Related parties, be they family members or commonly-controlled business entities, must be careful when transacting business with one another. They, and their advisers, must recognize that these transactions will be subject to close scrutiny by the IRS. The parties must treat each other, as much as possible, as unrelated persons, and they must be able to support the reasonableness of any business transactions between them. 
The advisers to the related parties in such transactions must be familiar with the various common-law doctrines by which the IRS and the Courts may re-characterize a related party transaction. Among these are the economic substance, substance-over-form, and step transaction doctrines, under which a transaction that would otherwise result in a beneficial tax result for a taxpayer will be disregarded if the transaction lacks economic substance.
As one taxpayer recently learned, the complexity of a series of transactions among several related companies will not ensure the result sought to be achieved; in fact, it may only invite closer scrutiny. Barnes Group, Inc. v. Comr., 2d Cir. No. 13-04298, Nov. 5, 2014.
Funding Expansion . . .
Taxpayer was a manufacturer and distributor that operated separate business segments through domestic and foreign subsidiaries. Taxpayer’s strategic objective was to expand its business primarily through acquisitions, which it financed through debt.
This increase in debt transformed Taxpayer from a relatively low-leveraged firm to one with significantly above-average leverage for companies within its industry, and also increased its cost of borrowing and debt-to-equity ratio.
After the initial phase of acquisitions, Taxpayer and its domestic subsidiaries had relatively few cash reserves, while its foreign subsidiaries had significant reserves. One subsidiary in particular (“Asia”) was generating cash well in excess of its operating needs, which enabled it to make loans to other subsidiaries and also allowed it borrow funds from an unrelated bank (“Bank”) at a preferential interest rate.
Accounting for all of the bank deposits held by Taxpayer’s domestic and foreign subsidiaries, Taxpayer was earning approximately 3% interest on its aggregate cash holdings. Conversely, Taxpayer had external borrowings with interest rates ranging between 7.0% and 9.50%.
Accessing Subsidiary Funds
Consistent with Taxpayer’s “growth by acquisition strategy,” Taxpayer sought to use Asia’s excess cash and borrowing capacity to finance one or more international acquisitions. However, Taxpayer understood that either a dividend or a loan from Asia to Taxpayer would trigger a federal income tax liability under the controlled foreign corporation rules.
Taxpayer and several of its subsidiaries, including Asia, hatched an investment plan that was structured so that Taxpayer would receive Asia’s excess cash, Asia’s receivables from foreign affiliates, and the proceeds of a loan from Bank.
Asia’s receivables related to Taxpayer’s UK and French subsidiaries; however, neither had the funds to repay its respective loan. Therefore, Taxpayer lent the funds to them, and they repaid their loans to Asia. Thereafter, Taxpayer’s Canadian subsidiary made alleged equity investments in the UK and French subsidiaries, and they repaid the loans from Taxpayer.
For purposes of implementing the reinvestment plan, Taxpayer formed a Bermuda and a Delaware subsidiary (“Bermuda” and “Delaware,” respectively). Bermuda was a controlled foreign corporation.
The reinvestment plan was structured to involve a similar series of transactions, to occur in the following order: (1) Asia (using its own reserves plus amounts borrowed from Bank) and Taxpayer would transfer foreign currency to Bermuda in exchange for Bermuda common stock; (2) Bermuda and Taxpayer would transfer foreign currency and Bermuda common stock to Delaware in exchange for Delaware common and preferred stock; and (3) Delaware would convert the foreign currencies into U.S. dollars and then lend the funds to Taxpayer which, in turn, used the funds to pay off its own debt.
As mentioned above, Bermuda and Delaware were formed for the purpose of participating in the reinvestment plan. Bermuda had only nominal amounts of income and deductions during the periods in question. Accordingly, Bermuda had no earnings and profits. Bermuda had no paid employees and had very little cash.
Bermuda’s board of directors included Taxpayer’s assistant treasurer, its CFO, and its treasurer. Taxpayer’s assistant treasurer was also Bermuda’s treasurer. In accordance with instructions from Taxpayer’s senior management, he signed many if not all of Bermuda’s corporate documents in order to implement the reinvestment plan, and was responsible for the movement of all cash under the reinvestment plan.
Delaware’s board of directors consisted of the same individuals. Like Bermuda, Delaware had no paid employees and nominal amounts of cash during the periods in question. Furthermore, Delaware’s function appears to have been limited to the currency conversions and subsequent lending transactions with Taxpayer.
The Courts Step In
In a notice of deficiency, the IRS increased Taxpayer’s taxable income by an amount equal to the aggregate transfer from Asia.
The IRS claimed, and the Tax Court and the Second Circuit agreed, that the “form” of Taxpayer’s transactions did not control the determination of their tax consequences. According to the Courts, one cannot ignore the effect of the step transaction doctrine, under which the individual steps in the integrated series of transactions (Taxpayer’s reinvestment plan) should be disregarded.
The step transaction doctrine, the Court stated, is a manifestation of the broader tax principle that substance should prevail over form. “By emphasizing substance over form, the step transaction doctrine prevents a taxpayer from escaping taxation. [It] treats the steps in a series of formally separate but related transactions involving the transfer of property as a single transaction, if all the steps are substantially linked.”
In deciding whether to invoke the doctrine, the Court applied the so-called “interdependence test.” This test focuses on whether a series of transactions are “so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series.”
The Court then applied the step transaction doctrine to collapse the series of transactions through which Taxpayer obtained the funds of its Asia subsidiary by channeling the funds through the Bermuda and Delaware subsidiaries, both created solely to facilitate the transfer. Each transaction in this series was completed pursuant to a plan of reinvestment that effectively acknowledged these transactions comprised “a single integrated plan.” The transactions contemplated “would have been fruitless without a completion of the series” of transactions culminating in a transfer of the funds to Taxpayer. Indeed, that transfer was the entire purpose of the series of transactions from the beginning. Thus, the steps by which Asia’s funds were transferred to Taxpayer were correctly treated as one transaction.
Taxpayer argued that application of the step transaction doctrine was inappropriate because the channeling of Asia’s funds through Bermuda and Delaware, rather than directly to taxpayer, served a valid business purpose. The Court found that Taxpayer failed to establish a valid business purpose for the circuitous structure of these transactions and it even failed to respect the bona fides of its own structure (for example, no interest payments to Delaware or dividend payments to Bermuda were ever made). The sole purpose was to transfer Asia’s funds to Taxpayer in a manner that had the appearance of a non-taxable transaction.
Given Taxpayer’s failure to establish that any of Asia’s funds were repaid, or that these transactions were bona fide investments, the Court found that the series of investments was “in substance dividend payments from Asia to” Taxpayer.
Careful What You Do
The tax adviser to a closely held business needs to familiarize him- or herself with the common-law doctrines described above. It is in the context of such a business that one will frequently encounter transactions between the business and its owners, or between the business and a related entity.
As a general rule, the relevant inquiry should be whether the transaction that generated the claimed tax benefit also had economic substance or a business purpose in order for the transaction to withstand IRS scrutiny. One must be especially diligent where the “transaction” actually involves a series of related steps. Although each step, standing on its own, may appear, at least superficially, to be bona fide from business perspective, a critical examination may lead to the conclusion that the steps had meaning only as part of a larger transaction.
In that case, the ultimate tax result may differ significantly from, and be much more expensive than, what the taxpayer hoped to achieve. The point is to understand the risk and to quantify the exposure.