The opinion
T.C. Memo. 1998-97
UNITED STATES TAX COURT
H ENTERPRISES INTERNATIONAL, INC., AND SUBSIDIARIES, Petitioner
v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 11478-93. Filed March 9, 1998.
W II, a subsidiary of HEI, borrowed funds, a part
of which was distributed to HEI with respect to its
stock in W II. HEI used a portion of the distribution
to buy portfolio stock and tax-exempt obligations and
held such stock and obligations for the 3 tax years in
issue. Held: the indebtedness was incurred to
purchase tax-exempt obligations for the purpose of
sec. 265(a)(2), I.R.C., and is directly attributable to
the acquisition of portfolio stock for the purpose of
sec. 246A, I.R.C.; respondent's disallowances of an
interest deduction pursuant to sec. 265(a)(2), I.R.C.
and of a dividend received deduction pursuant to sec.
246A, I.R.C., are sustained.
William L. Hippee, Jr., and Edward J. Pluimer, for
petitioner.
John Schmittdiel and Jonathon Decatorsmith, for respondent.
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MEMORANDUM FINDINGS OF FACT AND OPINION
HALPERN, Judge: This is our second report in this case, the
first also denominated H Enters. Intl., Inc., & Subs. v.
Commissioner, and appearing at 105 T.C. 71 (1995) (H Enterprises
I). The only issues for decision concern the applicability of
sections 246A1 and 265(a)(2) to the consolidated tax liability of
petitioner. In H Enterprises I, we denied petitioner's motion
for summary judgment (the motion) on the grounds that this case
presented genuine issues of material fact. As grounds for the
motion, petitioner argued that, as a matter of law (1) section
246A cannot be applied to disallow the dividends received
deduction to a parent corporation on account of indebtedness
incurred by its subsidiary corporation and (2) section 265(a)(2)
cannot be applied to disallow an interest expense deduction to a
subsidiary corporation on account of tax-exempt obligations
purchased by its parent corporation. In H Enterprises I, we held
that, in appropriate circumstances, sections 246A and 265(a)(2)
may be applied when one member of an affiliated group of
corporations is the borrower and another member is the purchaser
of portfolio stock (sec. 246A) or tax-exempt obligations (sec.
265(a)(2)). H Enterprises I at 81. We concluded: "Whether any
1
Unless otherwise noted, all section references are to the
Internal Revenue Code in effect for the years in issue, and all
Rule references are to the Tax Court Rules of Practice and
Procedure.
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of the borrowed funds in the present case are attributable to the
purchase of portfolio stock by HEI [the parent] or were used to
purchase or carry tax-exempt securities by HEI is a fact question
and not one to be decided on a summary judgment motion." Id. at
85. In this report, we address the factual questions identified
in H Enterprises I.
FINDINGS OF FACT
Certain facts have been stipulated and are so found. The
stipulations of facts filed by the parties, with attached
exhibits, are incorporated herein by this reference. Also, the
Court directed the parties to review those facts set forth in
H Enterprises I and provide the Court with statements of
differences or objections, if any, with respect to those facts.
The parties have identified as the facts set forth in
H Enterprises I the facts set forth in the five consecutive
paragraphs commencing with the last paragraph beginning on
page 73 of volume 105, U.S. Tax Court Reports (105 T.C. at 73;
the H Enterprises I facts). The parties agree with the
H Enterprises I facts subject to certain common, minor, or
inconsequential differences. In light of those agreements, we
shall adopt the H Enterprises I facts for purposes of this
report, subject to (and incorporating) the differences agreed to
by the parties, and we find accordingly. In the following
paragraphs of this portion of our report, we shall summarize
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certain facts from H Enterprises I necessary to the clarity of
our report and make additional findings of fact.
H Enterprises International, Inc.
H Enterprises International, Inc. (HEI), is a Delaware
corporation. From October 1, 1987, to March 9, 1994, the common
stock of HEI was owned by Eugene U. Frey, Richard E. O'Leary,
John E. Byrne, Anita M. Bertelsen, and trusts for the benefit of
Eugene U. Frey’s family members (collectively, the shareholders)
as follows:
Eugene U. Frey & Family Trusts 50.0 percent
Richard E. O'Leary 33.5 percent
John E. Byrne 14.4 percent
Anita M. Bertelsen 2.1 percent
During the years in issue, HEI was the common parent corporation
of an affiliated group of corporations making a consolidated
return of income (the affiliated group). The taxable year of the
affiliated group was a fiscal year ending on June 30.
