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Podcast: Illinois Tool Works Inc. & Subsidiaries v. Commissioner of Internal Revenue

Time to Listen: 12:45 Practices: Tax Controversy, Tax

In this Ropes & Gray podcast, Elizabeth Smith, counsel in the tax controversy group, is joined by David Saltzman, a partner in the tax group, to discuss the recent Tax Court memorandum decision, Illinois Tool Works Inc. & Subsidiaries v. Commissioner of Internal Revenue. This case involved a strategy designed to permit a U.S. multinational to repatriate cash from its foreign subsidiaries without incurring current U.S. federal income tax.

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Elizabeth Smith

Elizabeth Smith: Hello, and thank you for joining us today on this Ropes & Gray podcast. I'm Elizabeth Smith, counsel in the tax controversy group. Joining me today is David Saltzman, a partner in the tax group who focuses on international tax matters.

In this podcast, we will be discussing a recent Tax Court memorandum opinion as our case of the quarter.  The case, Illinois Tool Works Inc. & Subsidiaries v. Commissioner of Internal Revenue, involved a strategy designed to permit a U.S. multinational to repatriate cash from its foreign subsidiaries without incurring current U.S. federal income tax.

As background, Illinois Tool Works, or (“ITW”), is the U.S. parent of a multinational group, with a large number of European subsidiaries.  Like many U.S. multinationals prior to tax reform, ITW retained foreign earnings in its off-shore subsidiaries so as not to incur U.S. tax imposed on repatriation.  To access the cash without incurring tax, ITW devised a two-step strategy. First, a lower tier ITW foreign subsidiary loaned $357 million to its direct parent, also an ITW foreign subsidiary. Second, the foreign parent distributed the borrowed cash to its direct parent, an ITW subsidiary subject to U.S. tax.  Because the first step was a loan rather than a dividend, the earnings and profits did not tier up to the foreign parent.  Because the foreign parent did not have earnings, the distribution it made back to its U.S. taxable parent was classified as a tax-free return of capital.  ITW used the cash to pay down certain commercial paper obligations.

The IRS determined a deficiency of over $70 million for 2006. They argued, first, that the distribution from the lower-tier foreign subsidiary to the upper-tier foreign holding company was substantively a dividend.  A dividend, in contrast with a loan, would bring up earnings and profits to the upper-tier holding company, which in turn would cause the distribution it made to its U.S. parent to be treated as a taxable dividend, rather than as a return of capital.  Second, the IRS argued that even if the first step cash transfer to the upper-tier holding company should be treated as a bona fide loan, the court should apply one or more anti-abuse doctrines to recharacterize or collapse the transaction to find a dividend.  The Tax Court rejected both of these arguments, as well as other theories for taxing the repatriation, and ruled in favor of ITW, determining that each step of the transaction should be respected and that the ultimate distribution was properly treated as a tax-free return of capital.

David, thanks for joining me today.  Could you provide a bit of background on how U.S. multinationals are taxed and how Illinois Tool Works structured the transaction to avoid current U.S. income tax?


David Saltzman: Sure, Elizabeth.  Prior to tax reform, U.S. corporations generally were not taxed on the income earned by their foreign subsidiaries until the cash was actually repatriated to the U.S. as a taxable dividend.  And, if a U.S. multinational pledged to permanently reinvest foreign earnings abroad, it would benefit from favorable financial accounting treatment.  Specifically, the group’s foreign earnings would be tax-effected at the lower effective foreign tax rate, rather than at the higher U.S. tax rate that reflects the U.S. tax costs of repatriating those earnings.

In this case, a few basic rules underpin ITW’s tax planning.  First, a distribution from a corporation to its shareholders is taxable as a dividend only to the extent of its current or accumulated earnings and profits, or (“E&P”.)  If the corporation has no E&P, a distribution of property is generally treated as a tax-free return of capital that reduces the tax basis in the corporation’s shares.  Here, ITW’s upper-tier holding company did not have any E&P and was able to demonstrate it had very substantial tax basis in its shares (another issue that the IRS contested in this case).  In contrast with a U.S. consolidated group, the earnings of a lower tier subsidiary do not tier up to a foreign parent.  Only a dividend brings up those earnings.  ITW avoided bringing up the earnings of its lower tier operating subsidiaries by loaning the funds up to the foreign parent.  Because the foreign parent had no earnings, its distribution to the U.S. taxable group was simply a tax-free return of capital that lowered the tax basis in its stock.

Elizabeth Smith: Can a U.S. parent be taxed even if there is no actual repatriation of cash?

