Posted on January 20, 2010 by Jerald David August

IRS Releases Private Letter Ruling on Dividend Impacts of a "Foreign Sandwich"

PLR 200952031 (12/24/2009) addressed the application of the dividends received deduction (DRD) in the foreign context where a foreign corporation is the parent of a U.S. subsidiary. As a comment before discussing the ruling, sometimes in structuring an acquisition of a target that engages in both U.S. and non-U.S. business enterprises, it may be better to restructure the target's business operations before the acquisition instead of afterwards which may be the normal course.

Under the general facts of the ruling, acquisition group ("A") owned a U.S. subsidiary which had purchased all of the stock of a domestic target corporation ("T"). T conducted business operations both within and outside of the U.S. After the acquisition, T reincorporated as a foreign corporation, FT, which contributed its domestic business to New U.S.T. Then A’s U.S. subsidiary liquidated which resulted in A’s owned new FT with FT owning New U.S. T. This U.S. parent, foreign subsidiary, wholly owned U.S. subsidiary structure has been referred to as the "foreign sandwich". How will this structure affect the flow of profits from the lowest tier US subsidiary up the change of command?

The taxpayer seeking the ruling did not ask about the domestic to foreign transaction. The IRS simply stated in the ruling that the outbound transfer was an F reorganization. But, consider the drop out or drop down into the New U.S.T. Can it really be said that it was a true F reorganization? Perhaps it was instead an F involving the U.S.T. and then a dividend up of the foreign based business to the foreign company? See Treas. Regs. §§1.368-1(k)(1). 1.368-2(m). The ruling did not dwell on the F reorganization issues or problems but instead focused on the treatment of dividends from New U.S.T. to the FT and then from FT to A.

The ruling held: of course, based on the FT’s status as a foreign corporation, it is ineligible to qualify under §§902 and 960 on foreign tax credits (and corresponding gross up). FT’s foreign base company income for dividends paid by New U.S.T. will be reduced by the 80% DRD (dividends received deduction). Dividends paid up to A can be sheltered by 80% DRD for the U.S. source portion of the dividends from FT citing Weyerhaeuser, 38 BTA 594 (1935). Thus, FT would increase its earnings and profits account by the gross amount of its dividends received from New U.S.T. despite using the DRD in determining subpart F income.

Example. Assume that New U.S.T. had has earnings and profits of $500 and pays a $500 dividend to FT. New Foreign Target receives $100 in foreign base company income, assuming the 80% dividends received deduction applies. Acquirer includes this $100 in income currently and gets step-up in basis of stock per §961(a). This $20 amount is not a “dividend” and does not qualify for the dividends received deduction. Section 964(a)(6) does not mitigate because New U.S. Target is not a CFC.) When A receives a dividend of $100 (previously taxed income) it will reduce its basis in FT stock. §961(b). For amounts above the $100 of PTI, if from the U.S. source earnings, Acquirer will be allowed an 80% DRD. Thus, on a subsequent distribution of the $100 from New Foreign Target (assuming no change in accumulated earnings and profit and no current earnings and profits), $100 will reduce basis, and $400 will be treated as a dividend, 80% of which will qualify for the DRD.

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Posted on January 20, 2010 by Jerald David August

National Office of IRS Issues Private Letter Ruling on the Isolated Redemption Exception to Section 302(b)(1). PLR 201002022 (1/15/2010).

Treas. Reg. §1.305-3(b)(3) provides, in relevant part, that: a distribution of property incident to an isolated redemption of stock, e.g., a tender offer, will not trigger application of §305(b)(2) even though the redemption distribution is treated as a distribution of property to which §301 applies. Thus, an isolated non-pro rata redemption of stock does not result in a deemed distribution of stock under §305(c) to the nonredeeming shareholders, thereby negating the application of §305(b)(2) when the redemption is either (1) not treated by the redeeming shareholder as a Section 301(c)(1) distribution, or (2) an "isolated redemption."

The regulations illustrate Congressional intent where a majority shareholder causes a corporation to redeem some of its stock in a single, one-time redemption.

Treas. Reg. §1.305-3(e) Example (10) P has 1,000 shares of stock outstanding. T owns 700 shares of the P stock and G owns 300 shares of the P stock. In a single and isolated redemption to which §301 applies, the corporation redeems 150 shares of T's stock. Since this is an isolated redemption and is not part of a periodic redemption plan, G is not treated as having received a deemed distribution under §305(c) to which §§305(b)(2) and 301 apply even though he has an increased proportionate interest in the corporation.

