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GT Alert

The Oracle of Omaha Does It Again: Berkshire Hathaway Correctly Predicts a Successful Outcome to DRD Controversy

December 2005

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I have read some analysts’ reports on Berkshire Hathaway that have said the conglomerate’s best growth years are behind it. Well, even if these wags are right in predicting that top-line EBITA growth may be difficult to achieve, the Company has grown the bottom-line by successfully defending against an Internal Revenue Service (“IRS”) attack on its dividend received deduction (sometimes, the “DRD”). And what dyed-in-the-wool tax professional doesn’t believe that it’s after-tax results that matter the most?

“The OBH decision could provide a broad array of companies with significant permanent savings on their open tax years.”

Specifically, Berkshire Hathaway, now renamed OBH, Inc., successfully argued, in a decision released at the end of October 20051, that its dividend received deduction should not be reduced pursuant to the rules relating to debt-financing for portfolio stock contained in Code § 246A.2 While it is true that the decision handed down by the Nebraska District Court provided OBH with a distinct home court advantage, many companies, especially financial concerns who have taken conservative positions on reporting a DRD, may desire to file protective DRD-based refund claims. The decision could provide a broad array of companies with significant permanent savings on their open tax years. It also provides planning opportunities for 2006 and future years.3

Generally, the Code provides for a dividend received deduction (“DRD”) for corporate recipients of dividends on the theory that the earnings represented by the dividend have already been subjected to corporate tax. The DRD lessens (but does not eliminate) the triple (or greater) taxation that would result when dividends pass through multiple corporations before being distributed to individuals.4 Since dividends are tax-favored receipts in the hands of corporate recipients, it follows that corporations should not be entitled to deduct, in full, interest expense incurred to generate such income. If they could, they would receive a double deduction.5 Accordingly, Code § 246A provides that the deduction is scaled back to the extent that the dividends are debt-financed.6 From a bird’s eye view, the OBH decision held that the company was entitled to a full deduction even though substantial indebtedness had been incurred which, in part, may have partially funded the purchase of the dividend paying stock.

I. Facts of the Case

In the mid-1980s, Warren Buffett and Ajit Jain determined to make National Indemnity Insurance Company (“NICO”), a Berkshire Hathaway subsidiary, one of the world’s most prominent reinsurance companies.7 According to Buffet and Jain, OBH set off to increase NICO’s capital in pursuit of this goal by borrowing $750 million in four tranches between January 1988 and December 1989.8 The IRS, on the other hand, asserted that these four borrowings were incurred for the purpose of acquiring dividend-paying stocks. OBH placed the $750 million loan proceeds into NICO’s Omaha, Nebraska bank account with Norwest. This bank account was the main operating account for NICO, from which all expenses were paid and all receipts were posted. Over the two years, an additional $2.3 billion was deposited into this account, as money came into NICO from various sources. NICO (through Warren Buffett) sought to use the cash balances as profitably as possible and made daily allocation decisions as to where the money was invested or spent. The Court fully recognized that some portion of the borrowings must have found their way into one or more portfolio stocks.

“After a three-year review, the auditor concluded that the debt had been incurred for the purpose of buying dividend-paying stocks and that the acquisition of substantial positions in companies such as Coca Cola and US Air was directly traceable to the borrowings.”

The court decision recites that an IRS auditor read an article in Forbes Magazine that theorized that Berkshire Hathaway was claiming the full DRD notwithstanding that it used debt proceeds to acquire its positions. The auditor then spent three years (not a typo) analyzing the issue. After such review, the auditor concluded that the debt had been incurred for the purpose of buying dividend paying stocks and that the acquisition of substantial positions in Coca Cola, Champion International and US Air, among others, were directly traceable to the borrowings. Accordingly, the IRS sought to scale-back the DRD claimed by NICO pursuant to Code § 246A.

The first task for the IRS was to trace the proceeds from the borrowings to the stock purchases. In one instance, the IRS traced borrowings through 154 security transactions to find that the proceeds were ultimately used to acquire dividend-paying stocks. Frequently, on the dates of these interim trades, there was substantial other activity in the accounts. Nonetheless, the auditing agent allocated the proceeds from the borrowings, and then the interim investments, to the dividend-paying stocks based on an “arbitrary allocation.” The court accepted the converse testimony of the expert retained by OBH who concluded that the debt proceeds could not be traced either upon an “observable connection” or a “logical connection” basis.

