Illinois Tool Works Inc. & Subsidiaries, TC Memo 2018-121
The Tax Court has determined that a U.S. parent company’s repatriation transaction, involving an intercompany loan from a lower-tier controlled foreign corporation (CFC) to an upper-tier CFC followed by repatriation of the loan proceeds via a distribution to a domestic subsidiary, was properly treated as a nontaxable return of capital. In so holding, the Court found that the loan was true indebtedness and that the domestic subsidiary had sufficient basis in the upper-tier CFC to cover the whole distribution amount.
Background—dividends vs. loans. In determining whether the advance of funds from a corporation to a shareholder creates a bona fide debt or is a taxable dividend, the Seventh Circuit Court of Appeals—which is the court to which an appeal of this case would lie—determines whether, at the time of the withdrawals, the taxpayer intended to repay the withdrawals. (Busch v. Comm., (CA 7 1984) 53 AFTR 2d 84-930)
In determining whether the taxpayer intended to repay the withdrawals, the Seventh Circuit considers objective factors as indicative of intent but regards no single factor as dispositive. This determination is “purely a question of fact.” (Busch)
These factors include: (1) the taxpayer’s statement of intent to repay; (2) the extent of the shareholder’s control of the corporation; (3) the retained earnings and dividend history of the corporation; (4) the size of the transfer; (5) the presence of conventional indicia of debt, such as a promissory note, collateral, and interest charges; (6) the treatment of advances in corporate records; (7) the history of repayment; and (8) the taxpayer’s use of the funds. (Busch)
In making its determination in this case, the Tax Court also considered the following factors from Dixie Dairies, (1980) 74 TC 476: (i) participation in management as a result of advancing funds; (ii) the status of the advances in relation to regular corporate creditors; (iii) “thinness” of the capital structure; (iv) the risk involved in making the advances; (v) the identity of interest between the creditor and the shareholder; and (vi) the ability to obtain loans from outside sources.
Background—taxable vs. nontaxable distributions. Under Code Sec. 301(c)(1), the portion of a distribution “which is a dividend (as defined in section 316) shall be included in gross income.” Code Sec. 316(a) provides that “the term ‘dividend’ means any distribution of property made by a corporation to its shareholders” out of current E&P or out of E&P accumulated after Feb. 28, 1913. The portion of a distribution which is not a dividend is: (i) applied against and reduces the adjusted basis of the stock. (Code Sec. 301(c)(2)) and (ii) to the extent that it exceeds the adjusted basis of the stock, treated as gain from the sale or exchange of property. (Code Sec. 301(c)(3))
Background—economic substance. To determine whether a transaction has economic substance, courts usually make a two-pronged factual inquiry: (1) Was the taxpayer motivated by no business purpose (other than getting tax benefits) in entering into the transaction? (subjective test) (2) Did the transaction have objective economic substance, i.e., was there a reasonable possibility of a profit? (objective test) (Frank Lyon Co v. U.S., (S Ct 1978) 41 AFTR 2d 78-1142)
Facts. Illinois Tool Works (ITW) is the parent of an international group of more than 100 companies (ITW group). ITW indirectly owned Paradym, a domestic corporation and member of ITW’s group. Paradym was the sole shareholder of CSE, a holding company registered in Bermuda, which in turn was the sole shareholder of CSA, another holding company in Bermuda.
During 2006, approximately 50 members of the ITW group, including CSA and CSE, participated in a “notional cash pool”—basically, a structure under which the members’ accounts were treated collectively.
In September 2006, ITW began planning a repatriation of funds from its CFCs to take advantage of the so-called repatriation “holiday” (i.e., a temporary tax regime under which U.S. companies could repatriate earnings from their foreign subsidiaries at a reduced tax rate if several conditions and restrictions were satisfied), pay off some of ITW’s debt, and fund new acquisitions. For a variety of reasons, the parties decided that the best course of action was for CSE to secure an intercompany loan from CSA to fund the repatriation.
The steps of the loan included ITW causing its subsidiaries to borrow from their local banks and deposit the proceeds into the cash pool, CSA borrowing $357 million from the pool to fund a loan in the same amount to CSE, then CSE distributing the loan proceeds to its U.S. shareholder (i.e., Paradym), which was a member of the ITW group. ITW, in turn, used the proceeds to pay certain outstanding debt.
The CSA-CSE loan had a 5-year term and carried 6% interest, as documented in a one-page promissory note that also provided that no principal payments were due until maturity and that CSA could enforce payment of principal and interest. Lending funds to CSE resulted in CSA temporarily “going negative” in the cash pool and paying interest on its debit balance at the rate of 5.875%.
On its 2006 return, ITW didn’t report the CSE distribution as income because it treated the distribution as a nontaxable return of capital to Paradym for U.S. tax purposes. The overall repatriation strategy (loan and distribution) was projected to yield tax savings of about $47 million for the ITW group.
