In Barnes Group, Inc. and Subsidiaries, v. Commissioner, 114 AFTR 2d 2014-XXXX, (CA2), 11/05/2014, the taxpayer appealed an adverse decision from the United States Tax Court, 105 T.C. M. 1654 (2013) which sustained the adjustments made by the IRS to Barnes 2001 and 2000 federal income tax returns as well as the imposition of a 20% accurancy penalty for substantial understatement of tax. The penalty was held appropriate even though the taxpayer received a more likely than not opinion as well as a substantial authority position from its tax advisor
Barnes Group, Inc., manufactures and distributes specific metal parts and industrial supplies. By 1999, Barnes operated there separate businesses via domestic and foreign subsidiary corporations, i.e., Associated Spring, Barnes Aerospace, and Barnes Distribution. In 2001 a reinvestment plan was entered into by Barnes, as the parent corporation, and its subsidiaries. The reinvestment plan had as its objective the expansion of the company’s business through domestic and international acquisitions. Several acquisition, which in the aggregate cost approximately $200 million, were made in 1999 and 2000. Prior to the acquisitions, Barnes had $50 million of outstanding long-term debt and no outstanding balance on a revolving credit line. By the end of 2000, Barnes had approximately $230 million of outstanding debt and $50 million outstanding on its revolving credit line. This significantly lowered the overall capitalization of the companies which was, in comparison with its industry, more higly leveraged.
By June 1, 2000, Barnes and subsidiaries had $45.2 million in cash worldwide with the bulk or $43 million held by its foreign subsidiaries. Barnes wanted to use its Asian second tier subsidiary, ASA, excess cash position to help pay donw its acquisition indebtedness. Were Barnes to receive a dividend or a loan from ASA, Barnes US income tax liability would increase. In addition, Barnes had overall foreign losses at the time per section 904(f) and was not in a position to currently utilize indirect tax credits under section 902.
Barnes, through its vice president, tax, worked with three major accounting firms on how to avoid the adverse U.S. income tax consequences yet get the foreign cash earnings repatriated to the U.S. parent corporation. The solution arrived at, was a domestic and foreign finance structure. A blended fee based fee agreement was executed by Barnes and PWC. PwC issued a favorable opinion on its recommended strategy.
The basic outline of the plan to cause cash to come from ASA to the United States without a tax liability was as follows: (i) Barnes first creates a domestic financing entity; (ii) ASA creates a foreign financing entity; (iii) ASA exchanges its cash for the foreign financing entity’s stock; and (iv) the foreign financing entity transfers cash and its stock to the domestic financing entity in exchange for the domestic financing entity’s stock. Subsequently an exit strategy or unwind plan was added to the mix were Barnes to return the funds to ASA. A “draft” of a “business purpose” for the reinvestment plan was developed. The exit strategy involved the foreign financing entity’s purchse of the domestic financing entity’s stock from Barnes and then liquidating the domestic financing entity. The stated business purpose, international cash management. The plan was approved by Barnes’ board of directors on October 112, 2000.
Drilling down to the document facts, Barnes formed Bermudian and Delaware wholly onwed subsidiaries in late August and early September 2000. At such time ASA was still a second tier subsidiary of Barnes. Bermuda and ASA were CFCs of Barnes under section 957(a). The first part of the reinvestment plan was: (i) in a section 351 exchange, ASA and Barnes would trasfer foreign currency to Bermuda for Bermuda common stock; (ii) in a second section 351 transaction Bermuda and Barnes would transfer foreign currency and Bermuda common stock to Delaware for Delaware stock with Barnes receiving common stock and Bermuda preferred stock; and (iii) Delaware would convert the foreign currencies into U.S. dollars and lend the funds to Barnes. Under part II of the restructuring or reinvestment plan, ASA would borrow funds from a Singapore Bank before completing the two section 351 transactions. After completion of the plan, ASA and Delaware would own all of the common stock of Bermuda and Bermuda wouldl own all of the preferred stock of Delaware. The first part of the plan was effectuated in late 2000 and the send part effectuated in July 2001.
