CCA 200031007: Assigned income creates constructive dividends for common shareholders

Plain-English summary

A domestic corporation routed income from customer payments through an unrelated intermediary to a foreign corporation with substantially the same shareholders. Chief Counsel treated the arrangement as a sham assignment of the domestic corporation's income that gave a direct benefit to its shareholders. It advised treating the diverted payments as constructive dividends to those shareholders, followed by their capital contributions to the foreign corporation. The advice did not need to apply section 482 because it viewed the arrangement as a sham. It also concluded that shareholders who did not report the dividends in closed years could not later claim a related increase in their stock basis under the duty of consistency.

Ruling snapshot

• Question: Did diverted corporate income produce constructive dividends to the common shareholders and capital contributions to the recipient corporation?
• Outcome: Advice given; the payments were constructive dividends followed by shareholder capital contributions.
• Key authorities: IRC §§ 118, 316, and 482; Rev. Rul. 69-630; Rev. Rul. 78-83.

Full text (IRS public release)

                             DEPARTMENT OF THE TREASURY
                               I N T E R N AL R E V E N U E S E R V I C E
                                    WASHINGTON, D.C. 20224


                                                                        CC:INTL:Br6

Number: 200031007
Release Date: 8/4/2000
                                   April 17, 2000


UILC: 301.07-00; 482.22-02

                       INTERNAL REVENUE SERVICE
                  NATIONAL OFFICE FIELD SERVICE ADVICE


MEMORANDUM FOR


FROM:                  STEVEN A. MUSHER, Chief, Branch 6, CC:INTL

SUBJECT:


This Field Service Advice responds to your request for Field Service Advice
dated December 17, 1999. Field Service Advice is not binding on Examination or
Appeals and is not a final case determination. This document is not to be used or
cited as precedent.

LEGEND:
a                  =
b                  =
c                  =
Agency             =
Allowances         =

Authorizations     =
Corporation A      =
Corporation B      =
Corporation C      =
Corporation D      =

Costs              =

Country            =
Customers          =
Date A             =
Date B             =
Date C             =
Date D             =
Entities           =
Events             =
Individuals        =

Items              =
Owners             =

Payments           =

Permits            =
Service A          =
Service B          =

Service C          =

Service D          =
Service E          =
Status             =
Year 1             =
Year 2             =


ISSUE:

Whether a consequence of the sham transaction and assignment of income in this
case is a constructive dividend from Corporation A to its shareholders, and a capital
contribution from the shareholders to Corporation C.



CONCLUSION:

The assignments of income from Corporation A to Corporation C were distributions
from corporate earnings that yielded direct benefits to the common shareholders of
Corporation A and Corporation C. Accordingly, the payments should be classified
as constructive dividends to the shareholders of Corporation A, and subsequent
contributions by those shareholders to the capital of Corporation C.



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FACTS:

Background

Corporation A is a domestic provider of Service A to Customers. At issue in this
Field Service Advice are substantially all tax years subsequent to Year 1.

Pursuant to Authorizations and various Permits from Agency, Corporation A
provided Service B to all Customers, in conjunction with Service A. If a Customer
also desired Service C, he made Payments to Corporation A. Historically,
Corporation A included these Payments in its gross income.

On Date A, Corporation A formed a wholly-owned Country subsidiary, Corporation
B, the name of which was subsequently changed to Corporation C. On Date B,
after several capital contributions by Corporation A to Corporation C, Corporation A
declared a taxable dividend of one share of Corporation C stock per share of
Corporation A stock, to be paid to Corporation A shareholders-of-record as of Date
C. Corporation A held a minority interest in Corporation C, consisting of a% of the
shares outstanding on Date D. The proportionate ownership of the individual
shareholders in Corporation C was similar, but not identical, to that of the individual
shareholders in Corporation A.

From time to time, Corporation A obtained from Individuals shares of Corporation
C. However, in general, Corporation A later distributed such shares to Owners,
thereby eliminating its ownership of Corporation C shares for each year at issue.
Although the shares of Corporation C could be transferred, the right of transfer was
limited. On any particular date, the shareholders of Corporation A were
substantially identical to the shareholders of Corporation C, although the
proportionate ownership interest of a particular shareholder in Corporation A and
Corporation C would likely not be identical. Some shareholder divergence was also
attributable to intra-family and charitable gifts of shares, as well as some stock
redemptions by Corporation A.

