IRS Disregards Own Revenue Ruling in Barnes Decision
The Court of Appeals for the Second Circuit recently affirmed the Tax Court’s 2013 decision in Barnes Group, Inc. and Subsidiaries, T.C. Memo 2013-109, in which the Tax Court applied the step transaction doctrine to recharacterize a series of transactions employed by the taxpayer, a U.S. corporation, as part of its reinvestment plan. The result was a $58 million taxable dividend to the taxpayer, as well as the imposition of a 20% accuracy-related penalty, despite the taxpayer’s claim that it reasonably relied on a revenue ruling and an opinion letter from its tax advisors.
Barnes, a U.S. corporation, was engaged the business of manufacturing and distributing precision metal parts and industrial supplies. Barnes operated its business through its domestic and foreign subsidiaries and had significant operations in the United States, Canada, Europe, Latin America, and Asia.
In May 2000, Barnes and its subsidiaries collectively held $45.2 million of cash worldwide, with $43.7 million held by Barnes’s foreign subsidiaries. One of Barnes’s second-tier foreign subsidiaries, a Singapore corporation (ASA), had approximately $13 million of existing cash reserves and approximately $26.1 million of cash receivables from foreign affiliates. ASA was also generating cash in excess of its immediate operating needs, allowing it to borrow money from a Singapore bank at a preferential interest rate. Barnes, meanwhile, had incurred significant debt as a result of several business acquisitions, which also affected its borrowing capacity. As a result, ASA’s excess cash remained in Singapore earning approximately 3% in short-term deposit accounts while Barnes was incurring debt at borrowing rates in excess of 7%.
Barnes understood that either a dividend distribution or a loan from ASA would trigger a significant federal tax liability. A distribution to the extent of earnings and profits would result in a taxable dividend under Internal Revenue Code Sections 301 and 316, while a loan from ASA, a controlled foreign corporation (CFC), would be treated as taxable income under Sections 951 and 956. To resolve this issue, Barnes developed a foreign finance structure (the reinvestment plan) to allow it to use ASA’s excess cash and borrowing capacity without triggering a federal tax liability.
The Reinvestment Plan
For purposes of implementing the reinvestment plan, Barnes formed two wholly-owned subsidiaries, a domestic financing entity (Delaware Sub) and a foreign financing entity (Bermuda Sub). The reinvestment plan involved a series of transactions implemented in two parts and resulted in ASA and Delaware Sub owning all of the common stock of Bermuda Sub and Bermuda Sub owning all of the preferred stock of Delaware Sub.
First, in a tax-free Section 351 transaction, ASA and Barnes transferred foreign currency to Bermuda Sub in exchange for Bermuda Sub’s common stock. Second, in another Section 351 transaction, Bermuda Sub and Barnes transferred Bermuda Sub’s common stock and foreign currency to Delaware Sub in exchange for Delaware Sub’s stock, with Barnes receiving Delaware Sub’s common stock and Bermuda receiving Delaware Sub’s preferred stock. Third, Delaware Sub converted the foreign currency it received into U.S. dollars and transferred those funds to Barnes as a loan. A second series of transactions involving the same entities and steps was undertaken the following year as the second part of the reinvestment plan. Ultimately, Barnes ended up with cash that it used to pay off its debt ostensibly without triggering a federal tax liability.
Prior to the execution of the reinvestment plan, Barnes’s tax advisors, PwC, provided Barnes with an opinion letter that analyzed the federal income tax consequences of the reinvestment plan. The opinion letter focused on the two transfers between Bermuda Sub and Delaware Sub and analyzed whether those exchanges resulted in an income inclusion under Sections 951 and 956.
Tax Court Decision
As an initial matter, Barnes argued that the IRS was precluded from challenging the reinvestment plan because Barnes reasonably relied on Rev. Rul. 74-503, 1974-2 C.B. 117 and Rev. Rul. 2006-2, 2006-1 C.B. 261, which states that the Service will not challenge a position taken prior to December 20, 2005, with respect to a transaction occurring prior to such date, by a taxpayer that reasonably relied on the conclusions in Rev. Rul. 74-503.
In Rev. Rul. 74-503, one corporation (X) transferred shares of its treasury stock (FMV of $3,000x and basis of $2,000x) to a second corporation (Y) in exchange for newly issued shares of Y stock (with an FMV of $3,000x) that constituted 80% of the only outstanding class of stock of Y. The transaction was a tax-free Section 351 transaction for X, and no gain or loss was recognized to Y under Section 1032. No other facts or limitations on the facts are identified, including whether X and Y are foreign or domestic corporations. Rev. Rul. 74-503 concluded that the basis of previously unissued stock in the hands of the corporation issuing it in a transaction to which Section 362 applies is zero and treated a corporation’s treasury stock the same as its previously unissued stock. In December 2005, the IRS released Rev. Rul. 2006-2, which revoked Rev. Rul. 74-503, but on a prospective basis only, holding that the IRS wouldn’t challenge earlier positions that reasonably relied on it.
