H Enters. Int'l v. Commissioner

T.C. Memo. 1998-97

UNITED STATES TAX COURT

H ENTERPRISES INTERNATIONAL, INC., AND SUBSIDIARIES, Petitioner
v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 11478-93. Filed March 9, 1998.

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
sec. 265(a)(2), I.R.C., and is directly attributable to
the acquisition of portfolio stock for the purpose of
sec. 246A, I.R.C.; respondent's disallowances of an
interest deduction pursuant to sec. 265(a)(2), I.R.C.
and of a dividend received deduction pursuant to sec.
246A, I.R.C., are sustained.

William L. Hippee, Jr., and Edward J. Pluimer, for

petitioner.

John Schmittdiel and Jonathon Decatorsmith, for respondent.
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MEMORANDUM FINDINGS OF FACT AND OPINION

HALPERN, Judge: This is our second report in this case, the

first also denominated H Enters. Intl., Inc., & Subs. v.

Commissioner, and appearing at 105 T.C. 71 (1995) (H Enterprises

I). The only issues for decision concern the applicability of

sections 246A1 and 265(a)(2) to the consolidated tax liability of

petitioner. In H Enterprises I, we denied petitioner's motion

for summary judgment (the motion) on the grounds that this case

presented genuine issues of material fact. As grounds for the

motion, petitioner argued that, as a matter of law (1) section

246A cannot be applied to disallow the dividends received

deduction to a parent corporation on account of indebtedness

incurred by its subsidiary corporation and (2) section 265(a)(2)

cannot be applied to disallow an interest expense deduction to a

subsidiary corporation on account of tax-exempt obligations

purchased by its parent corporation. In H Enterprises I, we held

that, in appropriate circumstances, sections 246A and 265(a)(2)

may be applied when one member of an affiliated group of

corporations is the borrower and another member is the purchaser

of portfolio stock (sec. 246A) or tax-exempt obligations (sec.

265(a)(2)). H Enterprises I at 81. We concluded: "Whether any

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.
 - 3 -

of the borrowed funds in the present case are attributable to the

purchase of portfolio stock by HEI [the parent] or were used to

purchase or carry tax-exempt securities by HEI is a fact question

and not one to be decided on a summary judgment motion." Id. at

85. In this report, we address the factual questions identified

in H Enterprises I.

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 (105 T.C. at 73;

the H Enterprises I facts). The parties agree with the

H Enterprises I facts subject to certain common, minor, or

inconsequential differences. In light of those agreements, we

shall adopt the H Enterprises I facts for purposes of this

report, subject to (and incorporating) the differences agreed to

by the parties, and we find accordingly. In the following

paragraphs of this portion of our report, we shall summarize
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certain facts from H Enterprises I necessary to the clarity of

our report and make additional findings of fact.

H Enterprises International, 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 of the Waldorf business was approximately
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$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 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
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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 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.
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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 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 section 1.1502-14(a)(2), Income Tax Regs.
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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

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.
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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:
Tax Year Interest Expense Deduction Dividends Received Deduction
Ending Claimed Disallowed Claimed Disallowed
Sec. 265(a)(2) 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

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

I. Introduction

We must determine whether section 246A applies to eliminate

the dividends received deduction claimed by HEI with respect to

dividends received on the domestic shares owned by it and whether
 - 10 -

section 265(a)(2) applies to disallow a portion of the interest

deduction claimed by Waldorf II on the 1987 indebtedness.

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 in question or argue that they are in error (if,

indeed, section 265(a)(2) is applicable). By the amendment to

answer, respondent determined increased deficiencies on account

of increased adjustments resulting from the application of

section 265(a)(2). Respondent did not specify the amounts of the

increased adjustments. In the reply, petitioner denies any

increased deficiency but, otherwise, does not address the

increased adjustments in question. We assume that the parties

have a basis for calculating, and allocating, the section

265(a)(2) adjustments in question. We do not sustain any section

265(a) disallowance beyond that put at issue by the petition and

the answer, as amended.
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II. Arguments of the Parties

Effectively, the parties agree that application of sections

246A and 265(a)(2) depends on the purpose (or purposes) for

incurring the 1987 indebtedness. They disagree, however, as to

whether we may inquire beyond the narrow purposes of Waldorf II

(the borrower) and take into account the purposes of HEI in

forming Waldorf II and establishing the Investment Divisions.