The Waldorf Business
On July 15, 1985, HEI purchased a business involving the
manufacturing and selling of recycled paperboard, corrugated
medium, and folding cartons (the Waldorf business). The purchase
price was approximately $100 million. HEI financed a portion of
the purchase price by borrowing approximately $82.5 million from
General Electric Credit Corp. (GECC). The Waldorf business
thrived under HEI’s management, and, by mid-1987, according to an
appraisal, the value of the Waldorf business was approximately
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$210 million. Acquisition-related debt had been reduced to less
than $30 million.
The Restructuring Plan
In 1987, the board of directors of HEI (the HEI board)
decided upon and implemented a plan of corporate restructuring
(the restructuring plan). A subsidiary corporation (Waldorf II)
was to be formed and the Waldorf business contributed thereto in
exchange for all of the stock of the subsidiary. Subsequent to
that contribution, the remaining indebtedness to GECC was to be
refinanced from a larger borrowing, and a substantial
distribution was to be made to HEI.
The Shareholder Agreement
In connection with the restructuring plan, on October 1,
1987, the shareholders entered into an agreement (the shareholder
agreement). Among other things, the shareholder agreement
(1) recites that, effective October 1, 1987, HEI had transferred
substantial assets (the Waldorf business) to its wholly owned
subsidiary corporation and (2) provides for the division of HEI
into four divisions:
(1) Frey Investment Division. The stated purposes of this
Division (Investment Division I) include maintaining the
“investment account/portfolio” of the Eugene U. Frey interests in
any “dividend” paid by Waldorf II. Decision making for
Investment Division I is by a subcommittee of the HEI board of
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directors comprised of Eugene U. Frey and “MF” (we assume, Mary
Frey).
(2) O’Leary, Byrne, Bertelsen Investment Division. The
stated purposes of this division (Investment Division II) include
maintaining the “investment account/portfolio” of the O’Leary’s,
Byrne’s, and Bertelsen’s interests in any “dividend” paid by
Waldorf II. Decision making for Investment Division II is by a
subcommittee of the HEI board of directors composed of Richard E.
O’Leary, John E. Byrne, and Anita M. Bertelsen.
(3) Trident Service Division. The stated purpose of the
Trident Service Division is to provide various services to
Waldorf II and other entities.
(4) Trident Associates Venture Management Division. The
stated purpose of this division is to conduct venture management
activities on its own behalf and on behalf of certain others.
Waldorf II
Waldorf Corp. (Waldorf II), a Delaware corporation, is the
subsidiary corporation contemplated in the restructuring plan.
On October 1, 1987, Waldorf II received substantially all of the
assets of, and assumed substantially all of the liabilities
relating to, the Waldorf business. During the taxable years in
issue, HEI owned all of the outstanding voting shares of
Waldorf II, and Waldorf II was a member of the affiliated group.
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The Refinancing
On December 18, 1987, the board of directors of Waldorf II
(the Waldorf II board) resolved to borrow up to $175 million from
GECC. On December 23, 1987, Waldorf II borrowed approximately
$113,539,873.30 from GECC (the 1987 indebtedness or the borrowed
funds). At least in part, Waldorf II incurred the 1987
indebtedness in order to make a distribution to HEI with respect
to its stock in Waldorf II.
The Distribution
On December 18, 1987, the Waldorf II board resolved to
declare a dividend of $92 million payable to its shareholder,
HEI, and, on December 23, 1987, Waldorf II made a distribution to
HEI in satisfaction of that declaration of dividend (the
distribution). The distribution included a cash payment to HEI
in the amount of $73,803,000 (the cash distribution). The
borrowed funds were used to make the cash distribution.
For Federal income tax purposes, the amount of the
distribution was $123,657,000. Waldorf II had no current or
accumulated earnings or profits as of June 30, 1988. To the
extent of $41,250,353, the distribution was treated as a return
on capital on HEI's 1988 consolidated Federal income tax return.
That balance of the distribution created an "excess loss account"
within the meaning of section 1.1502-14(a)(2), Income Tax Regs.
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Disbursement
The cash distribution was disbursed by HEI into accounts
maintained by Investment Divisions I and II and the Trident
Service Division as follows: $9,803,000 to the Trident Service
Division and $32 million into each of Investment Division I and
II (together, the Investment Divisions).
Investments
Other than investment returns, the cash distribution was the
only significant source of funds for the Investment Divisions.
