecting the cumulative total

stepped-up January 1, 1987, tax basis in each of petitioner’s 376

group contracts.11


     11
        In the instant case, with regard specifically to the
burden of proof and particularly to the difference between the
                                                   (continued...)
                              - 37 -

     The task of resolving the fact issue as to the fair market

value of petitioner’s separate health insurance group contracts

is complicated by petitioner’s pre-1987 history as a nontaxable

entity, during which years petitioner’s tax basis in and the fair

market value of petitioner’s health insurance group contracts

were not relevant and were not recorded on petitioner’s books and

records.   This task is also complicated by the provisions of the

basis step-up provision of TRA 1986, under which it was

anticipated that taxpayers who thereby became taxable would go

through a process of identifying their assets, of making fair

market valuations of those assets as of January 1, 1987, and of

     11
      (...continued)
$2,648,249 in loss deductions originally claimed on petitioner’s
1994 corporate Federal income tax return and the $4 million in
loss deductions raised by petitioner at trial relating to
petitioner’s 376 group contracts, petitioner agrees that the
burden of proof herein is on petitioner. Rule 142(a).

     With regard, however, to the $2,648,249 in loss deductions
relating to the 376 group contracts that were claimed on
petitioner’s original 1994 corporate Federal income tax return,
petitioner asserts that respondent, in the notice of deficiency,
did not raise the factual valuation issue as a ground for the
disallowance of the claimed losses (i.e., whether petitioner, for
loss deduction purposes, adequately valued the 376 group
contracts). Petitioner therefore argues that respondent, rather
than petitioner, herein should have the burden of proof as to the
factual valuation issue to the extent of the $2,648,249 in loss
deductions claimed on petitioner’s original 1994 corporate
Federal income tax return. Rule 142(a)(1).

     We disagree. In disallowing the total $2,648,249 in loss
deductions claimed on petitioner’s original 1994 corporate
Federal income tax return, respondent’s notice of deficiency,
among other things, used broad language relating to whether
petitioner sustained “any loss”, which language we believe in
this case includes the factual valuation issue.
                              - 38 -

recording and reflecting those fair market valuations on their

tax books and records on an asset-by-asset basis.

     Herein, as explained, such 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.

     Further complicating the matter before us is the fact that

the health insurance group contracts at issue herein constitute

“customer-based” intangible assets of a type that, as discussed

above, are particularly difficult to categorize and to value, to

distinguish from a taxpayer’s goodwill, and that over the years

have been the subject of difficult litigation.

     Petitioner argues that its 23,526 health insurance group

contracts constituted separate, discrete assets that may be and

that were valued separately as of January 1, 1987, and that we

should accept petitioner’s $131,697,202 cumulative total

valuation for the 23,526 group contracts in effect on January 1,

1987, and petitioner’s $4 million cumulative total valuation for

the 376 group contracts terminated in 1994, and that we should

allow petitioner the total $4 million in loss deductions claimed.

     Respondent argues that petitioner’s valuation of the 376

group contracts is deficient, that it is based on a methodology

that effectively and improperly values the 376 group contracts as
                              - 39 -

part of a block rather than as separate assets, and that it fails

to take into account discrete characteristics of each group

contract, and therefore that the group contracts should be

treated as an indivisible mass asset ineligible for the loss

deductions claimed.

     We have considered carefully the above court opinions, and

we have reviewed carefully the parties’ arguments, expert witness

reports, and expert witness testimony.   Based on that

consideration and review, we conclude that petitioner’s valuation

of its health insurance group contracts is inadequate and does

not properly and credibly establish a discrete January 1, 1987,

value (and therefore a tax basis for loss deduction purposes) for

the 376 separate group contracts.   Petitioner is not entitled to

the claimed total $4 million in loss deductions under section 165

relating to the 376 group contracts terminated in 1994.

     The valuation of petitioner’s health insurance group

contracts by petitioner’s expert was inadequate for a number of

reasons.   Petitioner’s expert derived his value for petitioner’s

health insurance group contracts by treating all of petitioner’s

23,526 group contracts in effect on January 1, 1987, as if they

were sold by petitioner together as a group in a hypothetical

reinsurance transaction.   In this hypothetical, a buyer would

acquire from petitioner the right to premiums, the risk, and the

liabilities associated with all 23,526 group contracts, with

petitioner (in exchange for a fee to be paid by the buyer to

petitioner) continuing to service all of the group contracts
                             - 40 -

under petitioner’s existing name.    Under this reinsurance model

used by petitioner’s expert, petitioner’s 23,526 group contracts

effectively were valued together as a mass and not as distinct

assets separate from each other and from petitioner’s other

intangible assets.

