Barnes Group, Inc. v. Comm'r

T.C. Memo. 2013-109

UNITED STATES TAX COURT

BARNES GROUP, INC. AND SUBSIDIARIES, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 27211-09. Filed April 16, 2013.

Robin Lee Greenhouse, James Riedy, and Nathaniel J. Dorfman, for

petitioners.

Stephen C. Best and William T. Derick, for respondent.
 -2-

[*2] MEMORANDUM FINDINGS OF FACT AND OPINION

GOEKE, Judge: Respondent determined the following deficiencies and

section 6662(a)1 accuracy-related penalties with respect to petitioners’ Federal

income tax:

Penalty
Year Deficiency sec. 6662(a)
1
1998 $176,279 $35,256
2000 1,304,352 1,733,084
2001 1,807,478 307,735

1
Respondent disallowed petitioners’ net operating loss carryback of
$503,654 from its 2000 tax year.

The issues for decision are:

(1) whether Barnes Group, Inc. (Barnes),2 should have included in gross

income $38,919,950 and $19,378,596 for 2000 and 2001, respectively, under

sections 951(a)(1)(B) and 956 or under section 301 as a result of a series of

1
Unless otherwise indicated, all section references are to the Internal Revenue
Code (Code) in effect for the years in issue, and all Rule references are to the Tax
Court Rules of Practice and Procedure.
2
For Federal income tax purposes, Barnes is the common parent of the
affiliated group Barnes Group, Inc. & Subs.
 -3-

[*3] transactions between Barnes and its subsidiaries. We hold that Barnes should

have included the amounts in gross income under section 301;

(2) whether the fair market value of “clean rooms” transferred to Barnes in

2001 should be excluded from its income under section 109. We hold that the value

of the clean rooms should not be excluded from income; and

(3) whether petitioners are liable for the section 6662(a) accuracy-related

penalty for the years in issue. We hold that they are liable for the section 6662(a)

penalty for all years in issue.

FINDINGS OF FACT

At the time the petition was filed Barnes was a publicly traded Delaware

corporation that maintained its principal place of business in Connecticut.3

I. Business Operations

Founded in 1857, Barnes manufactures and distributes precision metal parts

and industrial supplies. By 1999 Barnes operated three separate business

segments through its domestic and foreign subsidiary corporations--Associated

Spring, Barnes Aerospace, and Barnes Distribution. These three business

segments had significant operations in the United States, Canada, Europe, Latin

3
The parties agree that this case is appealable to the Court of Appeals for the
Second Circuit.
 -4-

[*4] America, and Asia. Associated Spring manufactures precision mechanical and

nitrogen gas springs. Barnes Aerospace manufactures and repairs aircraft engine

and airframe components. Barnes Distribution distributes maintenance, repair, and

operating supplies.

II. Overview of Events

We must address two unrelated events in this case. The first concerns the

Agreement and Plan of Reinvestment (reinvestment plan or plan) executed between

Barnes and its subsidiaries in 2000 and 2001. The second concerns an agreement to

construct six “clean rooms” executed in 1985 between Barnes and International

Business Machines Corp. (IBM).4

4
The parties dispute whether sec. 109 applies to the receipt of the clean rooms
as well as the value of four of the clean rooms. The parties agree to the following
procedure to resolve the sec. 109 applicability and valuation issue:

(a) The Section 109 Issue will be submitted by the parties on a
stipulated record to the Court for decision. This stipulated record will
include the pertinent agreements executed by IBM and * * * [Barnes]
and any additional background facts necessary to resolve the Section
109 Issue.

(b) If Petitioners do not prevail with respect to the Section 109
Issue, Petitioners and Respondent agree that the value of the four
10,000 PPM clean rooms was $2,110,000 on March 31, 2001; that the
value of the two 100,000 PPM clean rooms was $850,000; and that the
value of the other property was $765,850. Thus, if Petitioners do not
prevail with respect to the Section 109 Issue, Petitioners must include
(continued...)
 -5-

[*5] III. Events Leading to the Reinvestment Plan

The reinvestment plan was executed as a result of a series of events arising

from Barnes’ strategic objective to expand the company primarily through

acquisitions. In accordance with Barnes’ strategic objective: (1) Barnes hired new

management (new management team) with strong backgrounds in growing

companies and extensive experience with domestic and international acquisitions;

and (2) made several acquisitions (early acquisitions) totaling approximately $200

million.

A. New Management Team

Between 1998 and the first quarter of 2000 Barnes replaced the majority of

its executive officers as part of its strategic objective to expand the company.

While the individuals most relevant to the reinvestment plan will be discussed in

more detail below, in 2000 and 2001 Barnes’ officers included: Edmund

Carpenter--president and chief executive officer; William Denninger5--senior vice

4
(...continued)
in income in 2001 the value of all such property ($3,725,850).
(c) Regardless of whether Petitioners prevail with respect to the
Section 109 Issue, Petitioners must include in income in 2001 the value
of the other property received ($765,850).
5
Mr. Denninger was responsible for approving significant long-term

(continued...)
 -6-

[*6] president, finance, and chief financial officer; Signe Gates–senior vice

president, general counsel, and secretary; Francis Boyle--vice president, controller;

Joseph DeForte--vice president, tax; Phillip Goodrich--senior vice president,

corporate development; and John Locher6 --vice president, treasurer.

B. Early Acquisitions

Before 1999 Barnes had not completed an acquisition for the better part of a

decade. As part of the new expansion objective, the new management team

engaged an outside consultant for assistance in identifying strategic growth areas for

Associated Spring’s business segment. The analysis and work product generated by

the consultant provided Barnes with the necessary data and confidence to pursue an

aggressive acquisition program specifically directed at Associated Spring’s

electronics business in Asia and Europe.

Barnes made three significant acquisitions during 1999 and 2000 totaling

$197.1 million: (1) August 1999--Barnes acquired the nitrogen gas springs

business of Teledyne Fluid Systems Division of Teledyne Industries, Inc., for

5
(...continued)
investments by any of Barnes’ offshore operations.
6
John Locher was Barnes’ vice president and treasurer in 2000 and 2001 until
his February 2001 retirement. Lawrence O’Brien was hired for the position
thereafter.
 -7-

[*7] $92.2 million; (2) May 2000--Barnes acquired Curtis Industries, Inc., for $63.3

million; and (3) September 2000--Barnes acquired AVS/Kratz-Wilde Machine Co.

and Apex Manufacturing, Inc., for $41.6 million.7

C. Result of Early Acquisitions

At the end of 1998 before the acquisitions began, Barnes had approximately

$50 million of outstanding long-term indebtedness and no outstanding balance on a

revolving credit line. By the end of 2000 Barnes had approximately $230 million of

outstanding long-term indebtedness including approximately $50 million due on its

revolving credit line. This increase in debt transformed Barnes from a relatively

low-leveraged firm to a firm with significantly above-average leverage for

companies within the industrial equipment and components industries. The early

acquisitions also increased Barnes’ cost of borrowing and debt-to-equity ratio.8

7
Barnes also made two relatively smaller acquisitions in 2001: (1) January
2001--Barnes acquired Euro Stock Springs & Components Ltd. for $708,000; and
(2) November 2001--Barnes acquired certain assets of Forward Industries for $2.5
million.
8
Barnes’ debt-to-equity ratio increased from .30 to 1.15.
 -8-

[*8] D. The Predicament

As of May 31, 2000, Barnes and its subsidiaries collectively had $45.2

million of cash worldwide--Barnes and its domestic subsidiaries held $1.5 million

and Barnes’ foreign subsidiaries held the remaining $43.7 million.

Associated Spring-Asia PTE Ltd. (ASA), a Singapore corporation and

second-tier Barnes subsidiary, conducted operations for Barnes’ Associated Spring

division in Southeast Asia. During the late 1990s ASA generated significant

profits.9 As of September 1, 2000, ASA had approximately $12.9 million of

existing cash reserves held in short-term accounts and approximately $26.1 million

of cash receivables from foreign affiliates. ASA was generating cash in excess of its

immediate operating needs, allowing ASA to borrow funds from the Development

Bank of Singapore Ltd., an unrelated third-party bank (Singapore Bank), at a

preferential interest rate.

Accounting for all of the bank deposits held by Barnes’ domestic and

foreign subsidiaries, Barnes was earning approximately 3% interest on its

aggregate cash and short-term investment holdings. Conversely, Barnes’ 2000

annual report indicated that Barnes had external borrowings with interest rates

9
Barnes reported that ASA had untaxed accumulated earnings and profits of
$80,082,311, $91,458,630, and $93,420,851 as of January 1, 2000, December 31,
2000, and December 31, 2001, respectively.
 -9-

[*9] ranging from 7.13% to 9.47%. While ASA was permitted to make short-term

money market style investments, other investments by ASA required approval from

Barnes’ CFO or treasurer.

Consistent with Barnes’ growth by acquisition strategy, Barnes sought to use

ASA’s excess cash and borrowing capacity to finance one or more international

acquisitions; however, no suitable targets had been identified during the late 1999 to

early 2000 period.10 As a result, ASA’s excess cash remained invested in short-

term deposit accounts earning approximately 3% while Barnes was incurring debt at

borrowing rates in excess of 7%. Barnes understood that either a dividend or a loan

from ASA to Barnes would trigger a Federal tax liability.11

IV. The Search for a Solution

Mr. DeForte (Barnes’ vice president, tax) was one of the primary players

involved with the reinvestment plan. At the time of his hiring, Mr. DeForte had

over 20 years of experience with large multinational corporations as an

international tax accountant (Pfizer Corp. and Johnson & Johnson), an

10
If a suitable acquisition had been identified, it would have taken over a year
to complete the transaction.
11
Furthermore, Barnes was in an overall “foreign loss position” as defined in
sec. 904(f) and therefore was not in a position to fully use foreign tax credits.
 - 10 -

[*10] international tax manager (ITT Sheraton Corp.), and a vice president, tax

(Millipore Corp. and Loctite Corp.).12 He worked on corporate acquisitions at

various times throughout his career.

