The Tax Court Rules That Cash Received From Foreign Subsidiary In A “Reinvestment Plan” Was Really A Taxable Dividend

Barnes Group, Inc. (“Barnes”) faced a common problem.  It needed cash; its foreign subsidiaries either had cash or could borrow on favorable terms.  But if the foreign subsidiaries paid a dividend to or invested in stock or debt of Barnes, that would be taxable income.  Its tax advisors designed a “reinvestment plan” that moved approximately $62 million worth of foreign currency back to the United States, as a tax-free investment in a new subsidiary.  On April 16th, the Tax Court issued its opinion in Barnes Group, Inc. v. Commissioner, holding that Barnes had received a taxable dividend instead and confirming a 20% penalty.

The source of cash was a Singapore subsidiary, ASA.  To implement the plan, Barnes formed two new subsidiaries – “Delaware” and “Bermuda.”  Then the parties executed a complex transaction with multiple steps.  A simplified version of the primary components:

1. ASA accumulated $62 million worth of foreign currency from its retained earnings, a bank loan, and collecting on receivables from English and French affiliates. 
2. ASA transferred the foreign currency to Bermuda in return for Bermuda’s common stock.
3. Bermuda transferred the foreign currency and its common stock to Delaware in return for Delaware’s preferred stock.
4. Delaware converted the foreign currency to US dollars and loaned the amount to Barnes.  Barnes used the proceeds to pay off other debt and apparently never repaid Delaware.

The accumulated foreign profits of ASA, for which Barnes had not been previously taxed, returned to the US in the third step above.  If the transfer had been directly to Barnes, it would clearly have been taxable.  Barnes argued that it was not taxable because it was transferred to Delaware instead. 

Under Section 951 and Section 956 of the Code, a US shareholder of a controlled foreign corporation is taxed on its pro rata share of the controlled foreign corporation’s earnings that are invested in U.S. property, including stock of a U.S. corporation.  Section 956(a) of the Code limits the amount taxable to the US shareholder (Barnes) to the controlled foreign corporation’s (Bermuda) adjusted basis in US property (Delaware’s stock).  Barnes relied on Revenue Ruling 74-503, which stated that when two corporations exchange their own stock, their basis in the stock received is $0.  Therefore, Bermuda could transfer $62 million worth of foreign currency, representing a portion of ASA’s accumulated profits, to Delaware without triggering US income tax.  Neither the IRS nor the court agreed. 

The court rejected Barnes’ reliance on the Revenue Ruling finding that Barnes’ facts were considerably different from those in the Revenue Ruling.

Alternatively, the court concluded that the transaction should be treated as a taxable dividend from ASA under the step-transaction doctrine.  The interim steps involving Bermuda and Delaware could be disregarded because Barnes did not convince the court that those entities had a business purpose other than to avoid tax liability.  Further, the court was not persuaded that Barnes had even followed the form of the transaction.  There was insufficient evidence that Barnes had paid Delaware any interest on the loan or that Delaware made required preferred dividend payments to Bermuda.

This case may have implications for other structured transactions.  For more information about the case and how it might affect you, please contact one of the undersigned or any of the tax lawyers at Thompson & Knight.

- Bob Probasco, Thompson & Knight LLP
- Mary McNulty, Thompson & Knight LLP
- Lee Meyercord, Thompson & Knight LLP