Finally, the regulations contain an example in which a series of non-pro rata redemptions does not result in a deemed distribution under §305(c) when the redemptions have some valid business purpose (e.g., to fund an employee benefit plan), provided that the redemptions were not in pursuance of a plan to increase the proportionate interests of some shareholders and to distribute property to other shareholders. Because the redemptions in the cited examples are not motivated by an intent to increase the proportionate interest of some shareholders, §305(b)(2) does not tax the increased interests as a dividend. See also Rev. Rul. 77-19, 1977-1 C.B. 83 (corporation’s redemption of stock from some minority shareholders for cash in a merger was not equivalent to a taxable dividend with respect to the continuing shareholders in the surviving corporation).

With that as a backdrop, in PLR 201002022 the Service hints a significant nontax business purpose for the redemption will support a conclusion that §305 is inapplicable even though the distributions increase the proportionate interests of nonredeeming shareholders, and even if the distribution of stock and other properties is part of a series of distributions. In addition, if the distributing corporation is publicly held, a strong argument can be made that any stock and property distribution policy or plan adopted by the corporation that results in changes in proportionate interest of the remaining shareholders is not intended as a device to bail out the corporation's E&P. This argument is particularly applicable where the change in proportionate interests among the shareholders is minor. But neither the statute nor the regulations specifically adopt these implicit and practical limitations on the finding of a Section 305(b)(2) dividend distribution in a non-pro rata redemption.

Unlike the examples in the regulations which set out the isolated redemption exception, neither the legislative history nor the preamble to the regulations make any reference to a business purpose exception. While the more typical isolated redemption avoids dividend equivalence for valid reason, the expanse of a business purpose exception could be limitless and perhaps is too optimistic. Redemptions by co. of Class B common stock held by described retirement plan will qualify as redemptions that aren't essentially equivalent to dividend within meaning of Code Sec. 302(b)(1); , and distributions in redemption of stock owned by retirement fund will be treated as distributions in full payment in exchange for stock owned by retirement plan as provided in Code Sec. 302(a); .

Under the facts of the PLR, the Company is a privately owned company engaged in a business and has 2 class of outstanding common stock, voting and non-voting. The Company has an ESOP which owns shares of the nonvoting stock. Prior to Date 1, in order to provide liquidity to the Retirement Plan and to help the Retirement Plan diversify its assets, Company's board of directors plan to annually redeem an amount of shares of Class B common stock held by the Retirement Plan. At the meeting, the board of directors approved a financial forecast that included a dedicated line item for the planned redemptions. Absent further redemptions, the Retirement Plan will have sufficient liquidity to meet its obligations for only the next 3 to 5 years.

On Date 1, Company redeemed e shares of Class B common stock from the Retirement Plan in exchange for cash, which reduced the Retirement Plan's ownership of Company's total shares of common stock outstanding . On or about Date 2, Company will redeem shares of Class B common stock from the Retirement Plan in exchange for cash which will reduce the Retirement Plan's ownership of Company's total shares of common stock outstanding. Barring unforeseen or unanticipated business circumstances regarding cash flow, Company plans additional annual redemptions from the Retirement Plan.

On or about Date 3, Company will redeem shares of Class B common stock from the Family Group in exchange for cash. Currently, there is no plan to offer any further redemptions to the Family Group.

The Service rule that the planned series of redemptions of Class B stock from the Retirement Plan will be treated as redemptions that are not essentially equivalent to a dividend per §302(b)(1). See United States v. Davis , 397 U.S. 301 (1970); Rev. Rul. 75-512, 1975-2 C.B. 112; Rev. Rul. 77-426, 1977-2 C.B. 87. It further ruled that the redemption of the family’s stock will constitute a single and isolated transaction and will not result in a deemed distribution under section 305 with respect to any of Company's shareholders, regardless of whether such shareholder has a portion of its stock redeemed in the transaction. See Treas. Reg. § 1.305-3(e), Examples (10) and (11). See also Rev. Rul. 77-19, 1979-1 C.B. 84.

 

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Posted on January 20, 2010 by Jerald David August

Court of Claims Strikes Down Wells Fargo's SILOs Tax Shelters

 

 

 

Tax refund suit filed by WF claiming over $115M in depreciation, interest and expenses for 2002 in connection with participating in 26 leveraged lease transactions, 17 with domestic transit agencies and 9 pertaining to qualified technological equipment ("QTE") Five of the 26 were selected for trial by agreement of the parties who agreed to allow the principles from these transactions to govern the balance. Of the five trial transactions, four involved public transit agencies, and one a QTE lease involving cellular telecommunications equipment. The lessees were public authorities or governmental agencies. A sale in/lease out or SILO tax shelter is where a tax-exempt entity transfers tax benefits for a fee to a United States taxpayer, e.g., WF. The transactions involving depreciable property ranging from buses to trains to telecommunications equipment. The object for each transaction is for the purchaser-lessor to obtain substantial tax deductions from an otherwise tax-exempt entity (seller-leaseback lessee).