Upon arriving at Barnes, Mr. DeForte met with key personnel in the treasury,

legal, and accounting departments to identify potential corporate opportunities,

existing pitfalls, prior strategies, and the valuable assets and operations of Barnes’

three business segments. Mr. DeForte first learned of the aforementioned

predicament in late 1999 during a meeting with Barnes’ assistant treasurer, David

Sinder.13

Mr. DeForte first contacted Ernst & Young (E&Y) and Deloitte & Touche

(Deloitte) for assistance in addressing the predicament. Specifically, Barnes

sought a way to (a) “arbitrage” the interest rate differential, (b) without incurring

Federal income tax, (c) while retaining the foreign funds for overseas investment

12
Mr. DeForte was also the chief financial officer (CFO) of Loctite Corp. As
CFO he had broad oversight over the treasury, financial, and tax operations of the
company.
13
Mr. Sinder was employed by Barnes from 1986 until 2010. As Barnes’
assistant treasurer, he was responsible for short-term cash management for the
domestic companies in Barnes’ consolidated group.
 - 11 -

[*11] opportunities. After rejecting the ideas proposed by E&Y and Deloitte, Mr.

DeForte contacted Dennis Lubozynski, a tax partner at PricewaterhouseCoopers

(PwC).14

Barnes had been a client of PwC since 1993. From 1993 through the time of

trial, PwC provided Barnes with audit and tax advisory services. At the time Mr.

DeForte contacted PwC for assistance, PwC had been providing these services to

Barnes for over seven years.

After receiving the request for assistance, PwC reviewed its Ideasource

database15 and spoke with several professionals around the firm to determine what

ideas would be available to meet the needs of Barnes. PwC proposed several

solutions. After some followup meetings between members of Barnes’ tax

department and PwC professionals, Barnes decided to construct a domestic and

14
Before joining Barnes, Mr. DeForte had significant work experience with
PwC professionals, including Mr. Lubozynski and Paul Coneys. Mr. Coneys was
the initial PwC tax professional assigned to Barnes in 1993.
15
During the late 1990s all PwC tax professionals were encouraged to submit
their experiences and ideas to a database. The information was entered in the
database in a way that did not reveal client-identifying information so that the
entries were suitable for sharing with other PwC professionals.
 - 12 -

[*12] foreign finance structure16 as a solution to its predicament. This structure

eventually developed into the reinvestment plan.

V. The PwC Engagement Letter

Barnes and PwC executed an engagement letter that identified the scope of

services to be provided by PwC as well as the agreed-upon fee arrangement. The

terms of the engagement letter were negotiated between Mr. DeForte and Mr.

Lubozynski.

The scope of the services to be performed by PwC included--

[D]esigning an appropriate * * * [reinvestment plan]; working closely
with personnel of * * * [Barnes] and its subsidiaries to implement the
* * * [reinvestment plan]; and providing tax opinions in the countries with
subsidiaries affected by the * * * [reinvestment plan] (anticipated to be
Singapore, Canada, United States and one other tax jurisdiction). * * *

Services provided in Singapore will include all tax and legal
services needed to implement the * * * [reinvestment plan]. These
services will include preparation of legal documents, share registration
documents and a tax and legal opinion on the Singapore tax
implications of the * * * [reinvestment plan].

The fee arrangement included in the engagement letter had two components.

The first component required Barnes to pay 70% of PwC’s standard hourly rates

16
The domestic and foreign finance structure was similar to a structure
described in Ideasource entry 1365. Ideasource entry 1365 was added to the
database in June 1996 by a tax professional at PwC.
 - 13 -

[*13] during the course of the engagement. The second component of the fee

arrangement, to be paid at the end of the engagement, was based on an agreement

between Barnes and PwC regarding the quality of the services provided by PwC.

Specifically, the engagement letter listed multiple factors to be considered in

determining the second component of the fee arrangement--

The second component will be a fee at the completion of the
engagement based on an agreement at that time between PwC and
* * * [Barnes] as to the quality of the services provided hereunder.
This determination will be an assessment determined by mutual
agreement, based on a number of factors, including but not limited to,
(i) the complexity of the matters which are the subject of this
engagement, (ii) the creativity of the advice provided by PwC, (iii)
the effort expended in rendering the professional services, and (iv)
the value added to * * * [Barnes] by PwC.

The total amount Barnes paid PwC in connection with the reinvestment plan

is unclear from the record. Barnes submitted numerous billing statements totaling

roughly $463,000; however, the only billing statement reconciling prior billing

was a billing statement “for professional services rendered through September 30,

2000”. Most of the billing statements indicated that they were for “professional

services” or a “progress bill” related to the “Treasury Assistance Project”. A

$2,886 bill in the record was paid for PwC employee hours worked.17 The final

17
The reconciling billing statement mentioned supra indicated that prior billing
was for “time incurred since inception of project”; however, it did not provide the
(continued...)
 - 14 -

[*14] bill for “tax consultation” regarding the “Treasury Assistance Project” was for

professional services through July 31, 2001.

VI. Developing the Reinvestment Plan

Barnes and PwC spent three to four months over the summer of 2000

working together on developing the transaction structure for the reinvestment plan.

The PwC professionals assigned to assist Barnes (PwC project team) were in the

United States, Singapore, Canada, France, and the United Kingdom; however, Mr.

Coneys was the project leader, and Mr. Lubozynski was the initial engagement

partner. The PwC project team were technical specialists responsible for the day-

to-day work on the reinvestment plan. In addition to Mr. DeForte, several other

Barnes officers and employees participated in developing the reinvestment plan.

On April 6, 2000, Mr. DeForte sent an email to Mr. Denninger giving him a

brief summary of the proposed method to transfer cash from ASA to the United

States without a tax liability: (1) Barnes creates a domestic financing entity; (2)

ASA creates a foreign financing entity; (3) ASA exchanges its cash for the foreign

financing entity’s stock; and (4) the foreign financing entity transfers the cash and

17
(...continued)
amount of time.
 - 15 -

[*15] its stock to the domestic financing entity in exchange for the domestic

financing entity’s stock.

Later that month Mr. DeForte emailed Mr. Denninger several possible

“enhancements” to the plan, including the possibilities of involving other foreign

subsidiaries and/or additional capital from a third-party loan. He concluded the

email with his recommendation that Barnes go forward with the plan.

On May 5, 2000, PwC provided Mr. DeForte with the following: (1) an “exit

strategy” to “unwind” the reinvestment plan in the event Barnes sought to return the

funds to ASA; and (2) a “draft” of a “business purpose” for the reinvestment plan.

The recommended exit strategy involved the foreign financing entity’s purchasing

the domestic financing entity’s stock from Barnes and then liquidating the domestic

financing entity. The business purpose draft contained several broad statements of

general applicability on international cash management. Moreover, the draft

included “XXXXX” in place of a company name and listed the company as a

“multinational transportation company”.18

18
Barnes provided a “business purpose” document to PwC in July 2000. The
document stated substantially the same business purposes as the draft originally sent
by PwC; however, Barnes added further background information and changed the
company’s business from “multinational transportation company” to “multinational
manufacturing and distribution company”.
 - 16 -

[*16] On July 7, 2000, Mr. DeForte provided PwC with a “cost benefit analysis of

the repatriation project”. The analysis assumed that the reinvestment plan would be

“unwound” after 15 years but claimed not to take into account the tax savings from

repatriating the funds in year 1 “since * * * [Barnes] would not do it if there was a

tax cost.” The analysis concluded that the plan would provide a net benefit of

approximately $2.1 million.

PwC and Barnes worked on many other preimplementation steps through

August 2000, including: (1) identifying the foreign and domestic financing

entities, the jurisdiction for the foreign financing entity, and which subsidiaries

would contribute to the foreign financing entity; (2) discussing and planning for

foreign tax and nontax issues, including Singapore corporate law,19 Singapore tax

law, and Canadian tax law; (3) drafting a representation letter20 and an opinion

letter; and (4) drafting the board of directors resolutions that would ratify the

19
In a PwC memo regrading the “Singapore tax consequences of the * * *
[reinvestment plan]”, there is a brief discussion on Singapore corporate law. The
memo states that sec. 21 of the Singapore Companies Act does not allow a
subsidiary to hold shares of its Singapore parent.
20
The first draft of the representation letter was prepared by PwC and
subsequently provided to Barnes for review. Barnes’ CFO and other officers and
employees reviewed the draft representation letter for accuracy. After they
concluded that the representation letter was accurate in every respect, it was signed
by Barnes’ CFO on December 6, 2000.
 - 17 -

[*17] reinvestment plan. Barnes’ board of directors ratified the reinvestment plan

on October 12, 2000.

VII. Summary of the Reinvestment Plan

Barnes and three of its subsidiaries were explicitly included in the

reinvestment plan--(1) ASA, mentioned supra; (2) Barnes Group Finance Co.

Delaware (Delaware), a Delaware corporation; and (3) Barnes Group Finance Co.

Bermuda Ltd. (Bermuda), a Bermuda corporation. Additionally, three other Barnes

subsidiaries played a role in the plan--(1) Barnes Group Canada Inc. (Barnes

Canada); (2) Bowman Distribution Europe Ltd. (Bowman UK); and (3) Bowman

Distribution France S.A. (Bowman France). The plan was structured so that Barnes

would receive ASA’s excess cash, ASA’s receivables from foreign affiliates, and

the proceeds of a loan from the Singapore Bank.

A. Receivables From Foreign Affiliates 21

While not explicitly mentioned in the reinvestment plan document, Barnes

Canada, Bowman UK, and Bowman France played a role in the plan. ASA’s

“receivables from foreign affiliates” related to Bowman UK and Bowman France;

21
The record lacks conclusive evidence of the precise series of events
between Barnes, Barnes Canada, Bowman UK, and Bowman France; however, this
section provides an approximate account of what occurred.
 - 18 -

[*18] however, neither had the funds to repay its respective loan.22 Therefore,

Barnes planned to have Barnes Canada make equity investments in the foreign

affiliates, and then the foreign affiliates would repay their loans to ASA.

Nonetheless, on account of purported “foreign asset passive income” and

“debt/equity” considerations, Barnes initially lent the funds to Bowman UK and

Bowman France. At some time around the execution of the reinvestment plan, ASA

collected its receivables from Bowman UK and Bowman France. Thereafter,

Barnes Canada made the alleged equity investments in Bowman UK and Bowman

France, and Bowman France and Bowman UK repaid the loans from Barnes.