Petitioner makes an argument similar to the argument it made

in H Enterprises I in support of the motion. Petitioner 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 sections 246A and 265(a)(2). Petitioner would

have us find that Waldorf II had purposes for incurring the 1987

indebtedness that were unrelated to its parent corporation's

(HEI's) use of the distribution made from the proceeds of that

indebtedness. Although petitioner believes it is irrelevant,

petitioner also argues that HEI had business reasons for

acquiring and maintaining investments in tax-exempt obligations

and domestic shares, including a need for liquid resources to

provide capital for funding business acquisitions and to provide

funds for stock redemptions, if necessary.

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
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indebtedness and the investments for purposes of sections 246A

and 265(a)(2). Respondent would have us find that Waldorf II and

HEI had a "common purpose established by [HEI]", to provide funds

to HEI by borrowing "in excess of the needs of the [Waldorf]

business" so that HEI could invest in a variety of products,

including tax-exempt obligations and domestic shares.

III. The Code

Section 265(a)(2) provides:

No deduction shall be allowed for * * * [i]nterest on
indebtedness incurred or continued to purchase or carry
obligations the interest on which is wholly exempt from
the taxes imposed by this subtitle * * *

Section 265(a)(2) does not operate to disallow interest on

indebtedness simply because the taxpayer simultaneously holds or

acquires tax-exempt obligations and incurs or carries

indebtedness. Bradford v. Commissioner, 60 T.C. 253, 257-258

(1973). The touchstone for decision is whether the taxpayer’s

purpose in incurring or continuing indebtedness was to purchase

or carry such obligations. Indian Trail Trading Post, Inc. v.

Commissioner, 60 T.C. 497, 500 (1973), affd. 503 F.2d 102 (6th

Cir. 1974). Purpose may be inferred from the taxpayer’s conduct

and the circumstances surrounding the borrowing. Id. (citing

Leslie v. Commissioner, 50 T.C. 11, 20-21 (1968), revd. on other

grounds 413 F.2d 636 (2d Cir. 1969)).
 - 13 -

Section 246A provides that there shall be a reduction in the

amount of the deduction allowable for dividends received (under

sections 243, 244, or 245(a)) with respect to debt-financed

portfolio stock. Debt-financed portfolio stock is defined in

section 246A(c) as any portfolio stock with respect to which

there is portfolio indebtedness. Portfolio indebtedness means

"any indebtedness directly attributable to investment in the

portfolio stock." Sec. 246A(d)(3)(A). We have found no cases

that interpret the expression "directly attributable" in the

context of applying section 246A. Section 246A was added by the

Deficit Reduction Act of 1984, Pub. L. 98-369, sec. 51, 98 Stat.

494, 562-564. H. Rept. 98-432, which accompanied H.R. 4170,

which became the Deficit Reduction Act of 1984, indicates that we

should inquire into the taxpayer’s purpose for incurring the

indebtedness and trace the use of the borrowed money: "[I]f

indebtedness is clearly incurred for the purpose of acquiring

dividend-paying stock or otherwise is directly traceable to such

an acquisition, the indebtedness would constitute portfolio

indebtedness." Id. at 1181.

Thus, the inquiry is similar under both sections 265(a)(2)

and 246A(d)(3)(A): In both cases, we must determine whether

there is a sufficient purposive connection between the borrowing

and the investments.
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IV. Discussion

In H Enterprises I, we held that, in appropriate

circumstances, sections 246A and 265(a) may be applied when one

member of an affiliated group is the borrower and another member

is the purchaser of the portfolio stock or tax-exempt securities.

H Enterprises I at 81. Implicit in that holding is the

recognition that the search for a prohibited purpose cannot be

focused exclusively on the subsidiary’s purpose in borrowing to

make a distribution. Generally, a distributing corporation has

no control over (or concern with) the use to which distributions

are put by the shareholder recipient. If we were to limit our

inquiry to whether the board of directors of a subsidiary

corporation borrowed to make a distribution to its parent and

whether the subsidiary used the borrowed funds for that purpose,

then the use of the distributed funds would be irrelevant and the

purpose of the distributing corporation would always be

acceptable. We, therefore, reject petitioner's argument that we

should look only to Waldorf II's purpose for incurring the 1987

indebtedness, and we direct our inquiry to the larger purposes of

HEI manifest by the actions of both Waldorf II and HEI.

