The Second Circuit did not make the parties wait very long to learn the outcome of the Barnes Group’s appeal from the Tax Court’s imposition of dividend treatment on its multi-step transaction that enabled it to use in the United States cash that was located in Singapore. See our prior reports here and here. Little more than a month after oral argument, the court of appeals today issued a summary order affirming the Tax Court in all respects. The first page of such unpublished orders recites that they “do not have precedential effect,” but they can be cited in future cases pursuant to Fed. R. App. P. 32.1 (albeit only in limited circumstances in the Second Circuit, see 2d Cir. Local Rule 32.1.1). In any event, the court issued a nine-page opinion briefly touching on the issues.
First, the court of appeals quickly agreed with the Tax Court that the IRS had not run afoul of the principle that it should not argue against its own revenue rulings. Even though Barnes had relied on Rev. Rul. 74-503 in determining the tax consequences of a key step in the transaction, the court of appeals accepted the Tax Court’s explanation that Rev. Rul. 74-503 could be disregarded because it “addressed the tax treatment of an isolated exchange of stock, and therefore provided no guidance on when the individual steps in an integrated series of transactions will be disregarded under the step transaction doctrine.”
The court then upheld the application of the step-transaction doctrine, agreeing with the Tax Court that the intermediate steps would have been fruitless unless they were part of a single integrated plan. The court rejected the taxpayer’s argument that the doctrine should not apply because the steps had a valid business purpose, finding that the Tax Court’s contrary finding of no valid business purpose was not clearly erroneous. Specifically, the court of appeals stated that “any non-tax benefit of including the financing subsidiaries was, at best, a mere afterthought.” Similarly, the court held that the Tax Court did not clearly err in premising its constructive dividend conclusion on a finding that Barnes failed to show that certain interest or preferred dividend payments were ever made.
Finally, the court of appeals upheld the imposition of the 20% accuracy-related penalty. It ruled that its previous distinction of Rev. Rul. 74-503 as not applying to a situation involving multiple steps also made that ruling unavailable as “substantial authority” that could eliminate the penalty. And it ruled that Barnes had no “reasonable cause and good faith” defense because the PwC opinion on which it had relied “does not advise as to the tax consequences of the entire series of transactions transferring funds from ASA to Barnes.”
All of the briefs have now been filed in the Barnes case. The government’s response brief defends the Tax Court’s decision as a run-of-the-mill application of substance over form principles. Quoting from True v. Commissioner, 190 F.3d 1165 (10th Cir. 1999), it argues that the step-transaction doctrine applies because the “Bermuda/Delaware exchanges did not ‘make[ ] any objective sense standing alone’ without contemplation of the other steps.” In arguing that these steps served no business purpose, the government relies heavily on evidence that the “reinvestment plan” was based on tax planning that the taxpayer’s accountants had previously done for another client. The government asserts that “Barnes and PwC went to great lengths to create out of whole cloth a business purpose for a tax-avoidance plan that originated in PwC’s database.” Rather than a legitimate business plan, the government alleges that “the entire repatriation scheme consists of essentially nothing more than a circular flow of funds among Barnes and its wholly owned subsidiaries.”
The government’s brief also notes that, if the court of appeals is unpersauded by the Tax Court’s opinion, it should remand for additional factual determinations to resolve two alternative government arguments that were not reached by the Tax Court: 1) that the transaction had the principal purpose of tax evasion and therefore deductions could be disallowed under Code section 269; and (2) that the Delaware preferred stock was held under the anti-abuse rule of Treas. Reg. § 1.956-1T(b)(4).
With respect to the issue discussed in our previous post regarding the taxpayer’s argument that the government was prohibited from disavowing Rev. Rul. 74-503, the brief largely tracks the Tax Court’s discussion. In other words, the government does not question the soundness of the principle stated in Rauenhorst that the IRS cannot argue against its Revenue Rulings. Rather, the brief simply doubles down on the step-transaction point and argues that the taxpayer could not reasonably rely on that ruling here because this case does not involve “bona fide § 351 exchanges.”
With respect to the penalty issue, the government again criticizes PwC’s role, arguing that PwC had a “conflict of interest” in issuing an opinion regarding the transaction because it had an interest in a favorable tax result that would allow PwC to “market [the tax plan] to other corporations seeking to repatriate funds from a controlled foreign corporation.” Accordingly, the government argues that the taxpayer could not reasonably rely on the PwC letter for “objective advice.” The government also argues that the taxpayer could not reasonably rely on the opinion because “PwC did not opine on the integrated repatriation scheme as a whole.”
The taxpayer’s reply brief argues that the government’s brief “mischaracterizes the substance of the plan” because the Bermuda and Delaware subsidiaries did not operate as conduits for a dividend payment. Instead, it accuses the government of making a policy-based argument that would “impermissibly convert Section 956 into an anti-abuse rule.” The brief then disputes in detail the government’s description of the transaction and underlying facts.