B. The Structure of the Plan

For purposes of implementing the reinvestment plan, Barnes formed

Bermuda and Delaware as wholly owned subsidiaries on August 29 and

September 12, 2000, respectively.23 At the time the plan was implemented,

Bermuda and Delaware were wholly owned subsidiaries of Barnes, and ASA was

22
Bowman UK and Bowman France owed ASA $15,750,000 and $3,800,000,
respectively.
23
Thereafter, on September 20, 2000, Delaware issued 500 shares of its
common stock to Barnes in exchange for Barnes’ transfer of $5 to Delaware. Then
on September 28, 2000, Bermuda issued 12,000 shares of its common stock to
Barnes in exchange for Barnes’ transfer of $12,000 to Bermuda on December 4,
2000.
 - 19 -

[*19] a second-tier subsidiary24 of Barnes. During 2000 and 2001 Bermuda and

ASA were controlled foreign corporations within the meaning of section 957(a).

The reinvestment plan was structured to occur in two parts, and both parts

were structured to involve a similar series of transactions. Part I was structured to

occur in the following order: (1) in a section 351 transaction25 ASA and Barnes

would transfer foreign currency to Bermuda in exchange for Bermuda common

stock; (2) in another section 351 transaction Bermuda and Barnes would transfer

foreign currency and Bermuda common stock to Delaware in exchange for

Delaware stock (Barnes would receive common stock and Bermuda would receive

preferred stock); and (3) Delaware would convert the foreign currencies into U.S.

dollars and then lend the funds to Barnes.

The main difference with part II of the reinvestment plan was that ASA

would first borrow funds from the Singapore Bank before completing the

aforementioned series of section 351 transactions. After completion of the plan,

24
Barnes owned 100% of the stock of an entity which in turn owned 100% of
the stock of ASA.
25
Sec. 351(a) provides for the nonrecognition of gain or loss upon the transfer
by one or more persons of property to a corporation solely in exchange for stock in
the corporation, if immediately after the exchange the person or persons are in
control of the corporation to which the property was transferred.
 - 20 -

[*20] ASA and Delaware would own all of the common stock of Bermuda and

Bermuda would own all of the preferred stock of Delaware.

VIII. Executing the Reinvestment Plan

The boards of directors of ASA, Bermuda, and Delaware all formally

approved the reinvestment plan. On December 6, 2000, Barnes, ASA, Bermuda,

and Delaware executed the plan.26 As structured, the reinvestment plan was

implemented in two parts--the first part was implemented in December 2000 and the

second part in July 2001.

A. Part I of the Reinvestment Plan

On December 7, 2000, Bermuda issued 222,000 shares of its common stock

to Barnes in exchange for Barnes’ transfer of 384,171 Singapore dollars (equivalent

to $222,000) to Bermuda on or about December 15, 2000. Also on December 7,

2000, Delaware issued 3,184 shares of its common stock to Barnes in exchange for

Barnes’ transfer to Delaware of: (1) 234,000 shares (100%) Bermuda common

stock issued on December 7, 2000; and (2) 5,137,425 Singapore dollars (equivalent

to $2,951,000) paid on or about December 19, 2000.

26
The reinvestment plan was amended on March 29 and June 21, 2001, to
provide ASA with the additional time necessary to close the loan with the Singapore
Bank.
 - 21 -

[*21] Next, on or about December 12, 2000, Bermuda issued 39 million shares of

its common stock to ASA in exchange for ASA’s aggregate transfer to Bermuda of

67,720,713 Singapore dollars (equivalent to $39 million) on or about December 12

and 18, 2000. Thereafter, on December 22, 2000, Bermuda transferred

approximately 68,104,884 Singapore dollars (equivalent to $39,222,000)27 and

2,950,000 shares of Bermuda common stock to Delaware in exchange for

Delaware’s issuance of 42,172 shares of Delaware preferred stock to Bermuda.

Four days later on December 26, 2000, Delaware converted 73,242,309 Singapore

dollars to $42,114,815. Delaware then transferred $42,105,000 to Barnes

structured as a loan, and Barnes in turn used the funds to pay off its own debt.28

B. Part II of the Reinvestment Plan

Several events occurred on or around July 2, 2001, in compliance with the

reinvestment plan: (1) ASA borrowed 3 billion Japanese yen from the Singapore

27
The $39,222,000 included the $39 million ASA transferred to Bermuda in
December 2000 and the $222,000 Barnes transferred to Bermuda in December
2000.
28
The $42,105,000 included the $39,222,000 Bermuda transferred to
Delaware in December 2000 and the $2,950,000 Barnes transferred to Delaware in
December 2000.
 - 22 -

[*22] Bank;29 (2) Bermuda issued 23,246,400 shares of common stock to ASA in

exchange for ASA’s transfer of 2.9 billion Japanese yen (equivalent to

$23,311,897) to Bermuda; (3) Bermuda issued 131,000 shares of its common

stock to Barnes in exchange for Barnes’ transfer of 16,342,315 Japanese yen

(equivalent to $132,112) to Bermuda on or about July 3, 2001; and (4) Delaware

issued 1,881 shares of its common stock to Barnes in exchange for Barnes’ transfer

of 131,000 shares of Bermuda common stock and 218,313,373 Japanese yen

(equivalent to $1,753,521) to Delaware. Thereafter, on or about July 9, 2001,

Bermuda transferred approximately 2,916,342,315 Japanese yen (equivalent to

$23,444,009) and 1,750,000 shares of its common stock to Delaware in exchange

for Delaware’s issuance of 25,127 shares of Delaware preferred stock to

Bermuda.30 The following day Delaware converted 3,134,655,688 Japanese yen to

29
ASA borrowed the funds pursuant to a “Facility Agreement” between ASA
and the Singapore Bank dated June 19, 2001. The interest rate on the Singapore
Bank loan was 2.15% with an effective rate of approximately 5.15% after
accounting for a yen/Singapore dollar hedge executed by ASA with the Singapore
Bank. Barnes guaranteed the loan.
30
The $23,444,009 included the $23,311,897 ASA transferred to Bermuda in
July 2001 and the $132,112 Barnes transferred to Bermuda in July 2001.
 - 23 -

[*23] $25,197,136. Delaware then transferred $25,500,000 to Barnes, structured as

a loan, and Barnes in turn used the funds to pay off its own debt.31

IX. Bermuda and Delaware

As mentioned, Bermuda and Delaware were formed for the purposes of

participating in the reinvestment plan.

A. Bermuda

Bermuda had no income or deductions for 2000 and nominal amounts of

income and deductions for 2001.32 Accordingly, Bermuda had no earnings and

profits as of December 31, 2000 or 2001. Bermuda had no paid employees in 2000

and 2001 and had $12,000 and $10,590 of cash at the end of 2000 and 2001,

respectively.

Bermuda’s board of directors included Mr. Sinder (Barnes’ assistant

treasurer), Mr. Denninger (Barnes’ senior vice president, finance, and CFO), and

Mr. Locher (Barnes’ vice president, treasurer). Mr. Sinder was also Bermuda’s

treasurer. In accordance with instructions from Barnes’ senior management, Mr.

31
The $25,500,000 included the $132,112 initially transferred from Barnes to
Bermuda, the $23,311,897 initially transferred from ASA to Bermuda, and the
$1,753,521 Barnes transferred to Delaware in July 2001.
32
In 2001 Bermuda reported $12,000 of revenue from a “foreign exchange
gain” and a $13,410 deduction from “outside services”.
 - 24 -

[*24] Sinder: (1) signed many if not all of Bermuda’s corporate documents in order

to implement the reinvestment plan, including the reinvestment plan itself and the

two amendments to the plan; and (2) was responsible for the movement of all cash

under the reinvestment plan, although he was not sure why each movement of cash

was necessary to accomplish the overall purpose of the plan.

B. Delaware

Similar to Bermuda’s, Delaware’s board of directors consisted of Mr. Sinder,

Mr. Denninger, and Mr. Locher. Like Bermuda, Delaware had no paid employees

and nominal amounts of cash in 2000 and 2001. Furthermore, Delaware’s financing

function appears to have been limited to the currency conversions and subsequent

lending transactions with Barnes. During 2000 and 2001 Delaware reported only a

foreign currency exchange loss and a foreign currency exchange gain, respectively.

1. Delaware Preferred Stock

The Delaware preferred stock issued in connection with the reinvestment

plan was referred to in Delaware corporate records as “Series A Cumulative

Preferred Stock” with a stated value of $1,000 per share. The holders of such

shares were entitled to receive, when and if declared by the board of the directors,

quarterly cumulative dividends at a rate of 7.4% of the stated value per annum.
 - 25 -

[*25] The preferred shares were not convertible into any other class of stock and

had no voting rights.

Delaware filed Forms 1042, Annual Withholding Tax Return for U.S. Source

Income of Foreign Persons, for tax years 2002, 2004, 2006, 2008, and 2009. The

Forms 1042 reported total gross income paid to Bermuda of $7,471,566 33 and total

Federal tax withheld of $2,241,469. After learning respondent’s position toward the

reinvestment plan, Bermuda filed Forms 1120-F, U.S. Income Tax Return of a

Foreign Corporation, for its 2002, 2004, 2006, and 2008 tax years. The returns

were filed on a “protective claim basis only”--in the event respondent’s position was

upheld, Bermuda wanted to toll the statute of limitations to apply for a refund of the

Federal tax withheld on the preferred dividend payments.

2. Delaware Loans

The loans from Delaware to Barnes (Delaware loans) were evidenced by

“Inter-Company Loan Agreement #1” and “Inter-Company Loan Agreement #2”

33
The Forms 1042 reported the following gross income paid to Bermuda:
2002--$1,245,261; 2004--$1,245,261; 2006--$1,245,261; 2008--$1,245,261; and
2009--$2,490,522. Nonetheless, it is unclear whether Delaware actually paid the
preferred dividends to Bermuda.
 - 26 -

[*26] dated December 26, 2001,34 and July 10, 2001, respectively. Corresponding

notes were attached to the Delaware loan agreements, dated December 26, 2000,

and July 10, 2001, respectively. Each note was signed by Mr. O’Brien sometime

after he was hired as Barnes’ vice president and treasurer in August 2001. Barnes

and Delaware recorded the Delaware loans in their financial statements as notes

payable and notes receivable, respectively.