During the years at issue, Corporation A had substantial earnings and profits.
Thus, any distributions of property by Corporation A to its shareholders would
constitute dividends for Federal income tax purposes.

Transaction

Prior to Year 1, Corporation A had obtained from Entities proposals for alternative
methods of treating Payments. In order to implement one of these proposals,


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Corporation A formed the corporation that came to be known as Corporation C, in
the manner described above.

Starting in Year 1, Corporation A decided to shift the Payments earned for Service
C to Corporation C. As a means of shifting this income, Corporation A entered into
a contract with an unrelated party, Corporation D, whereby the latter agreed to
provide Service D to Corporation A in connection with Corporation A’s performance
of Services A and C to its customers. Corporation A in turn agreed to pay
Corporation D the income from the Payments that were earned from Service C, net
of Costs incurred by Corporation A. Corporation A then deducted the net Payments
remitted to Corporation D on its income tax return.

In order to transfer the net Payments to Corporation C, Corporation D entered into
a contract with Corporation C whereby the latter agreed to perform Service E for
Corporation D. In exchange for this service, Corporation D paid Corporation C b%
of the Payments Corporation D received from Corporation A, less certain expenses
and fees charged by Corporation D. Hence, Corporation D acted merely as an
intermediary for transferring the Payments, less certain expenses and fees, to
Corporation C. While Corporation D and Corporation C agreed to perform Services
D and E for the benefit of Corporation A, neither entity assumed Costs in
connection with Events. Instead, Costs were assumed by Corporation A as Events
occurred.

Under the newly-structured transaction, Corporation A attempted to avoid Federal
income tax on Payments, and Corporation C accumulated investment income from
those amounts in Country, without imposition of either Country tax or U.S. income
tax on a current basis on Corporation A, Corporation C, or the shareholders. The
restructuring was performed for the purpose of avoiding tax, and the arrangement
between Corporation A, Corporation C, and Corporation D lacked economic
substance and business purpose. The purpose of the arrangement with
Corporation D and Corporation C was to confer tax-free benefits on the
shareholders of Corporation A and Corporation C. The arrangement was a sham
that involved an assignment of income from Corporation A to Corporation C.
Accordingly, Corporation A is not entitled to deduct the net Payments remitted to
Corporation D pursuant to their contract.


LAW AND ANALYSIS:

The correct characterization of excessive payments between corporations under
common ownership arises in several contexts, including I.R.C. §§ 61, 162, and


                                        -4-
482.1 To date, the courts have not articulated a single rule to govern the
classification of such payments in all cases. Rather, the facts in each case must be
examined in order to determine the correct characterization of the payments.

Section 316(a) of the Code provides that any distribution of property made by a
corporation to its shareholders out of earnings and profits (accumulated after
February 28, 1913) is a dividend. In general, a distribution by a corporation, or a
payment by a corporation for the benefit of a shareholder, whether or not it is
formally declared as a distribution, will, in the absence of a corporate business
purpose, constitute a constructive dividend to the shareholder.

An undeclared distribution by a corporation may be treated as a constructive
dividend to the shareholder if it is made for the shareholder’s direct benefit. In such
cases, the distribution need not be made directly to the shareholder, but may be
made to another party. Rapid Electric Co. v. Commissioner, 61 T.C. 232, 239
(1973).

In Rev. Rul. 69-630, 1969-2 C.B. 112, the Service treated an excessive payment
between brother-sister corporations as a dividend to the common shareholders, and
a capital contribution by the shareholders to the related corporation that received
the excessive payment. In the revenue ruling, individual A caused his wholly-
owned corporation, X, to sell certain assets at a less than arm’s length price to
another corporation wholly-owned by him, Y. A principal purpose of the sale was
the avoidance of Federal income tax. The Commissioner made an allocation of
income pursuant to section 482, in order to reflect an arm’s length price. The effect
of this allocation was to increase X’s income and Y’s basis in the transferred
assets. This increase was treated as a distribution to A with respect to his X stock,
and a capital contribution by A to Y.