     In his valuation, petitioner’s expert utilized incomplete

information and either ignored, improperly applied, or made

incorrect assumptions about unique characteristics associated

with petitioner’s group contracts.

     In his analysis of the life of petitioner’s health insurance

group contracts, petitioner’s expert incorrectly assumed a 20-

year useful life for all of petitioner’s separate health

insurance group contracts, and he incorrectly assumed that lapse

rates for the group contracts would be consistent with certain

outdated information.

     We explain further the key aspects of petitioner’s expert’s

valuation of the group contracts with which we disagree.12


Reinsurance Model
     The reinsurance model used by petitioner’s expert values

petitioner’s 376 group contracts that were terminated in 1994 and


     12
        In the instant case, because petitioner went to some
significant effort to cure the item by item valuation
deficiencies that the District Court detailed in its opinion in
Trigon Ins. Co. v. United States, 215 F. Supp. 2d 687 (E.D. Va.
2002), supplemented at 234 F. Supp. 2d 581 (E.D. Va. 2002), our
criticisms of petitioner’s valuation of the group contracts are
more general than those of the District Court in Trigon Ins. Co.,
but they are equally fatal to petitioner’s claimed loss
deductions.
                             - 41 -

that are in issue in this case as if the 376 contracts were sold

in a reinsurance transaction that occurred on January 1, 1987, as

part of a larger sale for $131.7 million of all 23,526 of

petitioner’s group contracts in effect on that date.

     In treating the 376 group contracts as if they were sold

together in one transaction, along with the balance of

petitioner’s 23,526 group contracts, petitioner’s expert

erroneously minimizes the risk inherent in each separate group

contract, maximizes the value of petitioner’s group contracts,

and, for loss deduction purposes, overstates their value.

Petitioner’s expert’s $131.7 million reflects the cumulative

total value of petitioner’s 23,526 group contracts as a whole,

and the expert appears to include therein the value of

petitioner’s other intangible assets (e.g., goodwill, trade name,

and provider network).

     Petitioner’s expert acknowledged that under his method he

valued petitioner’s group contracts in a way that reflected more

than just the value of each separate group contract.   In his

report and testimony, petitioner’s expert states as follows:


     as in the case of most intangible assets, the value of
     group health insurance contracts can be realized in a
     market transaction where the contracts are transferred
     together with other assets. In this case, the
     hypothetical market transaction to realize that value
     could be a transfer that includes all of * * *
     [petitioner’s] assets, including such assets as the
     provider network. As I indicated earlier, a
     hypothetical market transaction that realizes the full
     economic value of the contracts could be structured as
     a sale by reinsurance.
                              - 42 -

     Q: Now, in making your assumption in assuming this
     reinsurance transaction, did you assume that the
     contracts, in fact, would be sold one at a time?

     A: No. In fact, I would think that would be quite
     unlikely, for the most part.

     * * * I anticipate that somebody in the insurance
     business who would be an interested buyer of this
     business would wish to buy in bulk.


     Petitioner’s expert asserts that under his reinsurance model

the value (calculated for and assigned to each of petitioner’s

376 group contracts that terminated in 1994) would be the same

whether the hypothetical sale constituted a sale of all 23,526 of

petitioner’s group contracts or constituted a sale of just the

376 group contracts that terminated in 1994.    According to

petitioner’s expert, the 376 group contracts in issue would

themselves constitute a “credible” block (i.e., the expected

income flow from the group would not be affected significantly by

fluctuations in claims experience within the block).

     As noted however, and as it must, petitioner does not claim

a single loss deduction in 1994 upon the termination of the 376

group contracts.   Rather, petitioner claims 376 separate loss

deductions relating to the termination of each of the 376

separate group contracts.   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.

     In this regard, the District Court in Trigon Ins. Co. v.

United States, 215 F. Supp. 2d at 709, stated as follows:
                              - 43 -

     the issue is not whether the highest and best use of
     * * * [the taxpayer’s group] contracts is as part of an
     ongoing health insurance company. Indeed, that is the
     only use of the contracts. The issue, instead, is
     whether specific contracts can be valued separately
     from the block of contracts to which they belong.


     To account for intangible assets such as goodwill that were

associated with the group contracts and that were not lost upon

termination in 1994 of just 376 of the group contracts,

petitioner’s expert claims that (rather than make a capital

charge to account for and to carve out the appropriate value of

the other intangible assets) he made some type of vague expense

adjustment.   Petitioner’s expert’s explanation for failing to

make a capital charge for the value of other intangible assets

associated with the 376 group contracts is not credible.