The Delaware loan agreements allowed the lender to demand full repayment

of principal and interest at any time and permitted the borrower to make partial

repayments of principal at any time; however, the borrower was required to make

annual interest payments on the unpaid principal balance at a fixed rate equal to

7.5% commencing on December 1, 2002. As mentioned, the Delaware loans were

made for $42,105,000 and $25,500,000, respectively, for a combined total of

$67,605,000. As of December 31, 2010, the total Delaware loan balance reported

on Barnes’ tax return was $127,202,495. It is unclear whether Barnes made any

interest payments on the Delaware loans.

34
Petitioners contend that the December 26, 2001, date on the first Delaware
loan agreement was a typographical error and the date should have been December
26, 2000.
 - 27 -

[*27] X. PwC Opinion Letter

Before the execution of the reinvestment plan in September 2000, PwC

provided Barnes with a draft of an opinion letter that analyzed the Federal income

tax consequences of the reinvestment plan. Mr. DeForte carefully reviewed the

factual and legal analysis sections, created a markup of the draft opinion, and

provided suggested factual revisions. Moreover, he had several discussions with

PwC regarding the legal analysis and conclusions in the opinion. PwC provided

Barnes with the final opinion letter on December 7, 2000.35

The focal point of the opinion letter was the two transfers between Bermuda

and Delaware (BD exchanges), discussed supra, occurring on December 22, 2000,

and July 9, 2001, whereby Bermuda received shares of Delaware preferred stock in

exchange for foreign currency and shares of Bermuda common stock.36 The

35
The final opinion letter was 27 pages and did not materially differ from the
draft opinion letter.
36
Specifically, the BD exchanges refer to the following 2000 and 2001
transactions between Delaware and Bermuda: December 22, 2000--Bermuda
transferred approximately 68,104,884 Singapore dollars (equivalent to $39,222,000)
and 2,950,000 shares of Bermuda common stock to Delaware in exchange for
Delaware’s issuance of 42,172 shares of Delaware preferred stock to Bermuda; and
July 9, 2001--Bermuda transferred approximately 2,916,342,315 Japanese yen
(equivalent to $23,444,009) and 1,750,000 shares of its common stock to Delaware
in exchange for Delaware’s issuance of 25,127 shares of Delaware preferred stock
to Bermuda.
 - 28 -

[*28] opinion letter analyzed whether the BD exchanges resulted in an income

inclusion under sections 951 and 956. The opinion letter concluded--

The * * * [Delaware] preferred stock that will be held by * * *
[Bermuda] should constitute an investment in U.S. property within the
meaning of section 956(c)(1). However, * * * [Bermuda] should have
a zero basis in the * * * [Delaware] preferred stock for U.S. federal
income tax purposes. Since the income required to be included under
section 956 is limited to the adjusted basis that * * * [Bermuda] has in
the * * * [Delaware] preferred stock, no amount should be included in
Barnes’ income as a result of * * * [Bermuda’s] investment in the * * *
[Delaware] preferred stock.

Furthermore, the opinion letter addressed, to varying degrees, the implications

of sections 269 and 301 and the step transaction doctrine. After a three-page

analysis, the opinion letter concluded that section 269 should not apply to the

reinvestment plan. The opinion letter also stated that the transaction should not

result in a deemed repatriation of the funds under section 301. Moreover, the

opinion letter briefly discussed Esmark, Inc. v. Commissioner, 90 T.C. 171 (1988),

aff’d without published opinion, 886 F.2d 1318 (7th Cir. 1989), and concluded that

“no other form of investment is more direct than the proposed investment by * * *

[Bermuda] in the * * * [Delaware] shares.” Indeed, the opinion letter opined that

PwC’s cconclusions should not be altered by “step transaction principles” because

“there is no plan to alter the interests and relationships among the parties.”
 - 29 -

[*29] Finally, PwC found “substantial authority” for its findings in the opinion

letter, stating--

Provided that the information and assumptions contained herein are
correct, substantial authority, within the meaning of section 6662 of the
Code and Treas. Reg. Section 1.6662-(4)(d), exists to reach the
conclusions made in this opinion, and we conclude that “there is a
greater than 50-percent likelihood that the tax treatment” of the issues
on which we have opined in this opinion will be upheld if challenged
by the IRS.

XI. Other Matters

A. Subsequent Acquisitions

Following the completion of the reinvestment plan, Barnes continued

searching for opportunities to expand each of its three business segments. From

2002 through 2006 Barnes made several acquisitions both in the United States and

abroad.

B. Expert Testimony

Barnes hired two experts, Leigh Ann Riddick and Gordon Bodnar, to produce

expert reports on the pretax profitability of the reinvestment plan and the

characterization of the transfers between Barnes and its subsidiaries, respectively.

Dr. Riddick’s report concluded that without regard to any Federal tax

considerations, the reinvestment plan would have been expected to generate a net

economic benefit to Barnes of $1,294,229 to $2,054,706 during calendar year
 - 30 -

[*30] 2001 and $5,559,772 to $7,984,559 during calendar years 2001 through 2003.

Dr. Bodnar’s report concluded that from a finance perspective: (1) the preferred

stock issued by Delaware was an equity instrument and not a debt instrument; and

(2) the reinvestment plan did not reflect a loan from ASA to Barnes or any of its

subsidiaries.

XII. Clean Room Issue--IBM Agreement

Around July 18, 1985, Barnes entered into “Agreement No. F155W” with

IBM (1985 agreement) effective January 2, 1985. Pursuant to the 1985 agreement,

Barnes constructed six clean rooms in a warehouse at one of its facilities in

Windsor, Connecticut. The clean rooms were designed and constructed in

accordance with IBM’s specifications and could be used exclusively for IBM’s

work. The six clean rooms were each approximately 100 feet x 30 feet and included

flooring, light, wall, exhaust, ventilation, and associated equipment. IBM paid

Barnes for the construction costs of the rooms and retained ownership of the rooms,

as well as the equipment and other property housed within them.

Under the 1985 agreement, Barnes would use the clean rooms to produce

green sheets for IBM throughout 1985 and 1986 (although Barnes continued to use

the rooms to produce green sheets for IBM in later years). In return Barnes would

“recover its direct and indirect costs, including General and Administrative
 - 31 -

[*31] * * * at 6.718% for 1985, plus a fee at ten percent (10%).” The 1985

agreement further stated that “The projected operating costs/expenses for 1985 are

$1,273,021.” For future years, the parties agreed that they would “make all

attempts to convert from a cost plus fixed fee to a firm price contract” with “Future

G&A percentages * * * subject to negotiation.” Nowhere does the 1985 agreement

specify that the agreement is a lease of Barnes’ warehouse space, and no portion of

payments is specifically designated to use of the warehouse space.

On or about March 31, 2001, Barnes and IBM entered into the First

Amended and Restated Service Agreement No. MD003 (2001 agreement) effective

January 1, 2001.37 Pursuant to the 2001 agreement, IBM quitclaimed ownership of

the six clean rooms and other property to Barnes.

XIII. Barnes’ Tax Returns and Notice of Deficiency

Barnes timely filed consolidated Forms 1120, U.S. Corporation Income Tax

Return, for all years at issue, reporting: (1) taxable income of $39,705,238 for

1998; (2) a taxable loss of $503,654 for 2000; and (3) a taxable loss of

37
The 2001 agreement amends and restates Service Agreement No. MD002,
dated January 31, 1998. Barnes has not been able to find Service Agreement No.
MD002.
 - 32 -

[*32] $10,754,459 for 2001.38 Mr. DeForte reviewed and signed Barnes’ income

tax returns for all years at issue.

A. Reinvestment Plan

Barnes included the following documents related to the reinvestment plan

with its 2000 and 2001 Federal income tax returns: (1) Forms 926, Return by a U.S.

Transferor of Property to a Foreign Corporation, reporting the aforementioned series

of purported section 351 transactions among Barnes, Delaware, Bermuda, and ASA;

and (2) certain statements required by section 1.351-3(a), (b), and (c), Income Tax

Regs., further reporting details of the purported section 351 transactions. Barnes

did not report any income attributable to the reinvestment plan but later amended its

1998 Federal income tax return to claim a net operating loss carryback of $503,654

from its 2000 tax year.

B. IBM Agreement

On its Federal income tax return for the tax year ending December 31, 2001,

Barnes reported $3,315,850 of income attributable to the receipt of the six clean

rooms and other property: (1) $1,700,000 was attributable to the four 10,000 PPM

clean rooms; (2) $850,000 was attributable to the two 100,000 PPM clean rooms;

38
While Barnes did not report any tax due for 2001, Barnes reported
$1,026,372 of tax due on its 2000 income tax return as a result of the alternative
minimum tax.
 - 33 -

[*33] and (3) the balance was attributable to other property. Barnes also claimed a

$32,566 depreciation expense with respect to the clean rooms on its 2001 income

tax return.

C. Notice of Deficiency

In the notice of deficiency dated August 20, 2009, respondent: (1) increased

Barnes’ 2000 taxable income by $38,919,950, which represented ASA’s $39

million aggregate transfer (minus a minor conversion rate adjustment) that

eventually was transferred to Barnes; and (2) increased Barnes’ 2001 taxable

income by $19,378,596, which represented ASA’s $23,311,897 transfer (minus a

conversion rate adjustment and an earnings and profits adjustment) that eventually

was transferred to Barnes; (3) determined that the value of the four 10,000 PPM

clean rooms was $2,520,000 and that as a result Barnes should have recognized

additional income of $820,000 for the 2001 tax year; and (4) disallowed Barnes’

1998 net operating loss carryback of $503,654 from its 2000 tax year.

OPINION

I. Burden of Proof

The taxpayer bears the burden of proving by a preponderance of the

evidence that the Commissioner’s determinations are incorrect. Rule 142(a);

Welch v. Helvering, 290 U.S. 111, 115 (1933). In general, the burden of proof
 - 34 -

[*34] with regard to factual matters rests with the taxpayer. Under section 7491(a),

if the taxpayer produces credible evidence with respect to any factual issue relevant

to ascertaining the taxpayer’s liability for tax and meets other requirements, the

burden of proof shifts from the taxpayer to the Commissioner as to the factual issue.