Rev. Rul. 78-83, 1978-1 C.B. 79, held that if property is transferred from brother
corporation to a sister corporation without adequate consideration, a constructive
distribution has been made to the common parent, regardless of whether a motive
existed for improper allocation of income or deductions between the corporations.

Some courts have applied a “demonstrable business interest” theory. For example,
in Knipe v. Commissioner, T.C. Memo. 1965-131, aff’d per curiam sub nom.
Equitable Publishing Co. v. Commissioner, 356 F.2d 514 (3rd Cir. 1966), cert.
denied, 385 U.S. 822 (1966), the Tax Court held that where payments by a brother


      1
        Because the arrangement was a sham and an assignment of income, we need
not consider how section 482 might apply.

                                          -5-
to a sister corporation, purportedly for services, lacked a valid transferor business
purpose, they constituted constructive dividends to the common shareholders.

Courts often require a showing of direct benefit as a prerequisite for finding a
constructive dividend to the common shareholder(s). For example, in Rushing v.
Commissioner, 52 T.C. 888 (1969), aff’d, 441 F.2d 593 (5th Cir. 1971), the Service
argued that a transfer of cash between brother-sister corporations was a
constructive dividend to the common shareholder, and a contribution of capital to
the transferee corporation. Because the Tax Court viewed the benefit to the
common shareholder to be merely derivative, it held there was no constructive
dividend. Rushing, 52 T.C. at 894.

In White Tool v. Commissioner, T.C. Memo. 1980-443, aff’d, 677 F.2d 528 (6th Cir.
1982), cert. denied, 459 U.S. 907 (1982), a profitable brother corporation made
excessive payments to its loss sister corporation for rental of four motor vehicles
and an airplane. The Commissioner determined an arm’s length rent, allocated the
excessive rent from the loss corporation to the profitable corporation, and classified
the greater than arm’s length amount as a constructive dividend to the common
shareholders of the two corporations. Although the Tax Court upheld the primary
allocation of income pursuant to section 482, it viewed the benefits to the
shareholders as derivative in nature, and declined to find a constructive dividend.
See also R.T. French Co. v. Commissioner, 60 T.C. 836, 855-56 (1973)
(shareholder benefit was derivative; no constructive dividend to common parent of
brother-sister corporations that engaged in non-arm’s-length transaction where
parent never received the income, and where actual dividends paid to parent
exceeded amount of asserted constructive dividends); Gulf Oil Corp. v.
Commissioner, 89 T.C. 1010, 1028 (1987), aff’d on this issue, 914 F.2d 396, 413
(3rd Cir. 1990) (payments from affiliates to parent, although not deductible as
insurance premiums, were not constructive dividends because they benefited the
affiliates).

In AOD 1982-077, the Service declined to acquiesce in White Tool, and stated that
in its view the existence of a constructive dividend should be determined, not based
on whether a direct benefit accrues to the shareholder, but based on “whether the
intercorporate transfer serves a demonstrable, legitimate business interest of the
transferor” (emphasis added). In this connection, an earlier decision, Gilbert v.
Commissioner, 74 T.C. 60 (1980), held that a valid business purpose for the
payment, although not controlling, is a significant factor under the direct benefit test.

A court might conclude, based on White Tool and Rushing, that the tax avoidance
benefits to the shareholders in this case are nevertheless only “derivative,” rather
than “direct,” such that no constructive dividends resulted to them. Although this

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case is arguably distinguishable in that the tax avoidance was egregious, it is
uncertain whether that distinction would compel a different outcome on the
constructive dividend issue. Regardless of whether the demonstrable business
interest or the shareholder direct benefit test applies, the result in this case is in our
view the same, namely a constructive dividend to the shareholders, followed by the
shareholders’ contribution to the capital of Corporation C.2

