Plain Language

Since the code does not explicitly define the term “directly traceable”, the court had to look elsewhere.  The case of Watson v. Ray, 192 F.3d 1153, claims that if no “specific definition of the term is given in the statute itself, court should look to the ordinary common sense meaning of the words.”   Using this ruling as its basis, the court would examine the meaning of the word “direct”.  The word direct was found to mean “an immediate result” in common usage.  Once a definition was determined, the courts looked to Mr. Powell’s tests and denied that the traces were direct; in fact the traces were described as being “virtual antonyms” to being direct. 

Purpose Prong Test

H Enterprises

In the case of H Enterprises International Inc., et al. v Commissioner, a situation similar to the third scenario in the previously discussed Revenue Ruling is examined.  The original corporation creates a subsidiary in order to conduct business.  The subsidiary incurs indebtedness as part of a plan to refinance.  A large portion of this distribution was used to declare a dividend to the parent.  With the dividend the parent proceeded to invest the proceeds into tax exempt obligations and domestic stocks.  The parent then claimed a 70% DRD on the dividends received from the domestic stock investments.

The taxpayer claims that only the purpose of the subsidiary should be examined when applying §246A.  Since it is the subsidiary that procured the debt, and the subsidiary had a valid business reason for incurring the debt, other than the distribution and subsequent purchase, the subsidiary should not be held responsible for the actions of the parent, whom the subsidiary has no control over.  The parent’s actions and purpose should be considered unrelated to that of the subsidiary.

The court wholly rejected this argument.  First the court looked to the language of the Congressional report that enacted §246A and found that “if indebtedness is clearly incurred for the purposes of acquiring dividend-paying stock or otherwise is directly traceable to its acquisition the indebtedness would constitute portfolio indebtedness.” The court interpreted this as meaning that the ultimate purpose of the transaction must be examined.  If there is found to be a clear plan to purchase dividend-paying stock then §246A will apply and the DRD is limited.  In this case, the court would not limit the examination of purpose just to the board of the company in question, but to the entire entity.  If the examination were limited to just the board, then no transaction would ever be disallowed.  While there was no written plan and no testimony of predetermined plan, the court did look to the coincident or nearly coincident events to indicate a purpose.  Since the purchases were made within weeks of the receiving the funds from the loan, it implied a connection and a purpose.

The court also rejected the taxpayer’s other arguments.  The first being the fact that HEI had a valid business purpose for obtaining the loan.  While the court did not deny this reason, it also found that it was not inconsistent with the main purpose of having funds to make a distribution to the parent.  The second part of the argument that was rejected is the argument that the taxpayer had business reasons for holding a diversified portfolio.  However, here the court found no sufficient reason that would justify the need for the portfolio, especially as long as it was held.