Petitioners have not alleged that section 7491(a) applies or established their

compliance with its requirements. Therefore, the burden of proof remains on

petitioners. See Rule 142(a).

II. Revenue Ruling 74-503

As a preliminary matter, petitioners contend that respondent is precluded

from challenging the reinvestment plan because: (1) petitioners reasonably relied on

Rev. Rul. 74-503, 1974-2 C.B. 117; and (2) Rev. Rul. 2006-2, 2006-1 C.B. 261,

states that “Under the authority of section 7805(b), 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.”

Rev. Rul. 74-503, supra, provides guidance where treasury stock is

exchanged for newly issued stock of another corporation. Specifically, the ruling

addresses a situation where treasury stock is purchased by a corporation

(corporation X) from its shareholders for less than fair market value and
 - 35 -

[*35] subsequently exchanged for 80% of the newly issued stock of another

corporation (corporation Y), in a transaction in which no gain or loss was

recognized by either corporation under sections 351(a) and 1032(a).

The revenue ruling first concludes that section 358(a) should not determine

the basis of the stock received by each corporation--

Section 358(a) * * * provides * * * rules for determining the basis of
property received by a transferor in a transaction to which section 351
applies. However, section 358(e) provides that section 358(a) does not
apply to property acquired by a corporation by the exchange of its
stock as consideration in whole or in part for the transfer of property to
it. Therefore, section 358(a) is not applicable in determining the basis
of the [corporation] Y stock received by [corporation] X in the
transaction. [Rev. Rul. 74-503, 1974-2 C.B. at 117.]

The analysis continues by recognizing that section 1.1032-1(d), Income Tax

Regs., provides that the basis of property acquired by a corporation in connection

with a section 351 transaction should be determined under section 362. Section

362(a) provides that the basis to a corporation of property acquired in a section 351

transaction will be the same as it would be in the hands of the transferor, increased

by the amount of gain recognized to the transferor on the transfer. After

determining that unissued stock and treasury stock both have a zero basis, the

revenue ruling concludes that, according to section 362(a), the basis of the stock

received by each corporation in the exchange is zero.
 - 36 -

[*36] A. Arguments of the Parties

Petitioners focus their preclusion argument on the BD exchanges, discussed

supra, concluding that there are no material factual differences between the BD

exchanges and Rev. Rul. 74-503, supra. Conversely, respondent argues that the

reinvestment plan must be examined in its entirety, rather than focusing only on the

BD exchanges. Applying substance over form principles to the entirety of the

reinvestment plan, respondent argues that, in substance, the reinvestment plan

should be characterized as either a dividend or a loan from ASA to Barnes.

Respondent concludes that Rev. Rul. 74-503, supra, does not cover the facts of the

reinvestment plan.

B. Analysis

Section 601.601(d)(2)(v)(a), Statement of Procedural Rules, provides that

“[t]he conclusions expressed in Revenue Rulings will be directly responsive to and

limited in scope by the pivotal facts stated in the revenue ruling.” Furthermore,

section 601.601(d)(2)(v)(e), Statement of Procedural Rules, provides--

Taxpayers generally may rely upon Revenue Rulings published in the
Bulletin in determining the tax treatment of their own transactions and
need not request specific rulings applying the principles of a published
Revenue Ruling to the facts of their particular cases. However, since
each Revenue Ruling represents the conclusion of the Service as to the
application of the law to the entire state of facts involved, taxpayers,
Service personnel, and others concerned are
 - 37 -

[*37] cautioned against reaching the same conclusion in other cases unless
the facts and circumstances are substantially the same. They should consider
the effect of subsequent legislation, regulations, court decisions, and revenue
rulings.

In Briarcliff Candy Corp. v. Commissioner, T.C. Memo. 1987-487, we noted

that “Revenue Rulings of respondent speak to the limited fact situations before

respondent at that moment.” Moreover, in Anschutz Co. v. Commissioner, 664

F.3d 313, 330 10th Cir. (2011), aff’g 135 T.C. 78 (2010), the Court of Appeals for

the Tenth Circuit observed that the problem with the taxpayer’s reliance on a

revenue ruling was that the transactions at issue in the case before the court,

considered as a whole, were different from the entirety of the transactions at issue in

the revenue ruling.

Before comparing the facts considered in the revenue ruling with those of

the reinvestment plan, we note that petitioners’ preclusion argument can succeed

only if we respect the form of the reinvestment plan. See Frank Lyon Co. v.

United States, 435 U.S. 561, 573 (1978) (“The Court has never regarded ‘the

simple expedient of drawing up papers’, * * * as controlling for tax purposes when

the objective economic realities are to the contrary.” (quoting Commissioner v.

Tower, 327 U.S. 280, 291 (1946))). Accordingly, petitioners must clear two

hurdles in order to show that they reasonably relied on the conclusions in Rev.
 - 38 -

[*38] Rul. 74-503, supra, so that respondent is precluded from challenging the

reinvestment plan: (1) that we should respect the form of the reinvestment plan; and

(2) that the facts of the reinvestment plan are substantially the same as those

considered in the revenue ruling. Petitioners’ preclusion argument fails to clear

either hurdle.

First, as discussed infra, Rev. Rul. 74-503, supra, does not preclude

respondent’s challenge because we believe that the substance of the reinvestment

plan was a dividend from ASA to Barnes. Furthermore, even if we were to respect

the form of the reinvestment plan, Rev. Rul. 74-503, supra, still would not preclude

respondent’s challenge because there are substantial factual differences between

Rev. Rul. 74-503, supra, and the reinvestment plan.

Petitioners were cautioned against reaching the same conclusions as Rev.

Rul. 74-503, supra, unless the reinvestment plan involved substantially the same

facts and circumstances as the revenue ruling, and petitioners were advised to

consider subsequent legislation, regulations, court decisions, and revenue rulings.

See sec. 601.601(d)(2)(v)(e), Statement of Procedural Rules. The reasoning is

straightforward--additional facts beget additional issues.

We believe petitioners’ argument distorts the scope of the “will not

challenge” language in Rev. Rul. 2006-2, supra. Respondent is not challenging
 - 39 -

[*39] petitioners’ zero-basis conclusions as a result of the BD exchanges per se but

is challenging the reinvestment plan as a whole. In order for Rev. Ruls. 74-503 and

2006-2, supra, to preclude respondent’s challenge, the facts and circumstances

surrounding the reinvestment plan would have to be limited to the facts discussed in

Rev. Rul. 74-503, supra. The pivotal facts addressed in that revenue ruling involved

a corporation simply exchanging treasury stock for the previously unissued stock of

another corporation in a section 351 transaction.

The pivotal facts associated with the reinvestment plan far exceed the

circumstances addressed in Rev. Rul. 74-503, supra. The BD exchanges,

considered alone, do have factual similarities to the revenue ruling--primarily, both

involved stock-for-stock exchanges. However, there are also substantial differences

between the two: (1) the BD exchanges were between two wholly owned

subsidiaries that were formed to participate in a larger plan; (2) one of the

subsidiaries was a controlled foreign corporation; and (3) the exchanges involved

transferring approximately $62 million from a foreign country to the United States.

Notwithstanding the preceding analysis, the BD exchanges should not be

compared to Rev. Rul. 74-503, supra, in isolation because the BD exchanges were

part of a series of steps in an integrated transaction mandated by contractual
 - 40 -

[*40] agreement. Accordingly, we should compare the entirety of the reinvestment

plan to the situation in the revenue ruling in deciding whether respondent is

precluded from challenging petitioners’ plan. In doing so, we summarize the vast

factual disparities between the two: (1) the reinvestment plan involved, both

explicitly and indirectly, seven entities, six of which are subsidiaries of a common

parent, Barnes; (2) the plan involved multiple section 351 transactions and multiple

loans (one of which was from a third party); (3) Bermuda and Delaware were

formed for the purpose of participating in the plan; (4) ASA and Bermuda were

controlled foreign corporations; (5) ASA had substantial earnings and profits; (6)

Barnes, ASA, Bermuda, and Delaware contracted to undertake a series of

transactions that resulted in a substantial amount of money from three entities with

earnings and profits being transferred back into the United States without any tax

consequences; and (7) the resulting structure of the plan, discussed infra, was not

respected--particularly, Bermuda’s preferred stock investment in Delaware and

Delaware’s loan to Barnes.

Because the reinvestment plan far exceeded the scope of the stock-for-stock

exchange addressed in Rev. Rul. 74-503, supra, respondent is not precluded from

challenging the reinvestment plan.
 - 41 -

[*41] III. Worldwide Taxation

One of the primary reasons Barnes wanted ASA’s excess cash was so that

Barnes could put the money to a more productive use--specifically, to use ASA’s

excess cash that was earning a low rate of return to pay off Barnes’ high-interest

debt. Before discussing whether the substance of the reinvestment plan aligns with

its form, it is important to understand why ASA did not directly pay a dividend to

Barnes, make a loan to Barnes, or make an equity investment in Barnes.

U.S. corporations are ordinarily taxed under section 11 on their worldwide

income; however, subject to many exceptions, the income of a foreign subsidiary of

a U.S. corporation generally is not subject to U.S. tax if the income was earned

outside the United States and not repatriated as a dividend. See Boris I. Bittker &

James S. Eustice, Federal Income Taxation of Corporations and Shareholders, para.

15.20 [1][a], at 15-85, 15-86 (7th ed. 2002). Some domestic corporations,

therefore, choose to keep a foreign subsidiary’s earnings abroad in order to defer

U.S. tax until the money is repatriated. See Office of Tax Policy, U.S. Dept. of

Treasury, Doc. 2001-492, The Deferral of Income Earned through U.S. Controlled

Foreign Corporations: A Policy Study 13 (2000).
 - 42 -

[*42] A. Dividend Payment

A distribution of property by a corporation to a shareholder with respect to

his stock shall be included in the gross income of the shareholder as a dividend to

the extent of the corporation’s earnings and profits. See secs. 301(a), (c), 316(a).

ASA had earnings and profits in 2000 and 2001 in excess of the amounts ASA

transferred to Barnes through the reinvestment plan. Accordingly, if the

reinvestment plan is disregarded and ASA is deemed to have made a distribution

directly to Barnes, Barnes should have reported dividend income on its 2000 and

2001 Federal income tax returns equal to the respective amount of money received

from ASA’s earnings and profits each year.