We have considered and eliminated for now, the potential alternative
characterizations of the excessive payments attributable to the assignments of
income in this case as either loans or as non-shareholder contributions by
Corporation A to Corporation C. Excessive payments (or other transfers of funds)
between commonly-controlled corporations generally will not be characterized as
debt unless the economic substance of the transaction indicates that the parties
intended to create indebtedness. Litton Business Systems, Inc. v. Commissioner,
61 T.C. 367, 377 (1973) (critical inquiry is whether there was "a genuine intention to
create a debt, with a reasonable expectation of repayment, and [whether] that
intention comport[ed] with the economic reality of creating a debtor-creditor
relationship."); Fin Hay Realty Co. v. United States, 398 F.2d 694, 697 (3rd Cir.
1968) (court must determine whether investment, analyzed in terms of economic
reality, is "risk capital subject to the fortunes of the corporate venture . . . or
represents a strict debtor-creditor relationship."); see also Geftman v.
Commissioner, 154 F.3d 61 (3rd Cir. 1998). In particular, a debt will not be found
unless there is an unconditional obligation, either express or implied, to repay the
funds in question. Fin Hay Realty, 398 F.2d at 696.

In Altama Delta v. Commissioner, 104 T.C. 424 (1995), the Service imputed interest
on certain intercorporate payments pursuant to section 482, and argued that the
amounts should be treated as debt. The IRS prevailed on that theory, primarily
because the taxpayer failed to carry his burden of showing that the amounts in
question were not debt. In the instant case there is no evidence, direct or indirect,
whether in terms of writings, course of conduct of the parties, or otherwise, of a debt
obligation. The transfers to Corporation C occurred at regular intervals over a
period of c years without any repayment, demand for repayment, or other evidence
that a repayment obligation existed.



       2
         Since, as noted above, section 482 need not be applied in this case, we do not
address the separate analysis of secondary adjustments to conform accounts to reflect
primary adjustments under section 482, pursuant to the regulations and applicable
revenue procedures. See generally Treas. Reg. § 1.482-1(g)(3); Rev. Proc. 99-32,
1999-34 I.R.B. 296, superseding Rev. Proc. 65-17, 1965-1 C.B. 833.

                                            -7-
Similarly, the facts known to date do not support characterizing the excessive
payments attributable to the assignments of income as non-shareholder
contributions by Corporation A to Corporation C. The legislative history of I.R.C.
§ 118 recognizes that contributions to capital may be made by persons other than
shareholders: “Section [118] deals with cases where a contribution is made to a
corporation by a governmental unit, chamber of commerce, or other association of
individuals having no proprietary interest in the corporation. In many such cases
because the contributor expects to derive indirect benefits, the contribution cannot
be called a gift; yet the anticipated future benefits may also be so intangible as to
not warrant treating the contribution as a payment for future services.” S. Rep. No.
1622, 83d Cong., 2d Sess. (1954). For example, a developer, local government, or
business organization may contribute property to a corporation in order to obtain a
specific benefit, such as the location of a business in a particular locality. E.g., May
Department Stores v. Commissioner, T.C. Memo. 1974-253, aff’d, 519 F.2d 1154
(8th Cir. 1975). In determining whether payments are capital contributions, courts
generally look to the intent of the transferor. Among the factors indicating that a
transfer is a contribution to capital are bargaining with respect to the amount
contributed and a likelihood that the contribution will result in additional income for
the transferor. While courts have found capital contributions where unrelated
parties made payments to induce some action by the corporation, or where
shareholders made payments to their corporation, no decision has found a capital
contribution where excessive payments were made between brother-sister
corporations.

Further, Corporation C’s assets include the net amount of Payments remitted by
Corporation A to Corporation D that were subsequently transferred to Corporation C.
As discussed above, the consequences of the determination that the income
belongs to Corporation A were constructive dividends to the shareholders, followed
by deemed contributions by the shareholders of the constructive dividend proceeds
to the capital of Corporation C. The capital contributions thus belong to Corporation
C.

This conclusion would be the same even if it were determined that the deemed
transfers constituted non-shareholder contributions by Corporation A to the capital of
sister Corporation C, rather than deemed contributions by the shareholders to the
capital of Corporation C. Under either characterization, from the perspective of
Corporation C, the transfers were capital contributions, and the resulting assets
belonged to Corporation C.

We note that, with respect to the basis of the Corporation C stock in the hands of
the shareholders, all taxable years prior to Year 2 are now closed for most individual
shareholders. To the extent that the shareholders failed to report income on

                                           -8-
account of the constructive dividends received from Corporation A in the closed
years, the duty of consistency would bar them from claiming a step-up in the basis
of their stock in Corporation C as a result of the deemed contributions of capital to
Corporation C.