The government’s attacks on such arrangements generally involve: (i) applying the substance over form doctrine to determine whether WF really acquired ownership with respect to the purchased assets or whether in substance, the seller really retained ownership and all that is involved is an artificial shifting of tax benefits; (ii) does the financing aspects associated with such sale and lease back, which involves a loan to the original owner to finance the transaction should be respected and allow interest deductions on the loan repayments; and (iii) whether there is any economic substance to these transactions, other than the transfer of tax benefits, that would warrant depreciation and transaction cost deductions.

The Claims Court conducted a 20 day trial in Spring 2009 at which time 33 witnesses, including 13 experts testified. The evidentiary record was voluminous consisting of over 5,000 pages of trial transcript and over 1,100 exhibits. The Court conducted a 20-day trial in Washington, D.C. during April 6 through May 1, 2009.

Other courts have been asked to rule on SILOs or "lease in/lease out" or "LILO" transaction. With one exception, the courts have ruled against the taxpayers claiming the desired tax benefits. See AWG Leasing Trust v. United States, 592 F.Supp.2d 953 (N.D. Ohio 2008); BB&T Corp. v. United States, 2007 WL 37798 [99 AFTR 2d 2007-376], at 1 (M.D.N.C., Jan. 4, 2007), aff'd, 523 F.3d 461 (4th Cir. 2008); Altria Group, Inc. v. United States, 2009 WL 874207, at 1 (S.D.N.Y. July 9, 2009). The taxpayer was successful in Consolidated Edison Company of New York, Inc. v. United States, 2009 WL 3418533 (Fed. Cl. Oct. 21, 2009) (Horn, J.), also a Claims Court case which found that the particular LILO transaction involved had legitimate business purposes and allowed the claimed dedutions.

In Hoosier Energy Rural Electric Cooperative, Inc. v. John Hancock Life Ins. Co., 588 F. Supp. 2d 919 (S.D. Ind. 2008), aff’d 582 F.3d 721 (7th Cir. 2009), involved an insurance company which had its credit rating reduced as part of the economic downturn. The lessor of the property, John Hancock, exercised its right to demand that Hoosier Energy find a replacement for the tenant even though it had not missed any payments. The case involves Hoosier Energy's request for injunctive relief to maintain the status quo while Hoosier Energy seeks a replacement for the tenant. In granting injunctive relief, the district court described the SILO transaction as a "blatantly abusive tax shelter" that is "rotten to the core." The Court of Appeals affirmed the district court's grant of injunctive relief, but clarified that the agreements comprising the SILO transaction were legally enforceable under New York law, even if not an approved tax shelter under the Internal Revenue Code. The Court of Appeals gave Hoosier Energy until the end of 2009, approximately 3-1/2 months, to find a replacement user. 582 F.3d at 730.

After reviewing the record, the Claims Court found that WF is not entitled to the claimed tax deductions on the 5 trial transactions. WF never acquired the burdens and benefits of ownership. Moreover, the transactions lack economic substance, and were intended only to reduce WF’s federal taxes by millions of dollars. Although well disguised in "a sea of paper and complexity", the SILO transactions essentially amount to WF’s purchase of tax benefits for a fee from a tax-exempt entity that cannot use the deductions. The transactions are designed to minimize risk and assure a desired outcome to WF, regardless of how the value of the property may fluctuate during the term of the transactions. Indeed, nothing of any substance changes in the tax-exempt entity's operation and ownership of the assets. The only money that changes hands is Wells Fargo's up-front fee to the tax-exempt entity, and Wells Fargo's payments to those who have participated in or created the intricate agreements. If the Court were to approve of these SILO schemes, the big losers would be the IRS through the loss of millions of taxes.

On the issue of economic substance, the Court examined if there was any likelihood of profit aside from the tax benefits. After going through the detailed paperwork the Court concluded that the end result is that the trial transactions produce an overall loss without the tax benefits, and no rational person would engage in these transactions absent the tax benefits. The Court announced that it will set a conference with counsel during the next 45 days to determine whether any further proceedings are necessary to address the remaining 21 transactions at issue in this case.

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