Applying the rescission doctrine to dividend distributions: A practical guide

Editor: Annette B. Smith, CPA   Dividends — the primary means by which corporations transfer after-tax earnings to shareholders — are used in a variety of contexts. Some contexts are routine, such as quarterly dividend distributions, while other contexts are targeted to achieve a specific corporate purpose. In the targeted context, planning often is a dynamic process.

As planning and circumstances evolve, already consummated transactions may not survive as part of the plan; in that case, the legal concept of rescission may be available as an integral planning tool. Rescission, nonetheless, has its limits, particularly for legally declared dividends. Attempting to unwind a legally declared dividend without the appropriate planning is a trap for the unwary. Accordingly, this discussion explores the rescission doctrine, in general and in the dividend context, and provides insight into potential planning opportunities to avoid the trap of unwinding a dividend.

The rescission doctrine

In general: The IRS has stated that the “legal concept of rescission refers to the abrogation, canceling, or voiding of a contract that has the effect of releasing the contracting parties from further obligations to each other and restoring the parties to the relative positions that they would have occupied had no contract been made” (Rev. Rul. 80-58; the IRS no longer issues private letter rulings on whether a completed transaction can be rescinded for U.S. federal income tax purposes (Rev. Proc. 2018-3, §3.02(8))). Simply stated, rescission in the U.S. federal income tax context refers to the unwinding of transactions that occurred under a binding legal agreement between consenting parties to restore the previously existing state, or status quo ante.

For a transaction to be rescinded and therefore disregarded for U.S. federal income tax purposes, (1) the parties to the transaction must be restored to the status quo ante, and (2) the return of the parties to the status quo ante must occur in the same tax year in which the original transaction was consummated. While these requirements provide a general starting point for determining whether a transaction may be rescinded, the rescission doctrine is not set forth in the Code or in the regulations. Instead, the rescission doctrine in the U.S. federal income tax context is contained in a body of case law and administrative guidance. Thus, the rules in particular contexts can vary significantly.

Dividend context: In the dividend context, the general rule is that once a board of directors has legally declared a dividend, the dividend may not be rescinded for U.S. federal income tax purposes, even if a shareholder restores the proceeds of the dividend it received to the distributing corporation in the same tax year as the dividend declaration (see,e.g., Crellin’s Estate, 203 F.2d 812 (9th Cir. 1953), cert. denied, 346 U.S. 873 (1953)). Although the scope of the general rule is broad, there are legal exceptions to the general rule. Specifically, legally declared dividends have been effectively rescinded (1) under the doctrine of scrivener’s error (see, e.g., Hanco Distributing, Inc., No. C-291-71 (D. Utah 6/29/73)), (2) under a nunc pro tunc court order (see, e.g., Edler, T.C. Memo. 1982-67, aff’d, 727 F.2d 857 (9th Cir. 1984)), and (3) if the dividend is determined to be the result of a mutual mistake (see, e.g., Knight Newspapers, Inc., 143 F.2d 1007 (6th Cir. 1944)). These exceptions, however, do not provide for practical planning opportunities because the scope of their application is narrow. Nevertheless, a taxpayer may be able to implement affirmative planning techniques to avoid the general rule on unwinding legally declared dividends.

Potential planning opportunities

A dictum in Crellin’s Estate highlights the linchpin underlying unwinding a legally declared dividend. Specifically, the Ninth Circuit noted that in the case of a legally rescindable dividend, if the dividend proceeds are restored to the corporation in the same tax year that the dividend was declared, there was “no increment in gross income rather than an increment to gross income plus a deduction” (Crellin’s Estate, 203 F.2d at 814, n.1; it seems that the Ninth Circuit applied logic akin to the circular cash flow doctrine). Thus, the revocability of a legally declared dividend arguably hinges on whether an irrevocable vested legal right to payment has attached.

For example, assume that in anticipation of an all-cash stock acquisition, the board of directors of a subsidiary of the acquirer declares a dividend to move the cash consideration to the acquirer for purposes of facilitating the acquisition. The board resolution declaring the dividend includes language granting the board the legal right to compel the corporate shareholder to return the proceeds of the dividend upon request. Assume further that in the same tax year, but after the declaration, the relevant antitrust regulator disapproves of the acquisition. Consequently, the board exercises its right to compel repayment. Because the resolution provides the board with the legal right to compel repayment of the proceeds of the dividend, the shareholder arguably is not entitled to an irrevocable vested legal right to payment as a result of the declaration. In that situation, the dividend arguably should be disregarded for U.S. federal income tax purposes if the proceeds are restored in the same tax year as the dividend declaration.

If the proceeds of a legally rescindable dividend instead are restored to the corporation in a tax year after the dividend declaration, dictum in Crellin’s Estate indicates that the “claim of right” doctrine would apply. (The Ninth Circuit cited Lesoine, 203 F.2d 123 (9th Cir. 1953), providing that the claim-of-right doctrine stands for the “proposition that if a dividend is received in a given year under a claim of right and without restriction as to use, but in a subsequent year the invalidity of the dividend is established and its return compelled, the amount so returned is nonetheless taxable in the year received. If the repayment could have been compelled, however, the stockholder is entitled to a deduction in the year of repayment” (Crellin’s Estate, 203 F.2d at 814)). If so, the claim-of-right doctrine should entitle the shareholders to a deduction in the year of repayment.In such a case, rather than disregarding the legally rescindable dividend for U.S. federal income tax purposes, because the tax year has lapsed, the taxpayer instead would claim a deduction in the subsequent year when the proceeds are restored.

An important planning tool

The legal concept of rescission can be an important planning tool in appropriate circumstances. Although case authority indicates that a legally declared dividend may not be rescinded for U.S. federal income tax purposes once the board of directors has declared it, there are planning techniques that taxpayers can implement to provide additional flexibility. In particular, if the board resolution declaring a dividend provides the board with the legal right to compel repayment of the proceeds of the dividend, an irrevocable vested legal right to payment arguably should not be deemed to attach. If the shareholder restores the proceeds of that dividend to the corporation during the same tax year as the declaration, the dividend arguably should be disregarded for U.S. federal income tax purposes. If the shareholder instead restores the proceeds of that dividend to the corporation in the tax year after the tax year of the declaration, the taxpayer instead should claim a deduction in the later tax year. Accordingly, while unwinding a dividend for U.S. federal income tax purposes can be a trap for the unwary, there are practical means to avoid the trap.

EditorNotes

Annette B. Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.

For additional information about these items, contact Ms. Smith at 202-414-1048 or annette.smith@pwc.com.

Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.