Petitioner’s expert’s valuation does not properly value and carve

out from the valuation of the 23,526 group contracts, nor does it

separate from the value of the 376 group contracts in issue, the

value of related but nonterminated intangible assets such as

goodwill.

     In summary, by treating the 376 group contracts in issue as

if they were sold in a reinsurance transaction involving a

package of all 23,526 group contracts, petitioner’s expert

effectively lumps all of petitioner’s group contracts together

and values the group contracts as a block.   This approach is

contrary to petitioner’s position that for loss deduction

purposes the 376 group contracts that were terminated in 1994

were properly and discretely valued.   In other words, all
                              - 44 -

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.13


Contract Characteristics

     Even if petitioner’s expert’s valuation model (namely, a

reinsurance transaction involving all 23,526 group contracts)

were to be regarded as a proper model for the valuation for loss

deduction purposes of petitioner’s 376 group contracts terminated

in 1994, petitioner’s expert utilized incomplete information and

made erroneous assumptions relating to the characteristics of the

group contracts that alone would support disallowance of the

$4 million in loss deductions claimed.

     First, with regard generally to all of petitioner’s group

contracts (both community rated and experience rated),

petitioner’s expert:   (1) Ignored or did not consider historical

premium payment and claim patterns and renewal expectations



     13
        We note that the appendices to the valuation report of
petitioner’s expert list separate dollar amounts for each of
petitioner’s 23,526 group contracts in effect on Jan. 1, 1987.
The amount shown for each contract, however, was calculated by
petitioner’s expert based on a valuation methodology and
assumptions that relied on the attributes and characteristics of
all of petitioner’s group contracts rather than the attributes
and characteristics of each contract as a separate and discrete
asset. This is not to say that petitioner’s expert assigned to
each of the 23,526 group contracts the same dollar amount based
solely on a pro rata share of petitioner’s expert’s $131.7
million cumulative total valuation. The dollar amount calculated
by petitioner’s expert for each of the group contracts reflected
only limited contract-specific characteristics.
                             - 45 -

relating to each contract; (2) improperly applied average premium

rates to a number of group contracts with respect to which he

lacked premium data; and (3) improperly assumed that over time

there would be neither growth nor decline in the member size of

each group.

     Another of petitioner’s experts (petitioner’s second expert)

discussed the importance of petitioner’s knowing and

understanding the historical premium payment and claim patterns

and the expectation of renewal for each separate group contract.

In comparing the relationship between an insurance company and

its individual and group customers to the relationship between a

general service provider such as a fast-food restaurant or a

supermarket and its customers, petitioner’s second expert stated

that an insurance company has a personal relationship with each

of its customers while a general service provider has a

relationship with its customer base as a whole.   According to

petitioner’s second expert, this distinction is due, in part, to

the insurance company’s knowledge and information about the

unique characteristics of each of its customers including the

historical premium payment and claim patterns for each customer

and information regarding the likelihood that each customer will

or will not renew its contract with the insurance company.

     Had petitioner’s valuation been undertaken at a time more

proximate to the January 1, 1987, valuation date, it is likely

that important information relating to the particular
                                - 46 -

characteristics of each group contract would have been available

for use in the valuation of the group contracts.

     In order for the valuation of petitioner’s health insurance

group contracts to reflect a discrete value for each group

contract, the premium payment and claim patterns and the

information relating to renewal expectations for the separate

contracts were necessary and should have been available for use

by petitioner’s expert in the valuation.

     Of petitioner’s 11,070 group contracts involving basic

medical and/or basic hospital coverage in effect on January 1,

1987, petitioner lacked information regarding premium rates on

9,288 of the group contracts.    In light of this missing

information, petitioner’s expert derived an average premium rate

from petitioner’s 1,782 group contracts involving basic medical

and/or basic hospital coverage for which petitioner did have

available premium rate information.      These 1,782 group contracts

with premium rate information consisted of both community-rated

and experience-rated group contracts and varied in benefit type

between individual, parent with children, and family.     The

monthly premiums for these contracts ranged from a low of $29.83

to a high of $115.79.   From these 1,782 group contracts involving

basic medical and/or basic hospital coverage, petitioner’s expert

derived his average monthly premium rate of $55.42.

     Petitioner’s expert then assumed that each of the 9,288

group contracts involving basic medical and/or basic hospital

coverage with respect to which petitioner lacked premium
                              - 47 -

information had the same average monthly premiums regardless of

the type of benefit or whether the contracts constituted

community or experience-rated contracts.