With respect to the penalty issue, the reply brief states that the government “essentially rewrites the Tax Court’s factual findings” in criticizing reliance on the PwC opinion. The brief notes that PwC was Barnes’ long-time tax advisor and did not market the transaction to Barnes. It also states that the Tax Court held that the PwC advisor “was a competent professional who had sufficient expertise to justify reliance” and that Barnes “provided necessary and accurate information to the advisor.” In particular, the reply brief responds to the government’s “conflict of interest” accusation against PwC by noting that the Tax Court specifically observed that there was nothing “nefarious” about PwC keeping tax planning ideas in a database and by asserting that “the government’s unfounded assertions that PwC did not provide an adverse opinion in order to sell the transaction to others is ludicrous and without any factual basis.” The reply brief also argues that the government is incorrect in stating that the PwC opinion did not address the entire transaction, quoting the PwC opinion itself as stating that it “is premised on all steps of the proposed transaction.”
Oral argument has not yet been scheduled.
Briefing Underway in Barnes as Second Circuit Considers Application of Step-Transaction Doctrine to Impose Dividend Treatment on Movement of Foreign Cash
In Barnes Group v. Commissioner, the Tax Court (Goeke, J.) looked askance at the taxpayer’s strategy for minimizing the tax consequences of a movement of foreign cash to U.S. affiliates. As the taxpayer explained it, its foreign subsidiary in Singapore had excess cash and borrowing capacity that Barnes wanted to use to finance international acquisitions. For the time being, however, there was no suitable acquisition target, and the cash was earning only 3% in short-term deposit accounts while it could have been used more profitably in the U.S. to reduce Barnes’s expensive long-term debt. Barnes hired PricewaterhouseCoopers to help it develop an approach to allow the foreign cash to be used in the U.S. without incurring the adverse U.S. tax consequences of a direct loan or distribution to the U.S. parent.
The resulting “reinvestment plan” involved the creation of two new subsidiaries, one in Bermuda and one in Delaware, and two successive contributions of cash in section 351 exchanges – first from Singapore to Bermuda and second from Bermuda to Delaware. The Delaware subsidiary then loaned the cash to Barnes. Feel free to examine the opinion linked below for the details of the transaction, but suffice it to say here that a linchpin of the tax planning was reliance on Rev. Rul. 74-503, which concluded that when two corporations exchange their own stock under circumstances similar to the section 351 exchange between the Bermuda and Delaware subsidiaries, they take a zero basis in the stock received. (Rev. Rul. 74-503 was revoked by Rev. Rul. 2006-2, but the earlier ruling is still relevant in this case because Rev. Rul. 2006-2 is prospective and provides that the IRS will not challenge positions already taken by a taxpayer that reasonably relied on Rev. Rul. 74-503.) Although Bermuda’s ownership of stock in its Delaware affiliate was an investment in U.S. property under section 956 and therefore would typically result in adverse U.S. tax consequences similar to a distribution, Barnes argued that Bermuda’s basis was zero and therefore that its section 956 inclusion should be zero.
The Tax Court disagreed, holding that the U.S. tax consequences of the transaction were different from those anticipated by Barnes. The court first determined that Rev. Rul. 74-503 did not preclude the IRS from challenging the taxpayer’s position, giving two reasons. First, the court briefly stated that, because it believed that “the substance of the reinvestment plan was a dividend from [Singapore] to Barnes” (as it would explain later in the opinion), the court did not “respect the form of the reinvestment plan” and therefore the ruling was irrelevant. Second, the court said that the ruling was irrelevant in any event because of the “substantial factual differences” between the ruling and this case. The court acknowledged that the section 351 exchanges, “considered alone, do have factual similarities to the revenue ruling,” but noted that they also were different in that they involved new subsidiaries, including a controlled foreign corporation. In addition, the Tax Court emphasized that the Barnes transaction was more complex than the one described in the ruling and listed seven “vast factual disparities” between the two situations. The court, however, devoted little attention to explaining why these factual differences were material to whether the principle of the ruling should apply here. Instead, the court simply recited the factual differences and then concluded that, “because the reinvestment plan far exceeded the scope of the stock-for-stock exchange addressed in Rev. Rul. 74-503,” the IRS was not precluded from challenging the taxpayer’s position.
The court then applied a step-transaction analysis to support its holding that “the substance of the reinvestment plan was a dividend” from Singapore to Barnes and should be taxed as such. According to the court, the step-transaction doctrine provides that “a particular step in a transaction is disregarded for tax purposes if the taxpayer could have achieved its objective more directly but instead included the step for no other purpose than to avoid tax liability.” The court stated that the doctrine applies if any of three tests are satisfied: (1) the binding commitment test; (2) the end result test; and (3) the interdependence test. Finding the third test to be the most appropriate, the Tax Court concluded that the various steps were “so interdependent that the legal relations created by one step would have been fruitless without completion of the later steps.” The key premise underlying that ultimate conclusion was the court’s determination that there was no “valid and independent economic or business purpose . . . served by the inclusion of Bermuda and Delaware in the reinvestment plan.” This analysis is an aggressive application of the step-transaction doctrine, taking it beyond its usual sphere, given that the steps ignored by the court were not transitory and that the characterization of the transaction as a dividend did not leave the parties in an economic position consistent with their legal rights and obligations following the actual transaction.
