DocketNumber: Tax Ct. Dkt. No. 11478-93
Citation Numbers: 75 T.C.M. 1948, 1998 Tax Ct. Memo LEXIS 97, 1998 T.C. Memo. 97
Judges: HALPERN
Filed Date: 3/9/1998
Status: Non-Precedential
Modified Date: 11/20/2020
*97 Decision will be entered under Rule 155.
W II, a subsidiary of HEI, borrowed funds, a part of which was distributed to HEI with respect to its stock in W II. HEI used a portion of the distribution to buy portfolio stock and tax-exempt obligations and held such stock and obligations for the 3 tax years in issue. HELD: the indebtedness was incurred to purchase tax-exempt obligations for the purpose of
MEMORANDUM FINDINGS OF FACT AND OPINION*98
HALPERN, JUDGE: This is our second report in this case, the first also denominated H Enters. Intl., Inc., & Subs. v. Commissioner, and appearing at
*101 FINDINGS OF FACT
Certain facts have been stipulated and are so found. The stipulations of facts filed by the parties, with attached exhibits, are incorporated herein by this reference. Also, the Court directed the parties to review those facts set forth in H Enterprises I and provide the Court with statements of differences or objections, if any, with respect to those facts. The parties have identified as the facts set forth in H Enterprises I the facts set forth in the five consecutive paragraphs commencing with the last paragraph beginning on page 73 of volume 105, U.S. Tax Court Reports (
H ENTERPRISES INTERNATIONAL, *102 INC.
H Enterprises International, Inc. (HEI), is a Delaware corporation. From October 1, 1987, to March 9, 1994, the common stock of HEI was owned by Eugene U. Frey, Richard E. O'Leary, John E. Byrne, Anita M. Bertelsen, and trusts for the benefit of Eugene U. Frey's family members (collectively, the shareholders) as follows:
Eugene U. Frey & Family Trusts | 50.0 percent |
Richard E. O'Leary | 33.5 percent |
John E. Byrne | 14.4 percent |
Anita M. Bertelsen | 2.1 percent |
During the years in issue, HEI was the common parent corporation of an affiliated group of corporations making a consolidated return of income (the affiliated group). The taxable year of the affiliated group was a fiscal year ending on June 30.
THE WALDORF BUSINESS
On July 15, 1985, HEI purchased a business involving the manufacturing and selling of recycled paperboard, corrugated medium, and folding cartons (the Waldorf business). The purchase price was approximately $100 million. HEI financed a portion of the purchase price by borrowing approximately $82.5 million from General Electric Credit Corp. (GECC). The Waldorf business thrived under HEI's management, and, by mid-1987, according to an appraisal, the value*103 of the Waldorf business was approximately $210 million. Acquisition- related debt had been reduced to less than $30 million.
THE RESTRUCTURING PLAN
In 1987, the board of directors of HEI (the HEI board) decided upon and implemented a plan of corporate restructuring (the restructuring plan). A subsidiary corporation (Waldorf II) was to be formed and the Waldorf business contributed thereto in exchange for all of the stock of the subsidiary. Subsequent to that contribution, the remaining indebtedness to GECC was to be refinanced from a larger borrowing, and a substantial distribution was to be made to HEI.
THE SHAREHOLDER AGREEMENT
In connection with the restructuring plan, on October 1, 1987, the shareholders entered into an agreement (the shareholder agreement). Among other things, the shareholder agreement (1) recites that, effective October 1, 1987, HEI had transferred substantial assets (the Waldorf business) to its wholly owned subsidiary corporation and (2) provides for the division of HEI into four divisions:
(1) FREY INVESTMENT DIVISION. The stated purposes of this Division (Investment Division I) include maintaining the "investment account/portfolio" of the Eugene*104 U. Frey interests in any "dividend" paid by Waldorf II. Decision making for Investment Division I is by a subcommittee of the HEI board of directors comprised of Eugene U. Frey and "MF" (we assume, Mary Frey).
