Rev. Rul. 88-66

1988-2 C.B. 34, 1988-32 I.R.B. 7.

                       Internal Revenue Service

                                 Revenue Ruling

          DIVIDENDS RECEIVED DEDUCTION; DEBT FINANCED PORTFOLIO STOCK

                           Published: August 8, 1988

SECTION 246A. - DIVIDENDS RECEIVED DEDUCTION REDUCED WHERE PORTFOLIO STOCK IS DEBT-FINANCED

  Dividends received deduction; debt financed portfolio stock. Three situations set forth the application of section 246(d)(3)(A) of the Code as to whether indebtedness is "directly attributable" to an investment in portfolio stock.

                                     ISSUE

  In the three situations described below, is an indebtedness 'directly attributable to investment in the portfolio stock' within the meaning of section 246A(d)(3) of the Internal Revenue Code?

                                     FACTS

  SITUATION (1). X corporation owned portfolio stock, as defined in section 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 portfolio stock 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.

  SITUATION (2). 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.

  SITUATION (3). 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 Z Bank and the funds that it loaned to Parent which Parent invested in portfolio stock.

                                LAW AND ANALYSIS

  Section 246A(a) of the Code provides that, in the case of any dividend on debt-financed portfolio stock, there shall be substituted for the percentage which would otherwise be used in determining the deduction allowable under section 243, 244, or 245(a) a percentage equal to the product of -

    (1) 70 percent (80 percent in the case of any dividend from a 20-percent owned corporation as defined in section 243(c)(2)), and

    (2) 100 percent minus the average indebtedness percentage.

  Section 246A(c)(1) of the Code provides that the term 'debt financed portfolio stock' means any portfolio stock if at some time during the base period there is portfolio indebtedness with respect to such stock.

  Section 246A(c)(2) of the Code provides that the term 'portfolio stock' means any stock of a corporation unless the taxpayer owns at least 50 percent (20 percent if 50 percent is owned by 5 or fewer corporate shareholders) of the total voting power and value of the stock of the corporation.

  Section 246A(d)(3)(A) of the Code provides that the term 'portfolio indebtedness' means any indebtedness directly attributable to investment in the portfolio stock.

  The legislative history of section 246A of the Code indicates that Congress was concerned that the conjunction of the dividends received deduction and the interest deduction could result in the avoidance of substantial corporate-level taxes on corporate earnings. H.R. Rep. No. 432, 98th Cong., 2d Sess., pt. 2, 1180-81 (1984). Therefore, section 246A was enacted to reduce the dividends received deduction where indebtedness is directly attributable to investment in portfolio stock.

  The legislative history provides that the 'directly attributable' requirement is satisfied if there is a direct relationship between the debt and an investment in stock. Congress decided against incorporating an allocation or apportionment formula or a fungibility concept; thus, section 246A does not apply merely because of the existence of outstanding commercial paper that is issued as part of an ongoing cash management program or deposits received by a depository institution in the ordinary course of its business. Id.

  However, where indebtedness is clearly incurred for the purpose of ACQUIRING portfolio stock or otherwise is directly traceable to the acquisition, the indebtedness constitutes portfolio indebtedness. For example, any non-recourse loan secured in whole or in part with portfolio stock is portfolio indebtedness. H.R. Rep. No. 432 at 1181. Further, section 246A of the Code is also applicable where the indebtedness is directly attributable to the CARRYING of portfolio stock. For example, section 246A applies if portfolio stock is acquired by a corporation using its equity, and later the corporation borrows money using the portfolio stock as security, if the purchaser could reasonably have been expected to sell the portfolio stock rather than incur the indebtedness. H.R. Conf. Rep. No. 861, 98th Cong., 2d Sess. 813 (1984), 1984-3 (Vol. 2) C.B. 1, 67.

  Portfolio indebtedness is not required to be that of the holder of the dividend paying stock and may exist in the controlled group situation. Thus, for example, section 246A of the Code can apply where one member of an affiliated group incurs the portfolio indebtedness and another member of the group acquires the stock. H.R. Rep. No. 432 at 1181.

                                    HOLDINGS

  SITUATION (1). The debt incurred to finance the acquisition of a new facility is not indebtedness directly attributable to investment in portfolio stock because there is no direct relationship between the debt and the carrying of the portfolio stock. Although the mortgage permits the corporation to acquire its new facility without disposing of its portfolio stock investment or other assets, that debt is not allocated under an apportionment formula or a fungibility concept for purposes of determining what constitutes portfolio indebtedness. Under the circumstances, it is not reasonable to expect the borrower would have sold the stock to raise the proceeds for the acquisition in lieu of obtaining the mortgage loan.

  SITUATION (2). The debt issued to finance the construction of the new plant the proceeds from which are temporarily invested in portfolio stock is indebtedness directly attributable to investment in portfolio stock. The fact that this is a temporary investment does not change the result, because section 246A of the Code does not rely on the ultimate purpose for the indebtedness if it is clear that the loan proceeds were actually used to buy portfolio stock.

  SITUATION (3). Parent's investment in portfolio stock using the proceeds of the loan from Bank Z does not make the loan from Bank Z indebtedness directly attributable to investment in portfolio stock. Absent circumstances that demonstrate a direct relationship between outside group indebtedness and the investment in portfolio stock, the intercompany loans do not trigger the application of section 246A of the Code. This is because, in the consolidated return context, intercompany loans generally create a wash for federal income tax purposes and do not create the potential for tax avoidance that section 246A was designed to prevent. Thus, because the only outside indebtedness of the Parent-Bank group consists of deposits received by Bank Z in the ordinary course of business and there is no direct relationship between this outside indebtedness and the portfolio stock purchase, there is no indebtedness directly attributable to investment in portfolio stock subject to section 246A.

                              DRAFTING INFORMATION

  The principal author of this revenue ruling is Virginia S. Voorhees of the Interpretative Division. For further information regarding this revenue ruling contact Paul W. Horrell on (202) 566- 3957 (not a toll-free call).

Rev. Rul. 88-66, 1988-2 C.B. 34, 1988-32 I.R.B. 7.