Aside from the fairly clear facts in H-Enterprises (described below), the IRS previously had been fairly circumspect in asserting the application of Code § 246A to general purpose borrowings. In T.A.M. 9141006 (October 15, 1991), a corporation raised $8 million in 1983 as equity capital for investments and acquisitions. It invested a portion of these equity proceeds in portfolio stock. In 1985, the company undertook an acquisition and, instead of liquidating the portfolio stock, incurred acquisition debt and pledged the stock of the target company (which was also portfolio stock) to the lender. Although the previously-acquired portfolio stock was not pledged, the borrower did agree to maintain a specified level of “quick assets” to liabilities and the portfolio stocks were within the definition of quick assets.9 On these facts, the IRS held that no portion of the borrowing to acquire the stock in the target company should be imputed to the portfolio stock. Accordingly, such borrowing did not trigger the application of Code § 246A to the dividends on the portfolio stock. (We note that on similar facts, but when the stock of the portfolio companies was pledged, the IRS stated that it believed that the debt financed portfolio stock rules most likely did apply.)10 Nonetheless, given the IRS’s three-year investment in finding debt-financed portfolio stock at OBH, the IRS pressed its case against Warren Buffet and crew.

II. Legal Analysis Employed by the Court

The deduction scale-back rules contained in Code § 246A only apply with respect to dividends received on “portfolio stock.”11 Portfolio stock includes all stock unless, as of the beginning of the ex-dividend date, the taxpayer owned at least 50% of the vote or value of the stock of the corporation paying the dividend or, if the corporation paying the dividend has five or fewer corporate shareholders, the taxpayer owned at least 20% of the vote or value of the stock of the corporation paying the dividend.12 There was no issue as to the fact that the dividend-paying stocks held by OBH were portfolio stocks in OBH’s hands. Thus, the issue was squarely framed as to whether the four borrowings constituted “portfolio indebtedness.”

The Code itself defines portfolio indebtedness as any indebtedness that is “directly attributable to investment in the portfolio stock.”13 The legislative history accompanying the 1984 enactment of the statute contains an unusually detailed discussion of when the “directly attributable” to standard will be met.14 Conceptually, the standard does not provide for disallowance of the DRD based upon an allocation or apportionment of debt based upon outstanding borrowings.15 For financial companies, which tend to be highly leveraged, the legislative history contains three examples of when the rules will not apply:

1) The existence of a commercial paper program used in cash management will not in and of itself result in an allocation of CP borrowings to dividend paying stocks;

2) The existence of unsecured long-term debt issued by a corporation in the commercial or consumer finance business will not automatically result in DRD scale-back; and

3) The fact that deposits are received by a financial institution are used in the ordinary course of business will not trigger a per se DRD scale-back.16

The legislative history prescribes two alternative tests that Congress intended to be applied in determining whether indebtedness is portfolio indebtedness. Specifically, the history states that the debt will be treated as portfolio indebtedness if it either is (i) “clearly” incurred to acquire or carry the dividend-paying stocks (an intent test) or (ii) directly traceable to the dividend-paying stocks (an end result test).17 Debt is clearly incurred to acquire or carry portfolio stock if, for example, the taxpayer issues purchase money debt to the seller or uses substantially riskless tax-motivated dividend capture trading strategies.18 Debt is treated as directly traceable to portfolio stock if certain specified criteria are met. The court considered both tests.

Although the Code provides similar rules with respect to interest incurred to acquire or hold tax-exempt obligations,19 the court neither utilized nor referred to such rules. The IRS has stated in other contexts that the related function of the DRD and tax-exempt obligation rules makes decisions under either set of rules relevant to an interpretation of the other.20 The rules relating to the disallowance of interest expense incurred to acquire or hold tax-exempt obligations, however, require that the purpose of the borrowing be to acquire such obligations.21 Accordingly, the disallowance rules applicable to debt-financed portfolio stock are broader in application.

A. The Clearly Incurred Test

The court began by analyzing whether H-Enterprises Int’l, Inc. v. Comm’r 22 mandated a finding that the OBH debt was incurred for the purpose of acquiring dividend-paying stocks. In H-Enterprises, a corporate group executed a written restructuring plan first to borrow funds at a subsidiary level. Within a few days of the borrowing, the subsidiary declared and paid a dividend of equal to 70% of the loan proceeds to the borrower’s corporate parent. Within weeks of its receipt of the funds, the parent adopted and executed a portfolio stock purchase plan. All of these plans were evidenced by corporate minutes. The court concluded, on these facts, that the dominant purpose of the borrowing was to obtain debt-finance dividend income. In contrast, in OBH, the court found: (i) the IRS’s tracing of the borrowings to the portfolio stocks to be tenuous, (ii) that the IRS introduced no evidence to contradict Mr. Buffet’s statements that the debt was incurred to build NICO, not engage in dividend arbitrage strategies and (iii) the government’s “failure to put forth any credible purpose arguments.” Accordingly, the court found that the indebtedness was not purposefully incurred to invest in the portfolio stocks.