     Valuing approximately 40 percent of all of petitioner’s

group contracts (9,288 divided by 23,526 equals 40 percent) using

an average premium rate reflects the lack of contract-specific

information available to petitioner’s expert and the aggregate

valuation methodology used by petitioner’s expert.

     Petitioner’s expert also assumed that for each of

petitioner’s health insurance group contracts in effect on

January 1, 1987, the average number and the makeup of the

individual members covered under each group contract would remain

constant throughout the 20-year useful life period that he used

for each contract.   His assumption, however, was incorrect.    For

example, after downsizing its business, one of petitioner’s

groups that was enrolled with petitioner in 1989 with 200 members

later reenrolled with petitioner in 1992 with a group size of

just 32 members.

     The assumption regarding group size significantly affected

petitioner’s expert’s valuation of the group contracts.    As noted

by one of respondent’s experts, a mere 1-percent decline in the

total member enrollment relating to petitioner’s group contracts

would reduce the present value of all 23,526 group contracts by

approximately 15 percent.

     With regard specifically to petitioner’s community-rated

group contracts, petitioner’s expert valued these contracts using
                              - 48 -

average claims and expense ratios.     By applying average claims

and expense ratios to petitioner’s community-rated group

contracts, petitioner’s expert fails to account for the

characteristics of individual members of each group such as age,

gender mix, number of persons covered, family composition,

occupation, differing health conditions, and historical claims

experience unique to the individuals and families covered by each

group contract.

     We note that petitioner’s experts acknowledged that specific

characteristics unique to each community-rated group contract and

its members would be considered important by petitioner’s

competitors in any attempt to obtain (by purchase or otherwise)

discrete community-rated group contracts.

     Further, the use by petitioner’s expert of average claims

and average expense ratios for community-rated group contracts

explains why he treats each community-rated group contract as

profitable.   For example, use of a claims ratio just 1 percent

higher than the aggregate average claims ratio used by

petitioner’s expert for community-rated group contracts would

reduce petitioner’s projected profit relating to the contracts by

more than half.   Petitioner’s expert treats the average

community-rated group contract as profitable, and he treats each

community-rated group contract as profitable.

     Turning to petitioner’s experience-rated group contracts,

petitioner’s expert again assumes that all of the experience-

rated group contracts had the same profit margin and that
                              - 49 -

petitioner was realizing losses on none of the experience-rated

group contracts.   In explanation, petitioner’s expert notes that

the experience-rated group contracts had reserve mechanisms that

allowed petitioner potentially to recoup losses relating to

particular experience-rated group contracts.   Petitioner,

however, was not insulated from losses relating to experience-

rated group contracts, and every experience-rated group contract

could produce an unrecoverable loss for petitioner.   The

retrospective credit contracts could be terminated by the groups

at will even if they had a deficit account, and petitioner could

only recoup a shortage with respect to its retrospective refund

contracts if the contracts produced excess premiums in subsequent

years.

     By not taking into account contract-specific characteristics

relating to experience-rated group contracts, petitioner’s expert

concluded that the average experience-rated group contract would

not experience a loss, and his valuation did not reflect or

identify which experience-rated group contracts should be so

treated as loss contracts and valued accordingly.

     The error of petitioner’s expert’s approach in this regard

is illustrated by an example involving Pennsylvania Farmer’s

Union, and facts that generally postdate January 1, 1987, but

that nevertheless illustrate the problem with petitioner’s

valuation approach.   As of January 1988, Pennsylvania Farmer’s

Union maintained with petitioner three experience-rated,

retrospective credit group contracts with a cumulative deficit of
                              - 50 -

approximately $700,000.   By early 1994, the cumulative deficit

had reached $4 million, and petitioner had proposed a 48-percent

rate increase to take effect the following year.   Pennsylvania

Farmer’s Union did not accept the rate increase proposed by

petitioner, and its group contracts with petitioner were

terminated in 1994.

     In spite, however, of the millions of dollars in deficits

that petitioner had incurred relating to the three Pennsylvania

Farmers’ Union group contracts (particularly the $568,000

cumulative deficit that had built up in 1988 and prior years),

petitioner’s expert assigned the three Pennsylvania Farmer’s

Union contracts a total positive value of $479,000, or nearly 20

percent of the total value attributed to all of petitioner’s

experience-rated group contracts that were terminated in 1994.


Lifing Analysis

     In establishing the future income stream for the group

contracts, petitioner’s expert undertook a lifing analysis of

petitioner’s group contracts in which he, in present value terms,

set forth the after tax income he expected petitioner’s 23,526

group contracts to generate over the course of 20 years (1987-

2006).

