IRS Challenges Qualified Dividend Treatment

SIH Partners, a Delaware partnership, filed a petition in Tax Court challenging the IRS’s reclassification of $171 million of reported qualified dividend income (QDI) from Swiss stocks as ordinary dividend income for its 2012 tax year. The petition also challenges the IRS's disallowance of $26 million in foreign tax credits that SIH Partners claimed for Swiss withholding taxes on the dividends.

In general, to qualify as QDI under section 1(h)(11)(B)(iii), a dividend must be paid on stock that the taxpayer holds for at least 61 days during a 121-day period beginning 60 days before the ex-dividend date. To claim the foreign tax credit under section 901(k)(1), the taxpayer must hold the stock for at least 16 days during the 31-day period beginning 15 days before the ex-dividend date. The IRS asserts SIH Partners did not meet either holding period requirement because it also had short exposure to the stock through a portfolio swap.

The dispute in SIH Partners LLP v. Commissioner turns on whether, under section 246(c)(4)(C), the holding period for the Swiss stock should be reduced because SIH Partners had reduced its risk of loss by holding a position with respect to "substantially similar or related property" (SSRP). In 2012, SIH Partners held stock in Novartis, Roche, Nestle, and Swisscom. Also in 2012, SIH entered a swap with Morgan Stanley & Co. International PLC, which allowed it to make adjustments to a reference portfolio that included short exposure to the Swiss stocks and several indices. The IRS asserts that the portfolio swap is SSRP; in opposition, SIH asserts that the portfolio swap meets a safe harbor under Treasury regulation section 1.246-5 and does not violate the anti-abuse rule under the same regulation section.

Under the regulation, a position (such as a short portfolio swap) generally is SSRP for stocks if the position and the stocks substantially overlap. SIH argues that there is no substantial overlap because its short swap exposure to the Swiss stocks represented less than 70% of the swap's FMV.

An anti-abuse rule provides that a "position" (defined in the regs as "an interest...in property or any contractual right to a payment") will nevertheless be SSRP for a portion of the taxpayer’s stock holdings if (i) the position is reasonably expected to “virtually track” (directly or inversely) changes in the value of the stock and (ii) the position was acquired or held as part of a plan, the principal purpose of which was to obtain tax savings (including deferring tax), the value of which is significantly in excess of the expected pre-tax economic profits of the plan.

SIH asserts that its portfolio swap does not meet these conditions, and that the IRS erred in "bifurcating" the swap into (1) a position that inversely tracked Swiss stock and (2) a position on other assets. 

 

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