B. The Directly Traceable Test

The court gave full consideration to Revenue Ruling 88-66.23 In that Ruling, the IRS addressed a number of examples of when indebtedness would be considered to be portfolio indebtedness. The court found one of the three situations addressed in this Ruling to be particularly helpful in its analysis.24 Specifically, the Ruling hypothesizes that a corporation borrows to undertake a capital expansion program. Until the funds are ready to be invested in new plant and equipment, they are invested in portfolio stock. The Ruling concludes that the borrowings are directly attributable to the portfolio stock investment.25 The court then analyzed the facts pertaining to OBH’s borrowings and concluded that these borrowings were not directly traceable to the portfolio stock investments:

1) The theoretical traces made by the auditing agent were held to be inconsistent with the plain meaning of the words “directly traceable;”

2) The arbitrary allocations (an “attenuated connection” in the court’s words) were inconsistent with the examples in the legislative history and Revenue Ruling 88-66; and

3) The “fungibility of cash” approach inherent in the auditing agent’s purported tracing was inconsistent with the legislative history of Code § 246A.

Accordingly, the court found that the proceeds of the borrowings were not directly traceable to NICO’s investment in the portfolio stock.

III. Consequences of the Holding of OBH

The court itself recognized that its holding rendered Code § 246A virtually ineffectual:

[T]he Court is cognizant of the fact that § 246A’s current statutory and regulatory regime makes it virtually impossible for the [Internal Revenue] Service to trace debt proceeds and thus assess tax deficiencies under § 246A against companies . . . who engage in numerous investment transactions.

The Court then invited Congress and the IRS to change the law if necessary; but the court believed that its holding was mandated by the law applicable to the years at issue. It is worth noting that the law has not changed since 1989. This holding may create opportunities for many financial companies.

Many financial companies, including banks, have taken a conservative approach in scaling back their DRD in light of their substantial leverage. In fact, many banks have equity of less than 10% of total capital.26 Such financial institutions have scaled back their DRD to nil or a very small percentage. OBH is an important case because it has shown that courts will defer to the legislative mandate that either a prohibited purpose or direct tracing will be required before the DRD is scaled back pursuant to Code § 246A. Financial firms that have taken a conservative approach may desire to consider filing refund claims based upon this case. Of course, in doing so, such financial institutions should first undertake a tracking of their borrowing to ensure that such borrowing were not directly used to acquire portfolio stock positions. And, speaking of wags, as Robert Willens observed, “double-dipping seems to be alive and well.”27

 


Footnotes

1 OBH, Inc. v. Comm’r 209 Daily Tax Report K-6 (D.Neb. 2005).

2 Unless otherwise indicated, all “Section” and “Code §” references are to the Internal Revenue Code of 1986, as amended.

3 The IRS is considering issuing a rule that requires companies to scale back their DRD by allocating a pro rata portion of the interest expense to their portfolio stock holdings. REG-128572-03 (May 7, 2004). It is not clear whether such a rule would be elective in light of the statute’s mandate that debt be directly attributable to the stock in order to constitute portfolio indebtedness. The Securities Industry Association, through a well-written letter prepared by Rick Reinhold, has argued that the statute does not permit a pro rata allocation of indebtedness to portfolio stock. See SIA Questions Legality of Proposed Regs on Multiparty Financing Deals, 2004 TNT 164-12 (August 4, 2004).

4 If a corporation owns less than 20% of the vote and value of the stock of the dividend payor, the DRD is 70%. Code § 243(a)(1). If a corporation owns 20% or more of the stock of the dividend payor, but less than 80%, the DRD is 80%. Code § 243(c)(1). If a corporation owns 80% or more of the stock of the dividend payor, the DRD is 100%. Code § 243(a)(3). As noted in text, stock is portfolio stock if the dividend recipient owns less than 50% of the stock of the dividend payor.