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: “[T]he deduction will

be barred if there is ‘a sufficiently direct relationship’

between the incurring or continuing of the indebtedness and the
 - 15 -

acquisition or holding of the tax-exempt obligations.” Indian

Trail Trading Post, Inc. v. Commissioner, supra at 500 (citations

omitted). HEI, through the Investment Divisions, used the cash

portion of the distribution to purchase tax-exempt obligations

and domestic shares within weeks of receiving the funds and

maintained a substantial portion of its investment portfolio in

such investments for the years in issue. Accordingly, we find

that the borrowed funds were used directly to purchase tax-exempt

obligations and domestic shares and that sections 265(a)(2) and

246A apply. See Bradford v. Commissioner, supra at 258 ("Equally

clearly, the deduction is not allowable if the proceeds of the

borrowing are directly traceable to the purchase of tax-exempts."

(Citations omitted.)). The facts that the borrowed funds were

not used by Waldorf II to purchase tax-exempt obligations and

Waldorf II had a purpose for incurring the 1987 indebtedness (to

make a distribution to HEI) are simply not determinative in the

affiliated group context before us. We are, thus, satisfied

that, here, where the borrowing and distribution are all part of

a preplanned sequence, the distributed funds are distributed to a

parent corporation, and those funds are used to purchase tax-

exempt obligations and domestic shares, the required purposive

connection has been shown.

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
 - 16 -

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 Leslie v. Commissioner, 413 F.2d 636 (2d Cir. 1969)

(business reasons not related to the purchase of tax-exempt

securities must dominate the incurring of indebtedness to

insulate the borrowing from application of section 265(a)(2)),

revg. 50 T.C. 11 (1968).

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.

Indian Trail Trading Post, Inc. v. Commissioner, 60 T.C. 497, 500

(1973). HEI received regular reports on the investments held in

the Investment Divisions, including reports of its after-tax

returns, and we are not inclined to second-guess its investment

decisions. See generally Illinois Terminal R.R. v. United

States, 179 Ct. Cl. 674, 375 F.2d 1016, 1021-1022 (1967)

(taxpayers need not receive economic benefits from tax-exempt

securities for section 265(a)(2) to apply).
 - 17 -

Finally, petitioner argues that HEI had business reasons for

holding a liquid, diversified investment portfolio that included

tax-exempt obligations and domestic shares. Petitioner relies on

Swenson Land & Cattle Co. v. Commissioner, 64 T.C. 686 (1975),

and points to HEI's objectives of having capital available to

support possible acquisitions of other businesses in the future

and having sufficient liquidity to fund redemptions in case of

the death of a principal shareholder or on account of disputes

among the shareholders. In Swenson, we were persuaded that the

taxpayer was considering detailed and concrete proposals for

expansion that justified a large contingency reserve of liquid

funds. Here, HEI had no specific plans for the borrowed funds,

other than funding the Investment Divisions, which were set up

during the restructuring of the Waldorf business, and, although

petitioner has demonstrated that there were disputes among the

shareholders that may have made it advisable to plan for a stock

redemption, those disputes arose after the restructuring plan was

implemented. Nor has petitioner offered any sufficient business

reason for HEI's maintaining millions of dollars in liquid

reserves for over 3 years. See, e.g., New Mexico Bancorp. &

Subs. v. Commissioner, 74 T.C. 1342 (1980). Whatever HEI's

ultimate objectives for the borrowed funds may have been, its use

of those funds for investments in the relevant years provides the

"necessary purposive connection" for us to link the borrowing and
 - 18 -

the investment. See Indian Trail Trading Post, Inc. v.

Commissioner, supra at 501.

V. Conclusion

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 section 265(a)(2) and that a portion of the

indebtedness is directly attributable to the purchase and

carrying of portfolio stock (by the Investment Divisions) for the

purpose of section 246A. We note, however, that in a less clear-

cut case we would be substantially aided in reaching a decision

by the regulations called for by section 7701(f).

Decision will be entered

under Rule 155.