Barnes contended that the exchanges between Bermuda Sub and Delaware Sub mirrored the exchanges in Rev. Rul. 74-503 and, as a result, it reasonably relied on Rev. Rul. 74-503. The IRS argued that Rev. Rul. 74-503 did not cover the facts of the reinvestment plan. Moreover, the IRS asserted that, looking at the reinvestment plan as a whole, the plan should be characterized as either a dividend or a loan from ASA to Barnes. The Tax Court agreed with the Service, stating that, before Barnes could claim reasonable reliance on the ruling, it would have to show both that the form of the reinvestment plan should be respected and that the facts of the reinvestment plan are substantially the same as those considered in the ruling. Here, the Tax Court found that Barnes was unable to show either and thus its reliance on the ruling was misplaced.
The Tax Court then analyzed the reinvestment plan applying the step transaction doctrine. The doctrine treats the steps in a series of formally separate but related transactions involving the transfer of property as a single transaction, if all the steps are substantially linked. In deciding whether to invoke the step transaction doctrine, courts generally apply one of three alternate tests: (1) the binding commitment test, (2) the end result test, and (3) the interdependence test. The interdependence test focuses on whether a series of transactions are “so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series.” To apply this test, a court must determine whether the individual steps had independent significance or whether they had meaning only as part of the larger transaction.” The Tax Court determined that the application of the step transaction doctrine was appropriate because, under the interdependence test, there was no valid and independent economic or business purpose served by including Bermuda Sub and Delaware Sub in the reinvestment plan. Applying the step transaction doctrine to treat the steps of the reinvestment plan as a single transaction, the Tax Court concluded that the reinvestment plan was, in substance, dividend payments from ASA to Barnes in 2000 and 2001, taxable under Section 301.
Finally, the Tax Court sustained the 20% accuracy-related penalties imposed by the IRS for substantial understatement of tax. Barnes argued that the penalties were improperly imposed because Rev. Rul. 74-503 provided substantial authority for Barnes’s tax position and Barnes acted with reasonable cause and in good faith in relying on an opinion issued to it by its tax advisor, PwC. The Tax Court, however, held that Barnes’s reliance on Rev. Rul. 74-503 was not reasonable given the significant factual differences between the reinvestment plan and the ruling. Moreover, the Tax Court found that Barnes did not rely in good faith on PwC’s advice by not respecting the structure of the reinvestment plan.
Second Circuit Decision
On appeal, the Second Circuit affirmed the Tax Court’s holding that the series of transactions involved in the reinvestment plan were, in substance, a single transaction amounting to a dividend from ASA to Barnes.
The Court found that Barnes’s Rev. Rul. 74-503 argument ignored the effect of the step transaction doctrine. The Court stated that Rev. Rul. 74-503 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. Thus the Court concluded that Barnes did not reasonably rely on Rev. Rul. 74-503 and the IRS was not precluded from challenging Barnes’s tax position.
The Court also concluded that the Tax Court properly applied the step transaction doctrine and the interdependence test to collapse the series of transactions through which Barnes obtained ASA’s funds by channeling those funds through Bermuda Sub and Delaware Sub. The Court noted that each transaction in the series, except the last—i.e., the purported loan to Barnes from Delaware sub—was completed pursuant to a written plan that acknowledged that the transactions comprised “a single integrated plan.” The Court also noted that although the loan to Barnes was not explicitly part of the plan, the transactions involved in the reinvestment plan would have been fruitless without the transfer of the funds to Barnes, and that transfer was the entire purpose of the reinvestment plan.
Finally, the Second Circuit affirmed the Tax Court’s imposition of the accuracy-related penalty, finding that Rev. Rul. 74-503 was not substantial authority and that Barnes did not reasonably rely on it. The Court also found that Barnes’s reliance on the PwC opinion suffered from the same defect as its reliance on Rev. Rul. 74-503 because the opinion did not advise as to the tax consequences of the entire series of transactions transferring the funds from ASA to Barnes. The opinion addressed the specific question of whether Bermuda Sub’s investment in Delaware Sub would result in income inclusion to Barnes and did not analyze the loan to Barnes as a transaction step. As a result, the Court concluded that the opinion could not reasonably be relied upon as an assessment of the tax consequences of the entire series of transactions.
Revenue rulings are the IRS’s official interpretation of the law and are generally binding on the IRS. The IRS states that taxpayers may rely on published revenue rulings in determining the tax treatment of their own transactions that arise out of similar facts and circumstances. How similar is similar enough though? In the Barnes case, the Tax Court and the Second Circuit both held that the taxpayer unreasonably relied on a revenue ruling because the facts of the transaction exceeded the scope of the facts in the ruling. Many revenue rulings, however, are deliberately broad and are intended to state legal principles of universal application, making it difficult for a taxpayer to ever be able to rely on a ruling with any degree of certainty. Moreover, the courts in Barnes not only granted the IRS permission to argue against its own revenue ruling but imposed substantial penalties as well. Following the Barnes decision, taxpayers may be left wondering when it is ever safe to rely on a revenue ruling to determine their tax treatment.