B. Debt or Equity Investment

A loan or equity investment from ASA to Barnes would also result in Barnes’

recognizing taxable income. Congress, through subpart F (sections 951 through

965), sought to limit tax deferrals by any foreign corporation that meets the

definition of a “controlled foreign corporation” (CFC) as defined under section
 - 43 -

[*43] 957(a).39 Elec. Arts, Inc. v. Commissioner, 118 T.C. 226, 272 (2002). The

parties agree that ASA and Bermuda were CFCs in 2000 and 2001.

The relevant subpart F provisions in this case are sections 951 and 956.

Under section 951, subject to various restrictions and qualifications, U.S.

shareholders of a CFC are taxed directly on their pro rata share of the CFC’s

earnings that are invested in certain types of U.S. property (section 951 inclusion).

Secs. 951(a)(1)(B), 956(a).40 U.S. property includes, inter alia, stock and debt of

U.S. corporations. See sec. 956(c)(1)(B) and (C). The amount of the investment is

the CFC’s adjusted basis in the U.S. property. See sec. 956(a).

In the case before us, Barnes is the U.S. shareholder of Bermuda and ASA,

both CFCs. Barnes, therefore, would recognize a section 951 income inclusion to

39
Generally, a controlled foreign corporation is any foreign corporation where
more than 50% of (1) the total combined voting power of all classes of stock of the
corporation entitled to vote, or (2) the total value of the stock of the corporation, is
owned by U.S. shareholders on any day during the taxable year of the foreign
corporation. See sec. 957(a).
40
More specifically, the sec. 951 inclusion is the U.S. shareholder’s pro rata
share of the lesser of two amounts: (1) the excess of (a) the average amounts of the
CFC’s investments in U.S. property as of the end of each quarter of the taxable year
over (b) the CFC’s earnings and profits representing previous sec. 951 inclusions; or
(2) the amount of the CFC’s “applicable earnings”, as defined in sec. 956(b)(1),
representing essentially the CFC’s current and accumulated earnings and profits that
have not already been included in its U.S. shareholders’ gross incomes. Rodriguez
v. Commissioner, 137 T.C. 174, 176, n.3 (2011).
 - 44 -

[*44] the extent of the adjusted basis of U.S. property held by Bermuda or ASA as a

result of the reinvestment plan (to the extent that Bermuda or ASA had earnings and

profits).

Petitioners assert that in substance and form Bermuda made investments in

Delaware’s preferred stock in section 351 transactions. Relying on Rev. Rul. 74-

503 and sections 358, 362, and 1032, discussed supra, petitioners argue that

Bermuda has a zero basis in Delaware’s preferred stock. Therefore, petitioners

conclude Barnes’ section 951 income inclusion is zero. Moreover, petitioners assert

that the substance over form doctrines only apply when the substance and form of a

transaction are not aligned. Because the substance of the reinvestment plan does not

reflect a loan or dividend from ASA, petitioners argue that respondent’s attempt to

recharacterize the reinvestment plan fails as a matter of law.

Respondent does not believe the substance of the reinvestment plan aligns

with its form. As mentioned supra, respondent argues that in substance the

reinvestment plan should be characterized as either a dividend from ASA to

Barnes under section 301 or as a loan from ASA to Barnes under sections

951(a)(1)(B) and 956. Respondent’s arguments rely on the substance over form
 - 45 -

[*45] principles embodied in the conduit theory, the step transaction doctrine, and

section 269.41

IV. Expert Reports

Petitioners submitted two expert reports to demonstrate that the reinvestment

plan would produce a net economic benefit and that the form of the plan should be

respected. We assume that it is economically beneficial in many instances for

multinational corporations to invest overseas profits in the United States. The

reason many corporations decide otherwise is simple--taxes. The correct inquiry

therefore is not whether there was an economic purpose for transferring ASA’s

excess cash to the United States. We can assume Barnes had one. The correct

41
Sec. 269 provides the Secretary with the authority to disallow deductions,
credits, or other allowances secured by a taxpayer in an acquisition when the
principal purpose of the acquisition was the evasion or avoidance of Federal income
tax. Furthermore, under the conduit theory of the substance over form doctrine, the
court may disregard an entity if it is a mere conduit for the real transaction at issue.
Enbridge Energy Co., Inc. v. United States, 553 F. Supp. 2d 716, 726 (S.D. Tex.
2008) (citing Commissioner v. Court Holding Co., 324 U.S. 331, 334 (1945)).

Because we find that the reinvestment plan in substance was a dividend from
ASA to Barnes under the step transaction doctrine, we do not address the following
any further: (1) respondent’s loan theory under secs. 951(a)(1)(B) and 956; (2)
respondent’s sec. 269 argument; and (3) respondent’s conduit theory argument.
 - 46 -

[*46] inquiry is whether the reinvestment plan is subject to taxation in the Untied

States. Accordingly, we need not discuss this expert report any further.

The second expert report also does not merit much consideration. This report

finds that the form of the reinvestment plan should be respected; however, the report

overlooks one serious consideration--petitioners have not shown that they respected

the form of the plan. Accordingly, the findings of this report are of minimal

probative value.

V. Substance Over Form

It is axiomatic that the substance of a transaction governs for tax purposes.

See Commissioner v. Court Holding Co., 324 U.S. 331, 334 (1945) (“The incidence

of taxation depends upon the substance of a transaction.”); Gregory v. Helvering,

293 U.S. 465 (1935); Calumet Indus., Inc. v. Commissioner, 95 T.C. 257, 288

(1990) (“[T]he substance of the transaction is controlling, not the form in which it is

cast or described.”). The judicial doctrines favoring substance over form are used as

a tool for effecting the underlying congressional purpose of a statute. Coltec Indus.,

Inc. v. United States, 454 F.3d 1340, 1354 (Fed. Cir. 2006). Consequently, despite

literal compliance with a statute, tax benefits will not be afforded on the basis of

transactions lacking in substance. Id.; see also Gregory v. Helvering, 293 U.S. at

469.
 - 47 -

[*47] While petitioners’ conclusions about the tax implications of the reinvestment

plan may have been based on their interpretation of Rev. Rul. 74-503, supra, and

sections 358, 362, and 1032, if the reinvestment plan lacked economic substance the

form of the plan will not be respected for Federal income tax purposes. See

Commissioner v. Court Holding Co., 324 U.S. at 334 (“To permit the true nature of

a transaction to be disguised by mere formalisms, which exist solely to alter tax

liabilities, would seriously impair the effective administration of the tax policies of

Congress.”).

A. Step Transaction Doctrine, in General

The step transaction doctrine generally applies in cases where a
taxpayer seeks to get from point A to point D and does so stopping in
between at points B and C. The whole purpose of the unnecessary
stops is to achieve tax consequences differing from those which a direct
path from A to D would have produced. In such a situation, courts are
not bound by the twisted path taken by the taxpayer, and the intervening
stops may be disregarded or rearranged. * * * [Smith v. Commissioner,
78 T.C. 350, 389 (1982), aff’d without published opinion, 820 F.2d
1220 (4th Cir. 1987).]

Under the step transaction doctrine, a particular step in a transaction is

disregarded for tax purposes if the taxpayer could have achieved its objective more

directly but instead included the step for no other purpose than to avoid tax

liability. Long-Term Capital Holdings v. United States, 150 Fed. Appx. 40, 43 (2d

Cir. 2005) (citing Del Commercial Props., Inc. v. Commissioner, 251 F.3d 210, 213
 - 48 -

[*48] (D.C. Cir. 2001)). On the other hand, the Commissioner may not “generate

events which never took place just so an additional tax liability might be asserted.”

Grove v. Commissioner, 490 F.2d 241, 247 (2d Cir. 1973), aff’g T.C. Memo. 1972-

98.

Courts generally apply one of three alternative tests in deciding whether to

invoke the step-transaction doctrine and disregard a transaction’s intervening steps:

(1) the binding commitment test; (2) the end result test; and (3) the interdependence

test. Superior Trading, LLC v. Commissioner, 137 T.C. 70, 88 (2011). We note that

these tests are not mutually exclusive and that a transaction need satisfy only one of

the tests to allow for the step transaction doctrine to be invoked. Id. at 90 (citing

Associated Wholesale Grocers, Inc. v. United States, 927 F.2d 1517, 1527-1528

(10th Cir. 1991)).

B. Three Tests

1. Binding Commitment Test

The binding commitment test considers whether at the time of taking the first

step there was a binding commitment to undertake the subsequent steps. See

Commissioner v. Gordon, 391 U.S. 83, 96 (1968) (holding that “if one transaction

is to be characterized as a ‘first step’ there must be a binding commitment to take

the later steps”). However, the binding commitment test “‘is seldom used and is
 - 49 -

[*49] applicable only where a substantial period of time has passed between the

steps that are subject to scrutiny’.” Superior Trading, LLC v. Commissioner, 137

T.C. at 89 (quoting Andantech v. Commissioner, T.C. Memo. 2002-97, aff’d in part,

remanded in part, 331 F.3d 972 (D.C. Cir. 2003)). The reinvestment plan was

executed in two parts spanning less than a year--each part took place over a matter of

days. We do not think the binding commitment test is appropriate in this case. See

Associated Wholesale Grocers, Inc., 927 F.2d at 1522 (declining to apply the

binding commitment test because the case did not involve a series of transactions

spanning several years).

2. End Result Test

“Under the end result test, the step transaction doctrine will be invoked if it

appears that a series of separate transactions were prearranged parts of what was a

single transaction, cast from the outset to achieve the ultimate result.” Greene v.

United States, 13 F.3d 577, 583 (2d Cir. 1994). The end result test focuses on the

parties’ subjective intent at the time of structuring the transaction. See True v.

United States, 190 F.3d 1165, 1175 (10th Cir. 1999) (holding that what matters is

not whether the parties intended to avoid taxes but whether they intended “to reach a

particular result by structuring a series of transactions in a certain way”). The test

examines whether the formally separate steps are prearranged components of a
 - 50 -

[*50] composite transaction intended from the outset to arrive at a specific end

result. Superior Trading, LLC v. Commissioner, 137 T.C. at 89.

