Directly Traceable Prong Test
Background
In Revenue Ruling 88-66, the service examines three fact patterns in order to determine if the each one would fall under the control of §246A. Each of the fact patterns are provided below, followed by the Ruling’s analysis and then an examination of how it applies to the case.
The first scenario is:
X corporation owned portfolio stock, as defined insection 246A(c)(2) of the Code, as well as certain other liquid assets, including cash, that it had on hand to meet its reasonably anticipated business needs. X acquired a new facility to meet the needs of its growing business and borrowed to finance its acquisition, rather than selling its portfolio stock and other liquid assets. *X’*s portfoliostock was not used as collateral for the loan, which was secured by the new facility. It was customary to use a mortgage loan for such acquisitions, and there were no other factors indicating such loan was obtained to facilitate the continued carrying of the portfolio stock.
In this scenario, even though the corporation could have sold the stock in order to acquire the property, or used the stock to secure the loan, the fact that it was not sold or used to secure the debt, does not indicate that there is a direct connection between the stock and the debt. Since it is common to finance an acquisition through the use of mortgage, it is reasonable to use that method instead of using the stock.
While these facts do not relate directly to the OBH case, there was no acquisition made, and the stock was purchased after the debt was incurred, the decision does point to the fact that the norms for the industry are used in determining if there is a direct attribution between stock and debt. Berkshire used debt to recapitalize, and use the stock as a temporary investment of excess funds. Both of these activities are common, especially within a Berkshire company.
The second scenario is:
Y corporation was engaged in the active conduct of a business. Y intended to begin construction of a new plant within the next 18 months and wished to finance the plant using long-term debt. Because the market conditions were favorable for a debt offering, Y issued its debt in advance of the planned construction and temporarily invested the proceeds it received in portfolio stock, as defined in section 246A(c)(2) of the Code.
In this scenario, the service found that the holding period of the stocks did not matter in whether the debt was attributable to it. When ignoring the holding period, it is obvious that the purchase of the stock is directly attributable to the proceeds of the debt.
In the OBH case, Berkshire did not claim that the temporary nature of the investment would preclude any attribution. However, the service is not able to make a temporal argument in order to support their case.
The third scenario is:
Z Bank was wholly owned by, and filed a consolidated return with, Parent holding company. Z Bank was chartered in state A, which precludes banks from investing in stock. Z Bank received deposits from its customers in the ordinary course of its business and not for the specific purpose of purchasing portfolio stock as defined in section 246A(c)(2) of the Code. Z Bank made a loan to Parent, so that Parent could invest the loan proceeds in portfolio stock, and Parent made this investment. There were no other circumstances demonstrating a direct connection between the deposits received by ZBank and the funds that it loaned to Parent which Parent invested in portfolio stock.
In this case, the IRS determined that the debt was not directly related, since the debt is that of Z, and the stock is purchased by the Parent. While the Parent purchased the debt with the loan from Z, intercompany loans do not provide the tax avoidance strategy that §246A is meant to prevent. In OBH, this example is very unlikely to apply. OBH’s debt was not incurred during the ordinary course of business; OBH was not in the business of receiving deposits for notes, like the bank in the example. In addition, OBH purchased the stock, not OBH’s parent.
While the Revenue Ruling does provide a starting point, the scenarios are not conclusive in what to do with the OBH case. Next, the court looked at the language of the statute and applied the plain language meaning of the statute.