In January and February 1988, the Investment Divisions entered
into investment management agreements with certain investment
advisers and, by February 1988, began acquiring investments,
including tax-exempt obligations and shares of stock in domestic
corporations (domestic shares). Within approximately 3 months of
receipt of their respective portions of the cash distribution,
the Investment Divisions had 22.7 percent of their funds invested
in tax-exempt obligations and 10.8 percent of their funds
invested in domestic shares. For the years in issue, the
Investment Divisions held an average of 35.3 percent of their
funds in tax-exempt obligations and 23.2 percent of their funds
in domestic shares. From December 1987 through the years in
issue, the value of assets in Investment Divisions I and II was
not less than $32 million and $31 million, respectively.
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Tax-Exempt Interest; Dividends on Domestic Stock
During the taxable years in issue, HEI received interest and
dividends on tax-exempt obligations and domestic shares,
respectively, held by the Investment Divisions. HEI deducted
70 percent of the dividends received on those domestic shares.
Respondent's Adjustments
Respondent proposes that we make the following adjustments
to petitioner's claimed interest expense deductions and dividends
received deductions:
Tax Year Interest Expense Deduction Dividends Received Deduction
Ending Claimed Disallowed Claimed Disallowed
Sec. 265(a)(2) Sec. 246A
6/30/89 $18,197,732 $2,891,294 $393,201 $393,201
6/30/90 $17,580,023 $3,478,858 $587,781 $572,329
6/30/91 $13,862,253 $4,380,018 $337,410 $337,410
ULTIMATE FINDING OF FACT
Based on the restructuring plan, the shareholder agreement,
and the sequence of events that followed, we find that the
dominant purpose for incurring the 1987 indebtedness was to
purchase tax-exempt obligations and portfolio stock.
OPINION
I. Introduction
We must determine whether section 246A applies to eliminate
the dividends received deduction claimed by HEI with respect to
dividends received on the domestic shares owned by it and whether
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section 265(a)(2) applies to disallow a portion of the interest
deduction claimed by Waldorf II on the 1987 indebtedness.
Petitioner's assignments of error with respect to the two
issues we must decide go to the propriety of respondent’s
adjustments and not to the calculation of those adjustments if
they are appropriate. On brief, petitioner objects to
respondent’s proposed finding of fact as to the interest
adjustments in question by stating that the amounts set forth in
respondent’s proposed finding of fact “exceed the sum of the
amount disallowed pursuant to the statutory notice of deficiency
and the amended answer.” Petitioner does not otherwise challenge
respondent’s proposed finding with respect to the interest
adjustments in question or argue that they are in error (if,
indeed, section 265(a)(2) is applicable). By the amendment to
answer, respondent determined increased deficiencies on account
of increased adjustments resulting from the application of
section 265(a)(2). Respondent did not specify the amounts of the
increased adjustments. In the reply, petitioner denies any
increased deficiency but, otherwise, does not address the
increased adjustments in question. We assume that the parties
have a basis for calculating, and allocating, the section
265(a)(2) adjustments in question. We do not sustain any section
265(a) disallowance beyond that put at issue by the petition and
the answer, as amended.
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II. Arguments of the Parties
Effectively, the parties agree that application of sections
246A and 265(a)(2) depends on the purpose (or purposes) for
incurring the 1987 indebtedness. They disagree, however, as to
whether we may inquire beyond the narrow purposes of Waldorf II
(the borrower) and take into account the purposes of HEI in
forming Waldorf II and establishing the Investment Divisions.
Petitioner makes an argument similar to the argument it made
in H Enterprises I in support of the motion. Petitioner contends
that we should look only to Waldorf II's purposes for incurring
the 1987 indebtedness and to Waldorf II's use of the borrowed
funds in applying sections 246A and 265(a)(2). Petitioner would
have us find that Waldorf II had purposes for incurring the 1987
indebtedness that were unrelated to its parent corporation's
(HEI's) use of the distribution made from the proceeds of that
indebtedness. Although petitioner believes it is irrelevant,
petitioner also argues that HEI had business reasons for
acquiring and maintaining investments in tax-exempt obligations
and domestic shares, including a need for liquid resources to
provide capital for funding business acquisitions and to provide
funds for stock redemptions, if necessary.
