General Limitations

Imagine a time where you could borrow money, use that to buy money, and then be paid by the government for doing so.  Prior to the enactment of §246A, a corporation could do this.  A corporation could invest the proceeds in dividend paying stock.  A good investment could pay for the interest on the debt, which at first appears to be a wash, however, §163 allows the corporation to deduct the interest on the loan, and §243 allows the corporation to take a 70% dividends received deduction on most investment dividends.  The tax savings would provide an additional benefit to the company that has no economic foundation.  To illustrate this, examine the following table.  In this example, a loan of $100,000 is procured at 5% interest.  The full $100,000 is invested in stock that has a history of paying 6% dividends.  Each year the stock pays dividends of $6,000.  Since the corporation qualifies, it will receive a 70% DRD per §243, and only $1,800 of the dividend is taxable.  At the top corporate tax rate, the company will have after tax cash of $5,370, of which $5,000 will be used to pay the interest on the loan, and $370 is created through tax savings. 

In contrast, if there no DRD was available to the corporation, then the full amount of the dividend would be taxable.  This would result in a tax liability of $2,100, and after-tax cash of $3,900.  Once the interest has been paid, then the corporation has lost $1,100.  There is a total savings of $1,470 between the two scenarios, and a recognizable profit in the first situation. 

In order to limit these artificial profits, §246A was enacted.  Now any dividends received that can be attributable to debt are limited in the amount of deduction that can be taken.  The above example would resemble the second situation more than the first.  However, even §246A will not fully limit the above example; since the dividend is greater than the interest payment a partial deduction is allowed.  A DRD is allowed on any amount that exceeds the amount of the actual interest payment.  In this example the interest payment is $5,000, and the dividend is $6,000, therefore the 70% DRD is allowed on the excess $1,000.  The taxable amount of the dividend is now $5,300 instead the original $1,800, or the worst case of $6,000.  With this new taxable amount, the corporation has an after-tax cash amount of $4,145, and once the interest is paid the corporation has lost $855. 

On the surface §246A appears to be a fairly simple provision.  If a corporation uses debt to purchase stocks, then the DRD will be limited by that amount.  However, it can be very difficult to determine if the debt proceeds were used to actually purchase the stock in question.  In the case of OBH, Inc. v. Comm., all of the  transactions originated in the same bank account, that processed thousands of transactions daily.  In this situation, it was impossible to determine if the debt proceeds were used to purchase the stock in question.  This case sets out some rules for tracing debt proceeds and stock purchases and will be examined in detail later. 

The case of OBH and its history will be examined first.  This will include an in depth look at the facts and reasoning of the case.  Included in this discussion is an examination of another case which the court used in its reasoning, and a Revenue Ruling that deals with the tracing of debt for the purposes of §246A.  Once this is complete some of the possible tax planning strategies and pitfalls will be discussed.