Prior to effectuation of the reinvestment plan in September 2000, the national acccounting firm which designed the plan issued a draft of an opinion letter. The opinon letter addressed whether the Bermuda and Delaware section 351 exchanges would result in income inclusion under sections 951 and 956. The opinion concluded that the preferred stock held by Bermuda in Delaware should consitute an investment in U.S. property under section 956(c)(1) but Bermuda should have a zero basis in the Delaware preferred stock. Since the income to be included under section 956 is limited to the adjusted basis that Bermuda has in the Delaware preferred stock, the opinion stated that no amount should be included in Barnes’ income as a result. The opinion also touched upon the step transaction doctrine, section 301 and section 269. The letter concluded that section 269 was inapplicable and the the transaction should not result in a repatriation of funds under section 301. It also commented that step transaction analysis should not apply since there “is no plan to alter the interests and relationships among the paries”. Citing Esmark Inc. v. Commissioner, 90 T.C. 171 (1988), aff’d w/o pub. Op., 886 F.2d 1318 (7th Cir. 1969). The national accounting firm involved, PwC, found “substantial authority” supported its conclusions within the meaning of section 6662 and Treas. Reg. §1.6662-4(d). It also reach a more likely than not opinion on the issues involved.
Barnes Tax Returns and IRS Notice of Deficiency.
For the years in issue, on Barnes consolidated icncome tax return it reported: (i) taxable income of $39.7M for 1998; (ii) a taxable loss of .503M for 2000; and (iii) a taxable loss of $10.7 million for 2001. The various section 351 transactions involving Barnes, Delaware, Bermuda and ASA werer fully reported.
In the notice of deficiency dated August 20, 2009, respondent IRS: (i) increased Barnes’ 2000 taxable income by $38,919,950, which represented ASA’s $39 million aggregate transfer (minus a minor conversion rate adjustment) that eventually was transferred to Barnes; and (ii) increased Barnes’ 2001 taxable income by $19,378,596, which represented ASA’s $23,311,897 transfer (minus a conversion rate adjustment and an earnings and profits adjustment) that eventually was also transferred to Barnes; (iii) determined that the value of the four 10,000 PPM clean rooms was $2,520,000 and that as a result Barnes should have recognized additional income of $820,000 for the 2001 tax year on an unrelated issue; and (iv) disallowed Barnes’ 1998 net operating loss carryback of $503,654 from its 2000 tax year.
After filing its petition with the U.S. Tax Court, the taxpayer argued that was entitled to rely on Rev. Rul. 74-503, 1974-2 C.B. 117 and Rev. Rul. 2006-2, 2006-1 C.B. 261, which stated that per section 7805(b) “the Service will not challenge a position taken prior to December 20, 2005 by a taxpayer that reasonably relied on Rev. Rul. 74-503, supra. Rev. Rul. 74-503 provides guidance where treasury stock is exchange for newly issued stock of another corporation. See also section 358(a), 362 and Treas. Reg. §1.1032-1(d). The Service argued the ruling inquestion does not apply to the facts at bar. The Tax Court agreed with the Service and found “vast factual disparities between the reinvestment plan and Rev. Rul. 74-503. Therefore the Service was not precluded from challenging the reinvestment plan.
Tax Court Proceeding
The Tax Court started its analysis with respect to the merits of the reinvestment plan having recognize that Barnes needed cash sourced from low-taxed profits of ASA to help amortize its large amounts of debt. In order to obtain ASA funds, Barnes had three basis options. First was a dividend from ASA that would be taxable as dividend income to Barnes. Second, a loan or equity investment by ASA to Barnes would trigger subjpart F income and also would be includible in gross income. Barnes is the U.S. shareholder of Bermuda and ASA, both CFCs. Barnes, therefore, would recognize a section 951 income inclusion to the extent of the adjusted basis of U.S. property held by Bermuda or ASA as a result of the reinvestment plan (to the extent that Bermuda or ASA had earnings and profits).