3. Interdependence Test

The interdependence test analyzes whether the intervening steps are so

interdependent that the legal relations created by one step would have been fruitless

without completion of the later steps. Greene, 13 F.3d at 584 (citing Am. Bantam

Car Co. v. Commissioner, 11 T.C. 397, 405 (1948), aff’g, 177 F.2d 513 (3d Cir.

1949)). If, however, intermediate steps accomplished valid and independent

economic or business purposes, courts respect their independent significance. See

id.; Superior Trading, LLC v. Commissioner, 137 T.C. at 90. Likewise, a taxpayer

may proffer some nontax business purpose for engaging in a series of transactional

steps to accomplish a result he could have achieved by more direct means, but that

business purpose alone does not preclude the application of the step transaction

doctrine. True, 190 F.3d at 1177 (citing Associated Wholesale Grocers, Inc., 927

F.2d at 1527); Long-Term Capital Holdings, 150 Fed. Appx. at 43.

Cognizant of our power to invoke the step transaction doctrine when any of

the three tests is satisfied, we believe the interdependence test is the most

appropriate for this case. In applying the interdependence test in this case, we
 - 51 -

[*51] focus on whether any valid and independent economic or business purpose was

served by the inclusion of Bermuda and Delaware in the reinvestment plan.

We begin by noting that during 2000 and 2001 Barnes directly or indirectly

owned 100% of the stock of ASA, Delaware, and Bermuda. As a result, the

reinvestment plan was executed between related parties and therefore deserves extra

scrutiny. See Merck & Co. v. United States, 652 F.3d 475, 481 (3d Cir. 2011);

Kraft Food Co. v. Commissioner, 232 F.2d 118, 123 (2d Cir. 1956), rev’g 21 T.C.

513 (1954); Maxwell v. Commissioner, 95 T.C. 107, 116 (1990).

Petitioners make the following representations: (1) Bermuda was incorporated

and included in the reinvestment plan at the suggestion of PwC because “Singapore

corporate law did not permit ASA to make the type of equity investment required by

the transaction”; and (2) Delaware was “necessary to provide Barnes with a State tax

benefit unrelated to Federal income taxes and also to facilitate the more effective

control over the funds invested by ASA.” Furthermore, petitioners argue that both

entities were necessary to accomplish Barnes’ overall goal of “more efficiently using

ASA’s excess cash and borrowing capacity to temporarily pay down third party

indebtedness while preserving all of ASA’s excess cash and borrowing capacity for

use in forthcoming acquisitions outside of the United States.”
 - 52 -

[*52] a. Bermuda’s Business Purpose

Petitioners rely on Mr. Coneys’ testimony that Singapore law restricted a

subsidiary from investing in its parent, to explain Bermuda’s nontax reason for

participating in the reinvestment plan. Petitioners go so far as to argue on brief that

“but for the Singapore law restrictions, Bermuda would not have been formed and

would not have participated in the transaction.”

In determining foreign law, we are free to consider “any relevant material or

source, including testimony, whether or not submitted by a party or otherwise

admissible. The Court’s determination shall be treated as a ruling on a question of

law.” Rule 146; see also Angerhofer v. Commissioner, 87 T.C. 814, 819 (1986).

The only specific reference to Singapore law restrictions was in the PwC memo

mentioning section 21 of the Singapore Companies Act. Oddly, petitioners do not

cite section 21 of the Singapore Companies Act in their brief, nor do they explain the

reason this restriction required involving Bermuda in the reinvestment plan. We will

not attempt to do petitioners’ research or make their argument for them. See Muhich

v. Commissioner, 238 F.3d 860, 864 n.10 (7th Cir. 2001) (issues not addressed or

developed are deemed waived; it is not the court’s obligation to research and

construct the parties’ arguments), aff’g T.C. Memo. 1999-192; 330 W.

Hubbard Rest. Corp. v. United States, 203 F.3d 990, 997 (7th Cir. 2000) (same);
 - 53 -

[*53] Larson v. Northrop Corp., 21 F.3d 1164, 1168 n.7 (D.C. Cir. 1994) (declining

to reach issues neither argued nor briefed). Furthermore, the PwC memo also states

“Singapore does not limit a corporate entity’s ability to invest internationally.”

(Emphasis added.) If that is true, contradictory to petitioners’ position ASA could

have invested its funds directly in Delaware.

b. Delaware’s Business Purpose

Similarly, petitioners provide minimal support for Delaware’s business

purpose other than testimony from Mr. Coneys and Dr. Riddick. Dr. Riddick

testified that it would be “highly unusual for * * * a large company with international

operations not to create a financial subsidiary for * * * [the reinvestment plan]

because doing so provides transparency * * * of what happened for everyone

involved in the company * * * [as well as] the shareholders”. Mr. Coneys testified

that Delaware: (1) “created a state tax benefit”; (2) was a necessary part to

accomplish the overall plan; and (3) provided centralized management and currency

controls.

Petitioners have not explained what “state tax benefit” they are referring to,

and as noted supra, we will not attempt to do their research or make their argument

for them. Furthermore, while we recognize that many large corporations create

financing subsidiaries for various legitimate nontax business reasons, petitioners’
 - 54 -

[*54] inability to show that the form of the plan was respected, discussed infra,

renders any further consideration of petitioners’ “cash management” argument

moot.

c. Substance of the Reinvestment Plan

As indicated, petitioners’ inability to show that the form of the reinvestment

plan was respected further undermines any legitimate nontax business purpose for

including Bermuda and Delaware in the plan. First, the Delaware loans were not

bonafide loans. While Barnes and Delaware complied with the initial formalities

of a bonafide loan, mainly signing written loan agreements and recording the

transactions on their respective financial statements, they failed to show that they

complied with the terms of the written agreements. The Delaware loans required

Barnes to make annual interest payments; however, as of December 31, 2010, the

loan balance had ballooned to over $127 million. Petitioners assert that Barnes

made over $8 million in interest payments during that period. They support their

argument by comparing (a) the Delaware loan balance reported on Barnes’ 2010

tax return with (b) what petitioners compute the 2010 loan balance would have

been if no interest payments had been made. The difference, petitioners attest,

represents interest payments. Nonetheless, petitioners do not identify any interest

payments recorded in Barnes’ or Delaware’s general ledgers or bank statements.
 - 55 -

[*55] Not only is petitioners’ supporting evidence far from sufficient; even if Barnes

had made over $8 million in interest payments as of December 31, 2010, this amount

is far short of the aggregate 7.5% annual interest payments required over that

period.42

It is less clear whether Delaware made any preferred dividend payments to

Bermuda. Petitioners rely on Forms 1042 and 1120-F to show that Delaware made

the preferred dividend payments to Bermuda; however, petitioners’ tax returns,

considered alone, are insufficient evidence to substantiate their position. See

Lawinger v. Commissioner, 103 T.C. 428, 438 (1994) (“Tax returns do not establish

the truth of the facts stated therein.”); Halle v. Commissioner, 7 T.C. 245 (1946),

aff'd, 175 F.2d 500 (2d Cir. 1949); Taylor v. Commissioner, T.C. Memo. 2009-235.

Moreover, petitioners failed to identify any of these transactions in Delaware’s or

Bermuda’s general ledgers or bank statements, nor did they produce a Delaware

board resolution declaring a preferred dividend. Finally, because, as we concluded,

Barnes failed to show it made any interest payments to Delaware, Delaware was

financially incapable of making the purported preferred dividend payments to

Bermuda.

42
For example, after the completion of the reinvestment plan in 2001,
Delaware had purportedly lent Barnes $67,605,000. After two full years Barnes
would have been required to make over $10 million in interest payments.
 - 56 -

[*56] d. Conclusion

In the light of the fact that petitioners bear the burden of proof and that the

reinvestment plan deserves extra scrutiny, petitioners’ vague assertions regarding

Singapore law impediments, State tax benefits, and cash management are insufficient

to support a finding that Bermuda and Delaware were created for legitimate nontax

business purposes. Furthermore, petitioners have not shown that they respected the

form of the reinvestment plan. Accordingly, we conclude that Bermuda and

Delaware did not have a valid business purpose and that the various intermediate

steps of the reinvestment plan are properly collapsed into a single transaction under

the interdependence test.

While petitioners assert that the reinvestment plan was always intended to be a

temporary structure, the objective facts suggest otherwise. ASA transferred a

substantial amount of cash to Barnes (funneled through Bermuda and Delaware)

which Barnes used to pay off its debt. Barnes has not shown that it returned any of

ASA’s funds. We find that the reinvestment plan was in substance dividend

payments from ASA to Barnes in 2000 and 2001, taxable under section 301.

VI. IBM Agreement and Section 109

In the petition petitioners argued that Barnes incorrectly included the value

of the clean rooms in 2001 income after those clean rooms were quitclaimed by
 - 57 -

[*57] IBM to Barnes during that year. Rather, petitioners claim that the value of the

clean rooms is excluded from income under section 109.

Section 109 provides that “[g]ross income does not include income (other than

rent) derived by a lessor of real property on the termination of a lease, representing

the value of such property attributable to buildings erected or other improvements

made by the lessee.” Petitioners claim that the 1985 agreement operated in

substance as a lease of Barnes’ warehouse by IBM, during which IBM had the clean

rooms constructed in the warehouse (by Barnes). Petitioners argue that this lease

ended when IBM quitclaimed the clean rooms to Barnes in 2001, and section 109

thus applies to Barnes’ receipt of the clean rooms. Respondent asserts that the 1985

agreement is purely a services agreement and that section 109 is inapplicable. We

agree with respondent that section 109 does not apply in this case.

The Court of Appeals for the Second Circuit has stated that “A ‘lease’ is a

contract conveying a temporary interest in real property, with reversion to the

grantor.” Resolution Trust Corp. v. Diamond, 45 F.3d 665, 673 (2d Cir. 1995). The

court in Resolution Trust also stated--

A lease is a species of contract--an “agreement which gives rise to [the]
relationship of landlord and tenant.” * * * The “tenant” is “one who
has the temporary use and occupation of real property owned by
 - 58 -

[*58] another person, (called the ‘landlord,’) the duration and terms of
his tenancy being usually fixed by an instrument called a ‘lease.’” [Id.
at 672-673 (citations omitted) (quoting Black’s Law Dictionary 1035,
1635 (4th ed. 1951)).]