The duty of consistency doctrine prevents a taxpayer, after taking a position in one
year that is to his advantage, and once an adjustment with respect to that year is
barred, from adopting a contrary position in a subsequent year. Johnston v. United
States, 605 F. Supp. 26, 28 (D. Mont. 1984). Thus, for example, a taxpayer who
benefited from a representation in one tax year may not reduce his tax in a
subsequent tax year by arguing, after the statute of limitations has run on the earlier
year, that his original representation was incorrect, and that more tax was due in the
now-closed year. See Herrington v. Commissioner, 854 F.2d 755, 758 (5th Cir.
1988), cert. denied, 490 U.S. 1065 (1989); Estate of Letts v. Commissioner, 109
T.C. 290 (1997). Thus, the duty of consistency prevents a taxpayer from obtaining a
permanent exclusion of income that is taxable, or from deducting the same expense
in multiple taxable years. Letts, 109 T.C. at 296.

The duty of consistency has three elements: (1) the taxpayer represented a fact or
reported an item for Federal income tax purposes for a particular year; (2) the
Service acquiesced in or relied upon the representation of fact or the reported item
for that year; and (3) the taxpayer attempts to change the representation or reporting
in a subsequent year, after expiration of the period of limitation, and the change is
detrimental to the Service. Herrington, 854 F.2d at 757; and Cluck v. Commissioner,
105 T.C. 324, 332 (1995).

A taxpayer’s inclusion or omission of a particular item on a tax return can be a
representation that the facts are consistent with how the item is reported. Thus,
failure to report a particular item of income may be an implied representation of fact
with respect to that item, which the taxpayer cannot repudiate at a later date. Letts,
109 T.C. at 300; Wentworth v. Commissioner, 244 F.2d 874, 875 (9th Cir. 1957)
(failure to report receipt of funds on an income tax return was a representation that
the funds were a loan repayment).

When the duty of consistency applies, the Commissioner may proceed as if the
original representation on which he relied continues to be true, even if it is not, and
the taxpayer is estopped from advancing a contrary position. Cleo Perfume, Inc. v.
Commissioner, T.C. Memo. 1998-155.

The duty of consistency does not apply to a mutual mistake of law, provided that
both the taxpayer and the Commissioner had knowledge of, or equal access to,
facts that would have alerted them to the mistake. Herrington v. Commissioner, 854

                                          -9-
F.2d at 758; Letts, 109 T.C. at 302; LeFever v. Commissioner, 100 F.3d 778, 788
(10th Cir. 1996); Estate of Ashman v. Commissioner, T.C. Memo. 1998-145; Ross v.
Commissioner, 169 F.2d 483, 496 (1st Cir. 1948) (taxpayer was entitled to change
position in second return to report constructive receipt of salary in an earlier year
because this was a question of law, not fact).

If the shareholders in the instant case failed to report dividend income in the years
prior to Year 2, they implicitly represented that the assignments of income from
Corporation A to Corporation C did not result in constructive dividends. This
position might have been reasonable if, for example, (under different facts) the
transfers had a valid business purpose, or if the shareholders did not directly benefit
from the transfers. On the facts of this case, however, the duty of consistency bars
the shareholders from disavowing the original representation.

Although the mistake in this case was legal in nature, the Commissioner did not
have equal access to the facts for the years that are now closed. In effect, the
Commissioner was led to rely on the belief that the transaction between Corporation
A and Corporation C constituted legitimate Service E, whereas in reality it was a
sham transaction and an assignment of income from Corporation A to Corporation
C, motivated by tax-avoidance considerations. The Commissioner failed to advance
the constructive-dividend theory in the intervening years because he was unaware of
the true nature of the transaction. Under these circumstances, the shareholders
cannot assert the “question of law” exception to the duty of consistency. Thus, the
shareholders would be precluded from arguing that they had dividend income in the
closed years, and that they are entitled to a corresponding step-up in the basis of
their stock in Corporation C.

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS:




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If you have any questions, please call (202) 874-1318.

___________________________
STEVEN A. MUSHER
Chief, Branch 6




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