     In his lifing analysis of petitioner’s group contracts, in

his attempt to account for the reality that not all of

petitioner’s group contracts would remain in existence for 20

years, petitioner’s expert utilized historical lapse rates

relating to a sample of petitioner’s group contracts that
                             - 51 -

terminated between 1982 and 1986, which indicated that each group

contract had a 2.2-percent to 7.5-percent probability of lapsing

from year to year, depending on factors such as group size and

duration of the contract.

     The lapse rates utilized by petitioner’s expert, however, do

not account for foreseeable, as of January 1, 1987, and

significant changes in the health insurance marketplace that were

imminent and about to impact petitioner’s business and that

constituted significant factors affecting the life and value of

petitioner’s health insurance group contracts.

     As explained, by the mid-1980s, the national health

insurance marketplace had become increasingly competitive with

escalating health care costs, the emergence of new health care

products, and the continued growth of alternative health care

product delivery services such as HMOs, PPOs, and plans

administered by third party administrators.

     As evidenced by the following quotation from petitioner’s

1985 Annual Report, by the mid-1980s petitioner’s management was

aware that new health insurance products and new marketing

techniques were creating an increasingly competitive health

insurance industry:


          We are witnessing the emergence of a new
     competitive market in the delivery and financing of
     health care services. During 1985 the once clear line
     of demarcation between the financing and the delivery
     of health care continued to fade. In Central
     Pennsylvania and the Lehigh Valley new competition
     emerged -- not just from insurance companies and third-
     party administrators, but from Health Maintenance
                             - 52 -

     Organizations (HMOs), Preferred Provider Organizations
     (PPOs), and other new delivery and financing schemes.

          Many of these new competitors are sponsored by or
     joint ventures with the doctors and hospitals who also
     provide care. This fading of the line between
     financing and delivery represents a major turning point
     for our industry. It creates a challenge to all of the
     traditional assumptions about our business.


     Minutes of petitioner’s 1986 corporate planning meeting

state as follows:


     The Plan will continue to face competition from new
     entities, e.g., self insurance, TPA’s, HMO’s and PPO’s.
     As this competition increases Capital Blue Cross must
     protect against cost shifting and adverse selection and
     become responsive to a changed marketplace.

     * * * Greater efforts will be made by commercial
     carriers to increase their share of the market. These
     carriers who are able to provide life, health,
     accident, etc., will be in an advantageous position by
     being able to provide wide-ranging benefits.


     By basing the lapse rates for his lifing analysis of

petitioner’s group contracts on 1982-1986 lapse rate information

relating to petitioner’s group contracts, petitioner’s expert

largely ignored the industry changes of which petitioner’s

management, as of January 1, 1987, was aware.   Any valuation of

petitioner’s group contracts should have considered the changes

occurring in the insurance marketplace as of January 1, 1987.

     Further and significantly, because petitioner’s group

contracts were effectively terminable at will, petitioner’s

customers could cancel their contracts with petitioner for any

number of reasons, making the realistic useful life or duration

of petitioner’s health insurance group contracts directly
                                - 53 -

impacted by what is referred to as “human elements”.   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.

     Various courts have commented on the difficulties presented

when such human elements are associated with the valuation of

intangible assets.   In Ithaca Indus., Inc. v. Commissioner, 17

F.3d at 689-690, the Court of Appeals for the Fourth Circuit

concluded that the taxpayer was not allowed to amortize the value

of its employee workforce due in large part to the human elements

associated with employee behavior.

     In Globe Life & Accident Ins. Co. v. United States, 54 Fed.

Cl. 132 (2002), the Court of Federal Claims held that the claimed

value of a group of insurance agents was not subject to

amortization due to the many variables involved in attempting to

determine the useful life of an intangible asset that is directly

tied to human relations.     Id. at 139.

     Petitioner’s expert did not adequately take into account

these human elements.   Indeed, there is not a single clear

reference in his valuation report relating to the human elements

to be taken into account in the valuation of petitioner’s health

insurance group contracts.    One vague reference thereto comments

simply that “It is not possible to predict when any particular

group contract will lapse.”

     By valuing all 23,526 of petitioner’s group contracts based

on a useful life of 20 years, petitioner’s expert implicitly
                                - 54 -

ignores the human elements associated with the group contracts

and whether they will be renewed or terminated by the group

sponsors.


Conclusion

     Petitioner is not entitled to the claimed $4 million in loss

deductions relating to the 376 health insurance group contracts

that were terminated in 1994.


                                     Decision will be entered

                                for respondent.