Respondent traces the borrowed funds to investments in tax-
exempt obligations and domestic shares and argues that this is
sufficient proof of the relationship between the 1987
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indebtedness and the investments for purposes of sections 246A
and 265(a)(2). Respondent would have us find that Waldorf II and
HEI had a "common purpose established by [HEI]", to provide funds
to HEI by borrowing "in excess of the needs of the [Waldorf]
business" so that HEI could invest in a variety of products,
including tax-exempt obligations and domestic shares.
III. The Code
Section 265(a)(2) provides:
No deduction shall be allowed for * * * [i]nterest on
indebtedness incurred or continued to purchase or carry
obligations the interest on which is wholly exempt from
the taxes imposed by this subtitle * * *
Section 265(a)(2) does not operate to disallow interest on
indebtedness simply because the taxpayer simultaneously holds or
acquires tax-exempt obligations and incurs or carries
indebtedness. Bradford v. Commissioner, 60 T.C. 253, 257-258
(1973). The touchstone for decision is whether the taxpayer’s
purpose in incurring or continuing indebtedness was to purchase
or carry such obligations. Indian Trail Trading Post, Inc. v.
Commissioner, 60 T.C. 497, 500 (1973), affd. 503 F.2d 102 (6th
Cir. 1974). Purpose may be inferred from the taxpayer’s conduct
and the circumstances surrounding the borrowing. Id. (citing
Leslie v. Commissioner, 50 T.C. 11, 20-21 (1968), revd. on other
grounds 413 F.2d 636 (2d Cir. 1969)).
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Section 246A provides that there shall be a reduction in the
amount of the deduction allowable for dividends received (under
sections 243, 244, or 245(a)) with respect to debt-financed
portfolio stock. Debt-financed portfolio stock is defined in
section 246A(c) as any portfolio stock with respect to which
there is portfolio indebtedness. Portfolio indebtedness means
"any indebtedness directly attributable to investment in the
portfolio stock." Sec. 246A(d)(3)(A). We have found no cases
that interpret the expression "directly attributable" in the
context of applying section 246A. Section 246A was added by the
Deficit Reduction Act of 1984, Pub. L. 98-369, sec. 51, 98 Stat.
494, 562-564. H. Rept. 98-432, which accompanied H.R. 4170,
which became the Deficit Reduction Act of 1984, indicates that we
should inquire into the taxpayer’s purpose for incurring the
indebtedness and trace the use of the borrowed money: "[I]f
indebtedness is clearly incurred for the purpose of acquiring
dividend-paying stock or otherwise is directly traceable to such
an acquisition, the indebtedness would constitute portfolio
indebtedness." Id. at 1181.
Thus, the inquiry is similar under both sections 265(a)(2)
and 246A(d)(3)(A): In both cases, we must determine whether
there is a sufficient purposive connection between the borrowing
and the investments.
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IV. Discussion
In H Enterprises I, we held that, in appropriate
circumstances, sections 246A and 265(a) may be applied when one
member of an affiliated group is the borrower and another member
is the purchaser of the portfolio stock or tax-exempt securities.
H Enterprises I at 81. Implicit in that holding is the
recognition that the search for a prohibited purpose cannot be
focused exclusively on the subsidiary’s purpose in borrowing to
make a distribution. Generally, a distributing corporation has
no control over (or concern with) the use to which distributions
are put by the shareholder recipient. If we were to limit our
inquiry to whether the board of directors of a subsidiary
corporation borrowed to make a distribution to its parent and
whether the subsidiary used the borrowed funds for that purpose,
then the use of the distributed funds would be irrelevant and the
purpose of the distributing corporation would always be
acceptable. We, therefore, reject petitioner's argument that we
should look only to Waldorf II's purpose for incurring the 1987
indebtedness, and we direct our inquiry to the larger purposes of
HEI manifest by the actions of both Waldorf II and HEI.
Here, Waldorf II incurred the 1987 indebtedness, at least in
part, in order to make the distribution. Coincident, or nearly
coincident, events may indicate purpose: “[T]he deduction will
be barred if there is ‘a sufficiently direct relationship’
between the incurring or continuing of the indebtedness and the
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acquisition or holding of the tax-exempt obligations.” Indian
Trail Trading Post, Inc. v. Commissioner, supra at 500 (citations
omitted). HEI, through the Investment Divisions, used the cash
portion of the distribution to purchase tax-exempt obligations
and domestic shares within weeks of receiving the funds and
maintained a substantial portion of its investment portfolio in
such investments for the years in issue. Accordingly, we find
that the borrowed funds were used directly to purchase tax-exempt
obligations and domestic shares and that sections 265(a)(2) and
246A apply. See Bradford v. Commissioner, supra at 258 ("Equally
clearly, the deduction is not allowable if the proceeds of the
borrowing are directly traceable to the purchase of tax-exempts."
