Tax

Dividends are Immune from Rescission Doctrine

Lehman Brothers tax expert Robert Willens explains why.
Robert WillensJune 21, 2001

In Rev. Rul. 80-58, the I.R.S. acknowledged that a sale of property that was, due to the failure of the buyer to secure the desired re- zoning of such property, rescinded, within the same year in which the original sale took place, would, in effect, be ignored for tax purposes.

More specifically, the rescission—which restored the parties to exactly the same position they would have occupied had the transfer and re- conveyance not taken place—was regarded as a nullity that entailed no tax consequences for the participants. On the other hand, the ruling warns, because of the primacy of the “annual accounting concept,” a rescission that spans two (or more) taxable years cannot be so regarded and the original transfer and subsequent re-conveyance will be treated as separate (taxable) transactions.

In LTR 200124008, a Field Service Advice Memorandum, the I.R.S. placed further limits on the rescission doctrine.

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There, a U.S. corporation purchased a substantial block of stock in a U.K. utility. The utility made a distribution to its shareholders, including the U.S. corporation. Concurrently, the U.K. imposed, on utilities and others, a windfall profits tax that the utility apparently found, in light of the drain on its resources resulting from the prior distribution, difficult to defray.

Accordingly, the U.S. corporation just 11 days after the distribution occurred, returned it to the utility. In due course, a formal rescission agreement, with respect to the payment and refund of the distribution, was executed. The U.S. corporation sought to avoid having to report the dividend—under the rescission doctrine—but its claims were rebuffed. The “claim of right” rule, in the case of a dividend, trumped the rescission doctrine.

Thus, the Service concluded that if, as here, a taxpayer receives income under a claim of right, that income must, in all events, be reported.

There are several elements to the claim of right rule and each was satisfied here: There was a receipt of cash or property that constitutes income and the recipient possessed unlimited control over the “use and disposition” of such income.

The Service did acknowledge one exception to this claim of right rule but, unfortunately, it could not be availed of here. If, in the year of receipt, the taxpayer acknowledges an obligation to repay the income (which is, in fact, so repaid) such obligation prevents recognition of the income. However, the case law suggests that such an obligation can never arise in the case of a declared dividend; a dividend, once it’s declared, cannot be revoked.

Accordingly, the rescission rules, apparently, can never apply to dividends because any obligation to restore the distribution cannot, apparently, survive its declaration. Therefore, in this case, the taxpayer was forced to report the foregone dividend as income and the return of the funds was considered, simply, a contribution to the paying entity’s capital, which augmented the U.S. corporation’s basis in its stock in the utility.