(2) O'LEARY, BYRNE, BERTELSEN INVESTMENT DIVISION. The stated purposes of this division (Investment Division II) include maintaining the "investment account/portfolio" of the O'Leary's, Byrne's, and Bertelsen's interests in any "dividend" paid by Waldorf II. Decision making for Investment Division II is by a subcommittee of the HEI board of directors composed of Richard E. O'Leary, John E. Byrne, and Anita M. Bertelsen.
(3) TRIDENT SERVICE DIVISION. The stated purpose of the Trident Service Division is to provide various services to Waldorf II and other entities.
(4) TRIDENT ASSOCIATES VENTURE MANAGEMENT DIVISION. The stated purpose of this division is to conduct venture management activities on its own behalf and on behalf of certain others.
WALDORF II
Waldorf Corp. (Waldorf II), a Delaware corporation, is the subsidiary corporation contemplated in the restructuring plan. On October 1, 1987, Waldorf II received substantially all of the assets of, and assumed substantially all*105 of the liabilities relating to, the Waldorf business. During the taxable years in issue, HEI owned all of the outstanding voting shares of Waldorf II, and Waldorf II was a member of the affiliated group.
THE REFINANCING
On December 18, 1987, the board of directors of Waldorf II (the Waldorf II board) resolved to borrow up to $175 million from GECC. On December 23, 1987, Waldorf II borrowed approximately $113,539,873.30 from GECC (the 1987 indebtedness or the borrowed funds). At least in part, Waldorf II incurred the 1987 indebtedness in order to make a distribution to HEI with respect to its stock in Waldorf II.
THE DISTRIBUTION
On December 18, 1987, the Waldorf II board resolved to declare a dividend of $92 million payable to its shareholder, HEI, and, on December 23, 1987, Waldorf II made a distribution to HEI in satisfaction of that declaration of dividend (the distribution). The distribution included a cash payment to HEI in the amount of $73,803,000 (the cash distribution). The borrowed funds were used to make the cash distribution.
For Federal income tax purposes, the amount of the distribution was $123,657,000. Waldorf II had no current or accumulated*106 earnings or profits as of June 30, 1988. To the extent of $41,250,353, the distribution was treated as a return on capital on HEI's 1988 consolidated Federal income tax return. That balance of the distribution created an "excess loss account" within the meaning of
DISBURSEMENT
The cash distribution was disbursed by HEI into accounts maintained by Investment Divisions I and II and the Trident Service Division as follows: $9,803,000 to the Trident Service Division and $32 million into each of Investment Division I and II (together, the Investment Divisions).
INVESTMENTS
Other than investment returns, the cash distribution was the only significant source of funds for the Investment Divisions. In January and February 1988, the Investment Divisions entered into investment management agreements with certain investment advisers and, by February 1988, began acquiring investments, including tax- exempt obligations and shares of stock in domestic corporations (domestic shares). Within approximately 3 months of receipt of their respective portions of the cash distribution, the Investment Divisions had 22.7 percent of their funds invested*107 in tax-exempt obligations and 10.8 percent of their funds invested in domestic shares. For the years in issue, the Investment Divisions held an average of 35.3 percent of their funds in tax-exempt obligations and 23.2 percent of their funds in domestic shares. From December 1987 through the years in issue, the value of assets in Investment Divisions I and II was not less than $32 million and $31 million, respectively.
TAX-EXEMPT INTEREST; DIVIDENDS ON DOMESTIC STOCK
During the taxable years in issue, HEI received interest and dividends on tax-exempt obligations and domestic shares, respectively, held by the Investment Divisions. HEI deducted 70 percent of the dividends received on those domestic shares.