Here Barnes argued that Bermuda made investments in Delaware’s preferred stock in section 351 transactions. Under Rev. Rul. 74-503, Bermuda would obtain a zero basis in Delaware’s preferred stock. Therefore Barnes section 951 income inclusion is based on “adjusted basis” of property distributed and since basis was $0 there was no dividend income. The government argued that the substance of the transactions was not reflective by its form and that in such instance the substance controls. Commissioner v. Court Holding, 324 U.S. 331, 334 (1954); Gregory v. Helvering, 293 U.S. 495 (1935); Coltec Industries , Inc. v. United States, 454 F.3d 1340, 1354 (Fed. Cir. 2006). In short, Rev. Rul. 74-503, supra, may have been relied upon by Barnes but the substance of the transaction here, i.e., the reinvestment plan, fell well outside the parameters of the ruling.
Tax Court Holding: For Government; Where’s the Business Purpose?
As with tax litigation cases in general, petitioners bear the burden of proof and in this case such obligation requires Barnes prove the merits of the reinvestment plan for federal income tax purposes and that such stratgey was not to circumvent the current inclusion of income from the deemed distribution of a dividend(s) from ASA to Barnes. In addition, the Court noted that the reinvestment plan deserves extra scrutiny, petitioners’ vague assertions regarding Singapore law impediments, state tax benefits, and cash management are insufficient to support a finding that Bermuda and Delaware were created for legitimate nontax business purposes. Furthermore, petitioners have not shown that they respected the form of the reinvestment plan.
Based on the record, the taxpayer did not meet its burden of proof. The Tax Court concluded that Bermuda and Delaware did not have a valid business purpose and that the various intermediate steps of the reinvestment plan are properly collapsed into a single transaction under the interdependence test as part of the step-transaction doctrine. While petitioners assert that the reinvestment plan was always intended to be a temporary structure, the Court found that the objective facts suggested otherwise. ASA transferred a substantial amount of cash to Barnes (funneled through Bermuda and Delaware) which Barnes used to pay off its debt. Barnes has not shown that it returned any of ASA’s funds. After review of the record and the briefs filed by the parties, the Tax Court found that the reinvestment plan was in substance dividend payments from ASA to Barnes in 2000 and 2001, taxable under section 301.
Second Circuit Court of Appeals Finds for Commissioner
On appeal to the Second Circuit, the Tax Court’s decision was affirmed. The three judge panel agreed that Barnes position ignored not only the business purpose doctrine but proper application of the step transaction doctrine. Therefore, Barnes’ stated reliance on Rev. Rul. 74-503, supra, was misplaced as the ruling only applied to an isolated exchange of stock and “provided no guidance on when the individual steps in an integrated series of transactions will be disregarded under the step transaction. Reliance on Revenue Rulings can only be made where the facts and circumstances are substantially the same. 26 C.F.R. §601.601(d)(2)(v)(i).
On application of the step-transaction doctrine, the Tax Court properly collapsed the series of transactions through which Barnes obtained the funds of its Singaporean subsidiary, Associated Spring-Asia PTE Ltd. (“ASA”), by channeling the funds through a foreign financing subsidiary (“Bermuda Finance”) and a domestic financing subsidiary (“Delaware Finance”), both created solely to facilitate the transfer. Each transaction in this series but the last purported loan to Barnes from Delaware Finance was completed pursuant to an Agreement and Plan of Reinvestment that acknowledged these transactions comprised “a single integrated plan. Indeed, that transfer was the entire purpose of the series of transactions from the beginning. Thus, the steps by which ASA provided funds from its earnings to Barnes were correctly treated as a series of integrated steps included in one transaction.
The Second Circuit also agreed with the Tax Court that the channeling of ASA’s funds through Bermuda and Delaware rather directly to Barnes did not serve any business purpose other than to transfer ASA’s funds to Barnes in a manner that had the appearance of a non-taxable transaction. Accordingly the transactions werer in substance dividend payments from ASA to Barnes.
It also affirmed the Tax Court’s imposition of a substantial underpayment penalty finding that Rev. Rul. 74-503, supra, was not sustantial authority and that Barnes did not reasonably rely on it. The opinion issued by PwC suffered from the same defects as to its reliance on Rev. Rul. 74-503, supra and does not advise of the tax consequences of the entire series of transactions transferring funds from ASA to Barnes. Therefore, in effect, the opinion was of no value for penalty avoidance.