Double dipping is “alive and well . . . with a little bit of finesse,” said one tax expert after a federal district court decision in late October.
He was not suggesting the company involved in the case was itself involved in double dipping, but that the court’s reasoning opened the door to such transactions.
Berkshire Hathaway borrowed $750 million in four debt offerings in the late 1980’s and used the money to inject capital into a reinsurance subsidiary, National Indemnity Company, in an effort to turn the company into a major player in the reinsurance market.
When a domestic corporation pays dividends to a US parent, the parent company does not have to pay income taxes on 70%, 80% or 100% of the dividend depending on the circumstances. That’s often because the parent can claim a “dividends-received deduction.”
Congress became concerned in the 1980’s about situations where a corporation borrows to buy stock in another company. In such cases, not only does it not have to pay taxes in full on the dividends it receives from the company whose stock it purchased, but it also has a deduction for interest it pays on the debt to acquire the stock. This leaves it with very little tax exposure.
Congress became unhappy about this “double dipping” of interest and dividends-received deductions after T. Boone Pickens used it to make a run at Gulf Oil. Congress tried to put a halt to the practice in 1984. Section 246A of the US tax code, enacted that year, reduces the dividends-received deduction to the extent that a corporation borrows money to buy stock in another corporation. The parent must own at least 50% of the other corporation for the limits to apply (except in some cases where the threshold is as low as 20%).
In Berkshire Hathaway’s case, the IRS read a Forbes magazine article suggesting that the company uses its insurance subsidiaries to hold preferred stock and receive partially-taxed dividends. The IRS assigned an agent to the case. The agent spent three years purporting to trace the four borrowings in the late 1980’s to stock that Berkshire Hathaway bought around the same time as the borrowing and directed the company to pay $16 million in back taxes and interest.
A federal district court rejected the IRS claim in late October. The agent basically assumed that the money went into shares in other companies that Berkshire Hathaway purchased around the same time on the theory that money is fungible and because the parent company was fairly diligent about keeping spare cash anywhere in the Berkshire Hathaway group fully invested. The judge said this was too thin a connection. Borrowing must be “directly traceable” to a purchase of shares in another company in order for section 246A to apply. The judge said he realized this reading of the statute makes it “virtually impossible” for the IRS to apply section 264A against big companies that have lots of transactions, but any decision to loosen the direct connection must come either from Congress or from the IRS through exercise of its authority to issue regulations. The case is OBH, Inc. v. United States. It was one of first impression for the courts.
The IRS is currently proposing to change its regulations to adopt a pro rata allocation rule to determine the use of borrowings that are not traceable to a specific use. It proposed the change in May 2004.