Because this case is appealable to the Court of Appeals for the Second Circuit, we

choose to follow that court’s precedent. See, e.g., Golsen v. Commissioner, 54 T.C.

742, 757 (1970), aff’g, 445 F.2d 985 (10th Cir. 1971).

After reviewing the 1985 agreement and other facts of the case, we find that

the 1985 agreement did not operate as a lease of Barnes’ warehouse by IBM.

Crucial in our determination is the fact that Barnes not only constructed the clean

rooms in its warehouse, but also maintained control of and used those clean rooms

for approximately 16 years making green sheets for IBM. In return Barnes was

paid by IBM for its services; these payments reimbursed Barnes for all direct and

indirect costs as well as a 10% fee. Although IBM had legal ownership of the

clean rooms, Barnes was the party using those clean rooms in its own warehouse

for its own benefit. The fact that the clean rooms were stored in the warehouse

may have provided some indirect benefits to IBM (such as protection from the

elements), but the direct benefit was to Barnes, which was able to use the clean

rooms to obtain a profit as a result of its deal with IBM. We thus believe that IBM
 - 59 -

[*59] was not using or occupying Barnes’ warehouse and was therefore not a tenant

to a lease.

We further note that Barnes and IBM did not label the 1985 agreement a

lease, and petitioners have provided no evidence that the parties ever used that term

with regard to the clean room arrangement. Considering the facts, we find that the

1985 agreement did not operate as a lease of Barnes’ warehouse to IBM and that

section 109 is inapplicable.

VII. Section 6662(a) Accuracy-Related Penalty

Respondent determined that petitioners are liable for 20% accuracy-related

penalties under section 6662(a) and (b)(1) for negligence or disregard of rules and

regulations, or in the alternative, under section 6662(a) and (b)(2) for substantial

understatements of income tax. Respondent determined that these penalties should

apply for 1998,43 2000, and 2001. Petitioners contest the imposition of

accuracy-related penalties on grounds that they had substantial authority for their

43
The penalty for a substantial understatement of income tax applies to any
portion of an underpayment in a carryback year that is attributable to a “tainted
item” in the year the carryback loss arose (loss year). Sec. 1.6662-4(c)(1), Income
Tax Regs. The determination of whether an understatement is substantial for a
carryback year is made with respect to the return of the carryback year. Id.
“Tainted items” are taken into account with items arising in a carryback year to
determine whether the understatement is substantial for that year. Id. A “tainted
item” is any item for which there is neither substantial authority nor adequate
disclosure with respect to the loss year. Sec. 1.6662-4(c)(3)(I), Income Tax Regs.
 - 60 -

[*60] position and that they reasonably and in good faith relied on the PwC opinion

letter.

Under section 7491(c), the Commissioner bears the burden of production with

regard to penalties and must come forward with sufficient evidence indicating that it

is appropriate to impose penalties. See Higbee v. Commissioner, 116 T.C. 438, 446

(2001). However, once the Commissioner has met the burden of production, the

burden of proof remains with the taxpayer, including the burden of proving that the

penalties are inappropriate because of reasonable cause or substantial authority under

section 6664. See Rule 142(a); Higbee v. Commissioner, 116 T.C. at 446-447.

Considering the facts of the case, we find respondent has met his burden of

production with respect to the accuracy-related penalties.

Section 6662(a) and (b)(1) and (2) imposes a 20% penalty on the portion of

an underpayment of tax (1) attributable to a substantial understatement of income

tax or (2) due to negligence or disregard of rules or regulations.44 Section 6662(c)

defines “negligence” as any failure to make a reasonable attempt to comply with

44
Only one accuracy-related penalty may be applied with respect to any given
portion of an underpayment, even if that portion is subject to the penalty on more
than one of the grounds set forth in sec. 6662(b). Sec. 1.6662-2(c), Income Tax
Regs.
 - 61 -

[*61] the provisions of the Code, and “disregard” as any careless, reckless, or

intentional disregard. A substantial understatement of income tax is defined as an

understatement that exceeds the greater of 10% of the tax required to be shown on

the tax return or $10,000. See sec. 6662(d)(1)(A). However, the understatement is

reduced to the extent that the taxpayer has (1) adequately disclosed his or her

position and has a reasonable basis for such position or (2) has substantial authority

for the tax treatment of the item. See sec. 6662(d)(2)(B). Petitioners have not

asserted that there was adequate disclosure of their position on the Forms 1120 for

2000 and 2001.

A. Substantial Authority

We previously concluded that the reinvestment plan was in substance

dividends from ASA to Barnes, taxable under section 301. In the absence of

substantial authority supporting their tax treatment of the reinvestment plan,

petitioners would agree that the understatements of tax for all years in issue exceed

the greater of 10% of the tax required to be shown on the returns or $10,000.

However, petitioners argue that there was no understatement of tax for any year

because they had substantial authority for the tax treatment of their plan. See sec.

6662(d)(2)(B).
 - 62 -

[*62] The substantial authority standard is an objective standard less stringent than

the more likely than not standard (the standard that is met when there is a greater

than 50% likelihood of the position’s being upheld). Sec. 1.6662-4(d)(2), Income

Tax Regs. There is substantial authority for the tax treatment of an item only if the

weight of all relevant authorities supporting the treatment is substantial in relation to

the weight of authorities supporting contrary treatment. Sec. 1.6662-4(d)(3)(I),

Income Tax Regs. The weight accorded an authority depends on its relevance and

persuasiveness and the type of document providing the authority. Sec. 1.6662-

4(d)(3)(ii), Income Tax Regs. For example, a case or a revenue ruling having some

facts in common with the tax treatment at issue is not particularly relevant if the

authority is materially distinguishable on its facts. Id.

Petitioners’ assert that Rev. Rul. 74-503, supra, and sections 358, 362, 1032,

and 956 provide substantial authority for their position.45 We disagree. As

discussed supra, the reinvestment plan involved a substantial amount of additional

fact not considered in the revenue ruling--the two are materially distinguishable on

their facts. Accordingly, petitioners’ position is afforded little weight. Moreover,

we have long recognized that a transaction lacking in substance will not be

45
Petitioners also cite G.C.M. 34998 (Aug. 23, 1972) to support their
position; however, general counsel memorandums over 10 years old are afforded
very little weight. See sec. 1.6662-4(d)(3)(ii), Income Tax Regs.
 - 63 -

[*63] respected for Federal income tax purposes. See, e.g., Frank Lyon Co., 435

U.S. at 573; Minn. Tea Co. v. Helvering, 302 U.S. 609, 613-614 (1938); Gregory

v. Helvering, 293 U.S. 465; Horn v. Commissioner, 968 F.2d 1229, 1236 (D.C. Cir.

1992), rev’g Fox v. Commissioner, T.C. Memo. 1988-570; see also CMA Consol.,

Inc. & Subs. v. Commissioner, T.C. Memo. 2005-16 (“Numerous courts have held

that a transaction that is entered into primarily to reduce tax and which otherwise

has minimal or no supporting economic or commercial objective, has no effect for

Federal tax purposes.”).

Considering the long history of the substance over form doctrine in

combination with petitioners’ inability to establish their business purpose for

Bermuda or Delaware, we find that petitioners’ reference to a factually dissimilar

revenue ruling has insufficient weight to support a finding that petitioners had

substantial authority for their tax treatment of the reinvestment plan.

B. Reasonable Cause and Good Faith

The section 6662(a) accuracy-related penalty does not apply to any portion

of the underpayment as to which the taxpayers establish that they acted with

reasonable cause and in good faith. See sec. 6664(c)(1); Neonatology Assocs.,

P.A. v. Commissioner, 115 T.C. 43, 98 (2000), aff’g, 299 F.3d. 221 (3d Cir. 2002).

The decision as to whether the taxpayer acted with reasonable cause and in good
 - 64 -

[*64] faith depends upon all the pertinent facts and circumstances, including the

taxpayer’s efforts to assess his proper tax liability, the taxpayer’s knowledge and

experience, and the reliance on the advice of a professional. See sec. 1.6664-

4(b)(1), Income Tax Regs. For a taxpayer to reasonably rely on the advice of a

professional so as to possibly negate a section 6662 accuracy-related penalty, the

taxpayer must prove by a preponderance of the evidence that he meets each

requirement of the following three-prong test: (1) the adviser was a competent

professional who had sufficient expertise to justify reliance; (2) the taxpayer

provided necessary and accurate information to the adviser; and (3) the taxpayer

actually relied in good faith on the adviser’s judgment. Neonatology Assocs., P.A.

v. Commissioner, 115 T.C. at 99.

Respondent does not dispute PwC’s expertise or whether petitioners provided

all necessary and accurate information to PwC. Respondent’s argument focuses on

the third factor--that petitioners did not actually rely in good faith on PwC’s advice.

We agree with respondent.

The opinion letter provided to petitioners from PwC discusses tax

implications of the reinvestment plan. However, as previously discussed,

petitioners did not respect the structure of the reinvestment plan. In particular,
 - 65 -

[*65] Bermuda’s preferred stock investment in Delaware and Delaware’s loan to

Barnes were not respected as bona fide transactions.

The reinvestment plan involves a complex and technical area of law in which

precision is required. However, petitioners did not act in accordance with the

specific requirements of the plan as stated in the PwC opinion letter. Petitioners’

employees (Mr. DeForte in particular) were highly knowledgeable people who

knew what they were doing and who thoroughly reviewed the reinvestment plan and

opinion letter. By failing to respect the details of the reinvestment plan set up by

PwC, we find that petitioners have forfeited any defense of reliance on the opinion

letter issued by PwC.

For the reasons discussed herein, we find that petitioners did not reasonably

and in good faith rely on the PwC opinion letter and are liable for the section 6662

accuracy-related penalty for each year in issue.

VIII. Conclusion

We conclude that the reinvestment plan was in substance dividend payments

from ASA to Barnes in 2000 and 2001, taxable under section 301. We also hold

that the value of the clean rooms is not excludable from Barnes’ 2001 income under

section 109. We further hold that petitioners are liable for the section 6662(a)

accuracy-related penalties.
 - 66 -

[*66] In reaching our holdings herein, we have considered all arguments made by

the parties, and, to the extent not mentioned above, we conclude they are moot,

irrelevant, or without merit.

To reflect the foregoing,

Decision will be entered

under Rule 155.