ITW considered a variety of repayment options over the next few years. In December 2011, when the note was due to mature, ITW was under examination and had its case pending with IRS’s Appeals Office. ITW thought it would be inadvisable to pay the note at that time, so it chose to extend the maturity of the loan until December 2012, at higher interest rates. A similar extension was recorded the next year.
Over 2012 and 2013, ITW divested itself of certain businesses and generated substantial cash, eventually using $329 million of it, through various subsidies, to make a capital contribution to CSE, which in turn paid the loan balance plus accrued interest to CSA.
IRS’s position. IRS examined ITW’s return and determined that the repatriation was taxable. IRS first found that the transfer from CSA to CSE was a dividend rather than a loan (i.e., a constructive dividend), and that CSE’s distribution to Paradym was therefore taxable as a dividend under Code Sec. 301(c)(1) and Code Sec. 316. Alternatively, IRS determined that ITW failed to substantiate Paradym’s basis in CSE, so that the distribution, if not a dividend, was not a tax-free return of capital under Code Sec. 301(c)(2) but rather was taxable capital gain under Code Sec. 301(c)(3).
IRS issued a notice of deficiency reflecting the above determinations, and ITW petitioned the Tax Court for redetermination. In an amended answer, IRS challenged the repatriation transaction on two alternative theories: (1) that the loan from CSA to CSE should be recharacterized as a dividend under judicial anti-tax-avoidance doctrines; and (2) that the transaction was in substance a loan from CSA directly to ITW or Paradym, generating a taxable investment in U.S. property under Code Sec. 956(a) and Code Sec. 956(c)(1).
Tax Court finds bona fide debt. The Tax Court, examining the Busch factors, found that the facts of the case supported treating the CSE note as a bona fide debt.
The Court found that the following factors supported this treatment:
- he parties’ conduct indicated a clear intent to repay at the time the advances were made, including execution of a legally binding note memorializing the loan and ITW’s favorable history of repaying intercompany loans.
- CSA had a substantial dividend-paying history—over $2.2 billion during the 10 years surrounding the year of the loan.
- The size of the advance was “not especially large relative to CSE’s equity cushion of $6 billion.”
- The loan was evidenced by a promissory note that set out payment dates and the right to enforce payment of interest and principal.
- The loan was treated as debt on CSA’s and CSE’s books.
- CSE had the ability to repay via its cashflow, and it did in fact make annual interest payments on the loan.
- The note didn’t subordinate CSA’s right to repayment to other creditors.
- CSE was strongly capitalized between 2006 and 2012.
- The advance was low-risk.
- CSE could have borrowed the funds from an outside lender.
The above factors outweighed those that the Court found favored dividend treatment (e.g., the fact that CSE was the sole shareholder of CSA at all relevant times) and those that were neutral or unhelpful to its determination, including the use of the advanced funds, participation in management, and identity of interest between credit and shareholder.
Court also rejects IRS’s economic substance argument to recharacterize transaction. The Tax Court also sided with ITW and concluded that the substance of the transaction was established under the above debt-vs.-dividend analysis and cannot be recharacterized under judicial doctrines such as economic substance.
And, the Court found that even if the doctrine were to apply, the loan and distribution had economic substance. Notably, the transactions meaningfully changed the parties economic positions and had a valid non-tax purpose of paying down debt. Similarly, the Court found that the step transaction doctrine had no application in this case, finding that IRS wasn’t so much “seeking to collapse unnecessary steps” but rather arguing to recharacterize the loan as a dividend—an argument already rejected by the Court—and rejected the “conduit theory” (i.e., that CSE served no purpose in the repatriation transaction) on similar grounds.
Finally, the Court rejected IRS’s argument that the repatriation transaction should be disallowed because it constituted subpart F avoidance. The Court found that the distribution by CSE to Paradym was governed by Code Sec. 301, not subpart F, and ultimately the Court declined to recharacterize the transactions based on “the policies underlying the Subpart F regime” absent a clear statutory directive.
The Court then found that CSE had no current or accumulated E&P for the year of the distribution and ultimately found, crediting the testimony of a summary witness, that CSE’s basis was adequately substantiated to cover the amount of the distribution to Paradym. In the alternative, the Court found that, if it were to apply the Cohan rule and estimate the amount of Paradym’s basis in CSE, it would be at least sufficient to cover the distribution.
Accordingly, the distribution was treated as a nontaxable return of capital under Code Sec. 301(c)(2).
References: For constructive dividends, see FTC 2d/FIN ¶ C-2512 ; United States Tax Reporter ¶ 3014.08. For the economic substance doctrine, see FTC 2d/FIN ¶ M-5900 et seq.; United States Tax Reporter ¶ 77,014.35. For the tax treatment of corporate distributions, see FTC 2d/FIN ¶ J-2352 ; United States Tax Reporter ¶ 3014.