(Citations omitted.)). The facts that the borrowed funds were
not used by Waldorf II to purchase tax-exempt obligations and
Waldorf II had a purpose for incurring the 1987 indebtedness (to
make a distribution to HEI) are simply not determinative in the
affiliated group context before us. We are, thus, satisfied
that, here, where the borrowing and distribution are all part of
a preplanned sequence, the distributed funds are distributed to a
parent corporation, and those funds are used to purchase tax-
exempt obligations and domestic shares, the required purposive
connection has been shown.
Petitioner also argues that Waldorf II incurred the 1987
indebtedness in order to obtain more advantageous terms on its
debt and to implement a new stock purchase plan for its
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employees. Neither of those reasons is inconsistent with what we
find to be the dominant objective in incurring the 1987
indebtedness, to make a cash distribution to HEI in order to
allow HEI to purchase tax-exempt obligations and domestic shares.
See generally Leslie v. Commissioner, 413 F.2d 636 (2d Cir. 1969)
(business reasons not related to the purchase of tax-exempt
securities must dominate the incurring of indebtedness to
insulate the borrowing from application of section 265(a)(2)),
revg. 50 T.C. 11 (1968).
Petitioner argues that there is no evidence that HEI or
Waldorf II contemplated investing in tax-exempt obligations or
domestic shares at the time Waldorf II incurred the 1987
indebtedness and that, at the time, it made no economic sense to
borrow in order to make such investments. We cannot look into a
taxpayer's mind to determine the purpose of incurring
indebtedness; we must infer that purpose from the evidence.
Indian Trail Trading Post, Inc. v. Commissioner, 60 T.C. 497, 500
(1973). HEI received regular reports on the investments held in
the Investment Divisions, including reports of its after-tax
returns, and we are not inclined to second-guess its investment
decisions. See generally Illinois Terminal R.R. v. United
States, 179 Ct. Cl. 674, 375 F.2d 1016, 1021-1022 (1967)
(taxpayers need not receive economic benefits from tax-exempt
securities for section 265(a)(2) to apply).
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Finally, petitioner argues that HEI had business reasons for
holding a liquid, diversified investment portfolio that included
tax-exempt obligations and domestic shares. Petitioner relies on
Swenson Land & Cattle Co. v. Commissioner, 64 T.C. 686 (1975),
and points to HEI's objectives of having capital available to
support possible acquisitions of other businesses in the future
and having sufficient liquidity to fund redemptions in case of
the death of a principal shareholder or on account of disputes
among the shareholders. In Swenson, we were persuaded that the
taxpayer was considering detailed and concrete proposals for
expansion that justified a large contingency reserve of liquid
funds. Here, HEI had no specific plans for the borrowed funds,
other than funding the Investment Divisions, which were set up
during the restructuring of the Waldorf business, and, although
petitioner has demonstrated that there were disputes among the
shareholders that may have made it advisable to plan for a stock
redemption, those disputes arose after the restructuring plan was
implemented. Nor has petitioner offered any sufficient business
reason for HEI's maintaining millions of dollars in liquid
reserves for over 3 years. See, e.g., New Mexico Bancorp. &
Subs. v. Commissioner, 74 T.C. 1342 (1980). Whatever HEI's
ultimate objectives for the borrowed funds may have been, its use
of those funds for investments in the relevant years provides the
"necessary purposive connection" for us to link the borrowing and
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the investment. See Indian Trail Trading Post, Inc. v.
Commissioner, supra at 501.
V. Conclusion
We are convinced that Waldorf II incurred a substantial
portion of the 1987 indebtedness to fund the Investment Divisions
and that the Investment Divisions used the borrowed funds to
purchase and carry tax-exempt obligations and portfolio stock
during the 3 years in issue. Therefore, we have no doubt that a
portion of the 1987 indebtedness was incurred to purchase and
carry tax-exempt obligations (held in the Investment Divisions)
for the purpose of section 265(a)(2) and that a portion of the
indebtedness is directly attributable to the purchase and
carrying of portfolio stock (by the Investment Divisions) for the
purpose of section 246A. We note, however, that in a less clear-
cut case we would be substantially aided in reaching a decision
by the regulations called for by section 7701(f).
Decision will be entered
under Rule 155.