The court found that there was no evidence that OBH used the funds from the indebtedness to purchase the stock. The traces that Mr. Powell conducted in order to conclude that there was initially a connection were found to be arbitrary and inconclusive. There was no other substantial evidence that would show a direct trace between the indebtedness and portfolio stock.
At the same time, there was no clear intent by OBH or Mr. Buffett that would indicate the funds were to be used to purchase dividend-paying stock. While the funds were meant to purchase stock, there was no clear plan to purchase a specific stock or even specific types. The timing of the transactions in question also did not indicate there should be a connection. The time between the transactions were too long to imply a coincidences.
With the examination of the two cases and the Revenue Ruling complete, some strategies for applying these principles to tax planning will follow. Two scenarios will be explored and the rules above applied.
In this example, company A is a wholly owned subsidiary of B. B also wholly owns company C a new start up. Due to A’s ability to obtain favorable financing, A secures a loan, in order to make a distribution to B. B in turn uses this distribution as a contribution to C. C plans to use the funds to build a factory. However, while C is waiting to start the construction, it temporarily invests the funds into various equity structures. C plans to sell off the equity investments as needed in order to fund the construction, and will not obtain any additional financing.
In this example, there is a very strong correlation to the HEI case. The main purpose for A to obtain the loan is to make the distribution to B. B’s main reason for authorizing the distribution is to make the contribution to C. While A and B do not have a direct interest in any dividends that are paid on the equity to C, when the group is viewed as a consolidated entity, as HEI was, then the purpose of the debt becomes obvious, especially if the time frame between each transaction is short. Regardless of how long C held the equity while awaiting the commencement of the construction, the dividends would be disqualified, according to Revenue Ruling 88-66.
The above evaluation assumes that A’s loan is not obtained in the ordinary course of business. If this is not the case, and A obtained the loan proceeds as an ordinary business transaction, then the dividends received would be eligible for the dividend received deduction.
If A made a direct loan to C, then the tracing rules would become even more obvious. However, if A made the loan at a rate that was below the market value for C’s status, then there might be an issue of a deemed dividend, but this issue is outside the scope of this discussion.
Finally, in the above example there is no discussion of existing earning and profit available for the distribution. In the original example, the facts already supported the fact that there was a strong purpose for the distribution. However, if the facts were more ambiguous, then whether this is sufficient E&P will become a factor in whether the distribution is a normal distribution, or one done within a specific plan.