Dividends-received deduction from portfolio stock.

One of Congress's goals is preventing taxpayers from taking undue advantage of the tax rules. To that end it passed IRC section 246A, which prevents corporations from claiming a dividends-received deduction against dividends from stock purchased using debt that generates an interest expense deduction.

To make its insurance subsidiary a leader in the field, OBH Inc. (formerly Berkshire Hathaway) borrowed $750 million in four separate transactions. The company deposited these loans in the subsidiary's bank account, which contained all the subsidiary's other funds. The subsidiary then used this account to purchase stocks and bonds.

During its investigation, the IRS "traced" the company's borrowed funds to several of its dividend-paying stock purchases and then invoked section 246A to reduce the corporation's dividends-received deduction. The taxpayer objected to the "tracing."

Result. For the taxpayer. Section 246A limits the dividends-received deduction for "portfolio stock" when there is related "portfolio indebtedness." Portfolio stock includes any stock owned by a corporation unless the corporation owns at least 50% of its outstanding stock; both sides agreed the dividend-paying stock at issue was portfolio stock.

"Portfolio indebtedness" refers to indebtedness that is directly attributable to an investment in portfolio stock. The tax code does not define "directly attributable." In the Congressional Record, however, the phrase describes a direct relationship between the debt and the stock purchase--the company either incurs the debt to purchase the stock or the debt is directly traceable to the stock purchase.

OBH said the first of these tests did not apply as it had borrowed the funds to expand its insurance subsidiary. The government claimed the subsidiary was adequately capitalized and, therefore, that OBH had borrowed the money to buy stock. The district court rejected the government's argument. Because, in this case, there was no evidence of a prearranged plan, the court accepted OBH's claim that it had borrowed the money simply to expand its insurance subsidiary.

Since the government failed to prove the debt was incurred to purchase the stock as required by the first test, it argued that the borrowed funds were directly traceable to the stock purchase as required by the second. The government supported its "indirect" tracing approach by arguing that cash is fungible. The court found, however, that Congress had rejected the fungibility-of-cash doctrine when it used the "directly traceable" language in the legislation rather than an allocation formula.

Further, both the Congressional Record and the sole revenue ruling on point illustrate the provision with examples in which the taxpayer uses the actual borrowed funds to acquire the stock. In addition the taxpayer's expert demonstrated that the company did not have to use the borrowing solely to purchase stock; it could have used the money to purchase many other items. Based on this evidence, the court held that these funds were not directly traceable to the purchases.

This decision clarifies the scope of section 246A. For this section to apply, either the company must incur the borrowing to buy the stock or the purchase must be directly traceable to the borrowing. If the taxpayer demonstrates a business reason for the debt and shows the corporation did not use the funds for purchase, the borrowing should fall outside the section's provision.

* OBH, Inc. v. United States, DC Neb. 2005, U.S. Dist. LEXIS 29382.

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.