RESPONDENT'S ADJUSTMENTS
Respondent proposes that we make the following adjustments to petitioner's claimed interest expense deductions and dividends received deductions:
Interest | Deduction | Dividends | Deduction | |
Tax Year | Expense | Disallowed | Received | Disallowed |
Ending | Claimed | Sec. 265(a)(2) | Claimed | Sec. 246A |
6/30/89 | $ 18,197,732 | $ 2,891,294 | $ 393,201 | $ 393,201 |
6/30/90 | $ 17,580,023 | $ 3,478,858 | $ 587,781 | $ 572,329 |
6/30/91 | $ 13,862,253 | $ 4,380,018 | $ 337,410 | $ 337,410 |
*108 ULTIMATE FINDING OF FACT
Based on the restructuring plan, the shareholder agreement, and the sequence of events that followed, we find that the dominant purpose for incurring the 1987 indebtedness was to Purchase tax-exempt obligations and portfolio stock.
OPINION
We must determine whether
Petitioner's assignments of error with respect to the two issues we must decide go to the propriety of respondent's adjustments and not to the calculation of those adjustments if they are appropriate. On brief, petitioner objects to respondent's proposed finding of fact as to the interest adjustments in question by stating that the amounts set forth in respondent's proposed finding of fact "exceed the sum of the amount disallowed pursuant to the statutory notice of deficiency and the amended answer." Petitioner does not otherwise challenge respondent's proposed finding with respect to the interest adjustments*109 in question or argue that they are in error (if, indeed,
Effectively, the parties agree that application of
Petitioner makes an argument similar to the argument it made in H Enterprises I in support of the motion. Petitioner*110 contends that we should look only to Waldorf II's purposes for incurring the 1987 indebtedness and to Waldorf II's use of the borrowed funds in applying
Respondent traces the borrowed funds to investments in tax-exempt obligations and domestic shares and argues that this is sufficient proof of the relationship between the 1987 indebtedness and the investments for purposes of
No deduction shall be allowed for * * * interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is wholly exempt from the taxes imposed by this subtitle * * *
Thus, the inquiry is similar under both
In H Enterprises I, we held that, in appropriate circumstances,
Here, Waldorf II incurred the 1987 indebtedness, at least in part, in order to make the distribution. Coincident, or nearly coincident, events may indicate purpose: "The deduction will be barred if there is a 'sufficiently direct relationship' between the incurring or continuing of the indebtedness and the acquisition or holding of the tax-exempt obligations."
Petitioner also argues that Waldorf II incurred the 1987 indebtedness in order to obtain more advantageous terms on its debt and to implement a new stock purchase plan for its employees. Neither of those reasons is inconsistent with what we find to be the dominant objective in incurring the 1987 indebtedness, to make a cash distribution to HEI in order to allow HEI to purchase tax-exempt obligations and domestic shares. See generally
Petitioner argues that there is no evidence that HEI or Waldorf II contemplated investing in tax-exempt obligations or domestic shares at the time Waldorf II incurred the 1987 indebtedness and that, at the time, it made no economic sense to borrow in order to make such investments. We cannot look into a taxpayer's mind to determine the purpose of incurring indebtedness; we must infer that purpose from the evidence.
Finally, petitioner argues that HEI had business reasons for *117 holding a liquid, diversified investment portfolio that included tax-exempt obligations and domestic shares. Petitioner relies on
We are convinced that Waldorf II incurred a substantial portion of the 1987 indebtedness to fund the Investment Divisions and that the Investment Divisions used the borrowed funds to purchase and carry tax-exempt obligations and portfolio stock during the 3 years in issue. Therefore, we have no doubt that a portion of the 1987 indebtedness was incurred to purchase and carry tax-exempt obligations (held in the Investment Divisions) for the purpose of
Decision will be entered under Rule 155.
1. Unless otherwise noted, all section references are to the Internal Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.↩
John E. Leslie and Evelyn G. Leslie v. Commissioner of the ... , 413 F.2d 636 ( 1969 )
Indian Trail Trading Post, Inc. v. Commissioner of Internal ... , 503 F.2d 102 ( 1974 )
Illinois Terminal Railroad Company v. The United States , 375 F.2d 1016 ( 1967 )
Bradford v. Commissioner , 60 T.C. 253 ( 1973 )
Indian Trail Trading Post, Inc. v. Commissioner , 60 T.C. 497 ( 1973 )