The court further found that Barnes did not “respect the form of the reinvestment plan” as Barnes made no interest payments to Delaware on the loan (even though interest had been accrued) and did not provide sufficient evidence that Delaware made any preferred dividend payments to Bermuda.
Finally, the court rejected the taxpayer’s contention that the reinvestment plan was intended to be a temporary structure under which the Singapore funds would ultimately be invested overseas when the right target appeared, noting that Barnes did not return any funds to Singapore.
The Tax Court also upheld the government’s imposition of a 20% accuracy-related penalty. The taxpayer raised two defenses to the penalty, arguing that its position was based on “substantial authority” and that it reasonably and in good faith relied on the PwC opinion letter. The court gave the “substantial authority” argument short shrift, simply repeating that Rev. Rul. 74-503 was “materially distinguishable” and hence should be afforded little weight. In response to the taxpayer’s additional citation of a 1972 General Counsel Memorandum, the court stated that GCMs “over 10 years old are afforded very little weight.” Given that taxpayers are generally invited to rely on the legal principles set forth in revenue rulings as precedent (see Treas. Reg. § 601.601(d)(2)(v)(d)), the court’s perfunctory dismissal of the taxpayer’s reliance on Rev. Rul. 74-503 as substantial authority – and consequent imposition of a penalty – appears fairly harsh.
With respect to reliance on the PwC opinion, the court rested its decision on its finding that Barnes and its subsidiaries did not respect the structure of the reinvestment plan by failing to pay loan interest or preferred stock dividends. In the court’s view, “by failing to respect the details of the reinvestment plan set up by PwC, . . . [the taxpayer] forfeited any defense of reliance on the opinion letter.”
The taxpayer’s opening brief contends that all of these determinations by the Tax Court are erroneous. The first and longest section of the brief criticizes the court’s step-transaction analysis and ultimate conclusion that the transactions simply amounted to a dividend from Singapore to Barnes. In the taxpayer’s view, the court’s analysis “invent[s] a new step” of a constructive dividend that “fails to account for all of the commercial realities that continue to this day for the four legally separate corporate entities.” For example, the taxpayer argues that the evidence showed that Barnes intended to repay the loans and therefore it could not be a constructive dividend. Much of this portion of the taxpayer’s brief argues that the Tax Court’s key factual findings were clearly erroneous – namely, that the two new subsidiaries lacked a non-tax business purpose; that Barnes paid no interest to Delaware; that no preferred dividends were paid; and that the reinvestment plan was not intended to be temporary.
Second, the brief argues that the government impermissibly disavowed Rev. Rul. 74-503. The taxpayer points to Rauenhorst v. Commissioner, 119 T.C. 157 (2002), for the proposition that the IRS cannot challenge the legal principles set forth in its own revenue rulings. It then argues that the factual differences identified by the Tax Court are irrelevant to the rationale for Rev. Rul. 74-503 and thus provide no basis for the government’s failure to abide by that rationale.
It will be interesting, and instructive for other cases, to see how the government deals with this point. If it is true that revenue rulings are supposed to provide guidance on legal principles on which taxpayers can rely, and if the IRS is constrained to some extent by its own rulings, it would seem apparent that merely identifying factual differences is not enough of a justification for disregarding the legal principles articulated in a revenue ruling. There are always going to be factual differences, especially when the ruling at issue contains only a brief and generic description of the facts, like Rev. Rul. 74-503. Will the government question the premise of the taxpayer’s argument in any way? Or will it accept the taxpayer’s statements about Rauenhorst and limit itself to defending the Tax Court’s position that the facts at issue are so materially different that the rationale of Rev. Rul. 74-503 cannot reasonably be applied here? Will it try to buttress the Tax Court’s reliance on the “vast factual disparities” between the two situations or will it simply focus on the argument that the tax effect of any individual step viewed in isolation is irrelevant (and therefore so is the ruling) because the transactions in substance amounted to a dividend?
Third, the taxpayer contests the court’s penalty determination. With respect to “substantial authority” the taxpayer relies primarily on the earlier discussion in the brief and maintains that it was reasonable to rely on the revenue ruling. With respect to the good faith argument, the taxpayer repeats its earlier discussion disputing the Tax Court’s finding that it did not respect the form of the transaction. It also argues that the PwC opinion, in any event, did not even address the loan and preferred dividend details on which the Tax Court rested its findings, and therefore the taxpayer’s alleged failures regarding those details do not undermine its claim of reasonable reliance on the PwC opinion. Finally, the taxpayer argues broadly that the Tax Court could not rest its good cause determination “on events that occurred after the returns were filed.”
The government’s brief is due May 15.