5 A short discussion of the history of Code § 246A is contained in F.S.A. 1998-236 (May 5, 1993).

6 Robert Willens provides an interesting history of the use of this arbitrage in the Mesa Oil bid for Gulf Oil in Willens, Berkshire Hathaway Retains Its Dividends-Received Deduction, Leaving IRS an Uphill Battle in Assessing Taxes Under Code Section 246A, Daily Tax Report, p. J-1 (November 11, 2005) (hereinafter, “Willens”).

7 It is unlikely that many folks who have worked in the credit derivative and reinsurance arena in the past 10 years would contest the conclusion that this goal was attained.

8 The DRD scale-back rules operate on a consolidated basis for affiliates filing consolidated returns. Rev. Rul. 88-66, situation 3, 1988-2 C.B. 34; P.L.R. 8906010 (February 10, 1989). Accordingly, OBH and NICO will be referred to interchangeably in text.

9 The legislative history makes clear that a cash purchase portfolio stock that is later followed by a borrowing in which the portfolio stock is pledged can be treated as portfolio indebtedness if it would have been reasonable for the taxpayer to have liquidated the portfolio stock instead of incurring the debt. H.R. Rep. No. 432, 98th Cong., 2d Sess., Pt. 2, 1181 (1984). The factors that bear on whether it would have been reasonable for the taxpayer to have liquidated the portfolio stock include (1) the nature of the taxpayer’s business, (2) the taxpayer’s basis in the stock, (3) the amount of inherent gain or loss in the stock, (4) the purpose for incurring the debt and (5) whether a sale of the stock held by the taxpayer would have flooded the market and depressed prices. F.S.A.1998-239.

10 F.S.A. 1998-239.

11 Code § 246A(a).

12 Code § 246A(c)(2).

13 Code § 246A(d)(2)(A).

14 The decision is unusual in the amount of deference it provides to the legislative history. Compare with Palmer v. U.S., 219, F.3d 580, 583 (6th Cir. 2000); United States v. Ron Pair Enterprises, Inc., 489 US 235, 241.

15 See also G.C.M. 39749, situation 1 (August 3, 1988).

16 S. Fin. Rept. No. _____, 98th Cong., 2d Sess. 166 (1984); see also H.R. Rep. No. 432, 98th Cong., 2d Sess., pt. 2, 1180-1 (1984); Rev. Rul. 88-66, 1988-2 C.B. 34 (Situation 3) (Bank borrows by way of receiving deposits, loans money to Bank holding company and Bank holding company invests in portfolio stocks; IRS concludes that “absent a direct relationship between outside group indebtedness and investment in portfolio stock,” Code § 246A does not apply.

17 Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, p. 130 (December 31, 1984).

18 Id.

19 See Code § 265(a).

20 G.C.M. 39749, situation 1, supra; REG-128572-03.

21 See Wisconsin Cheeseman, Inc. v. United States, 388 F.2d 420 (7th Cir. 1968); Rev. Rul. 55-389, 19551 C.B. 276.

22 183 F.3d 907 (8th Cir. 1999), aff’g 75 T.C.M. 1948 (1998); H Enterprises Int’l v. Comm’r, 105 T.C. 71 (1995).

23 1988-2 C.B. 34.

24 The court inadvertently referred to the facts in Situation 2 of Revenue Ruling 88-66 as the facts of situation 3.

25 The debt was not incurred for the purpose of acquiring the portfolio stock. It was incurred to finance the capital expansion program. See G.C.M. 39749 (August 3, 1988). It is interesting to note that the IRS reached a contrary conclusion with respect to the same facts if the proceeds had been invested in tax-exempt obligations. Id. This contrary conclusion was based upon the fact that debt proceeds were incurred to finance an expansion program, not invest in tax-exempt obligations.

26 Insert reference to NatWest II article here.

27 Willens at J-2.

 

This Alert was written Mark Leeds in the New York office. Please contact Mr. Leeds at 212.801.6947 or your Greenberg Traurig liaison, if you have any questions regarding the subject matter of this Alert.

Mark Leeds is a tax shareholder with Greenberg Traurig in New York and editor-in-chief of Derivatives: Financial Products Report. He thanks Adrienne Browning (adrienne.browning@db.com), a Managing Director with Deutsche Bank and much valued colleague, for her helpful thoughts and comments, and Artem Fokin (fokina@gtlaw.com), a tax attorney with Greenberg Traurig, for his research assistance. Mistakes and omissions are the sole responsibility of the author, and the views expressed herein should not be attributed to Greenberg Traurig.

This article originally appeared in 7 Derivatives 1 (December 2005). Copyright 2005 RIA. Reprinted with permission. All rights reserved.

© 2005 Greenberg Traurig


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