David Saltzman: Well, even absent a dividend, a U.S. corporation can be currently taxed on the foreign earnings of a “controlled foreign corporation” or a (“CFC.”)  Prior to tax reform, this was most likely to occur when a CFC received passive income sometimes referred to as Subpart F, which includes interest, dividends and royalties.  In addition, a CFC can be treated as paying a deemed dividend if it invests in U.S. property, which includes a loan from a CFC to a domestic entity.  So if one of ITW’s controlled foreign corporations had simply loaned money back to the U.S. group, a dividend would have resulted.

By structuring the transaction as a loan between the foreign subsidiaries followed by a tax-free distribution of capital, ITW was able to argue that the transaction did not actually result in an investment in U.S property or as a deemed distribution of earnings.

It’s worth noting that the Tax Cuts and Jobs Act (or the “TCJA”), enacted at the end of 2017, significantly affects how U.S. multinationals are taxed.  In fact, U.S. corporations can now be taxed currently on operating income (as well as passive income, under the so-called GILTI regime).  The TCJA provides for a participation exemption, which allows U.S. corporations a 100% dividends-received deduction for dividends received from foreign subsidiaries, provided that certain ownership and holding period rules are met.  Significantly, the TCJA deemed the repatriation of all pre-TCJA earnings and profits and taxed those earnings at reduced tax rates.  This in turn creates a large pool of previously taxed income that can be repatriated before the deemed dividend rules discussed above would kick in on a tax-free basis.  So really, this case is of interest to taxpayers defending similar historic strategies.

Elizabeth Smith: Thanks, David.  So with that background in mind, let’s discuss the court’s holding.  The court ruled in favor of the taxpayer and upheld the form of the transaction that ITW set up.  Do you think this is the result people were expecting?

David Saltzman: Well, ITW had favorable tax opinions and hadn’t established a financial accounting reserve for the issue, so there was high confidence on the taxpayer’s side.  On the other hand, the taxpayer’s planning was clearly tax motivated and the form of the transaction was without a compelling commercial justification. The upstream loan surely raised eyebrows.  But there is favorable law respecting upstream loans.  Like any related party loan it’s just subject to added scrutiny.   Here, the question was whether that loan passed muster.  And if so, whether the transaction as a whole could be reclassified for a lack of business purpose or commercial substance.

Elizabeth Smith: Thanks, David.  So let’s walk through the court’s reasoning behind its holding in more detail.  To reach this result, the court first conducted a multi-factor balancing test to determine whether the distribution from the lower-tier CFC to the upper-tier CFC was bona fide debt or, alternatively, a dividend.  Under the multi-factor balancing test, the court looked at a number of factors and found the vast majority favored treatment of the distribution as a bona fide debt obligation.  The factors favoring debt characterization included: the intent to repay; the dividend history of the distributing corporation; the formal indicia of the debt; the treatment of the distribution on the corporate books and records; the repayment history and source; the status of the distributions relative to other debt; the adequacy of capitalization; the risk involved in making the distribution; and the ability of the borrower to obtain loans from third parties.  The only factor the court found that favored dividend treatment was the upper-tier CFC’s control over the lower-tier CFC as its sole shareholder.  Based on the factors it analyzed, the court ruled that the distribution should be treated as a bona fide debt.

After determining that the distribution was in fact a bona fide debt obligation, the court considered whether certain anti-abuse judicial doctrines should apply to recharacterize the transaction.  The court first considered the economic substance doctrine.  The court found that it did not apply because both the lower-tier CFC and upper-tier CFC’s economic positions were changed as a result of the loan, and the loan had a valid non-tax business purpose (i.e., to pay down the U.S. entities commercial paper balance).  Additionally, the court rejected both the step transaction doctrine and the conduit theory because the lower-tier CFC could not have paid a dividend directly to the U.S. entity, and the actual transaction didn’t increase the number of steps.  The court similarly rejected the IRS’s argument that the transaction should be recharacterized based on general Subpart F avoidance principles, noting that Subpart F did not actually apply to any of the transactions at issue, and there was no authority for the IRS’s contention.  Based on the above, the court ruled in favor of ITW.

Was there anything you found notable about the result or the court’s analysis?  Are there any lessons taxpayers can draw from this result?

David Saltzman: This was a memorandum decision and therefore doesn’t have precedential value.  And the type of planning undertaken by ITW generally won’t be needed following tax reform. But there are definitely some lessons taxpayers can take from this ruling.  First of all, the transaction was carefully planned, documented and executed.  The taxpayer accurately reported the transaction for both tax and financial accounting purposes.  And the taxpayer acted consistent with its legal obligations and did not disregard the agreements it made. It’s important to note that the court gave significant weight to ITW’s observance of formalities.  The judge noted in several instances that ITW had complied with the terms of the loan agreement and had taken actions consistent with treatment of the distribution as a bona fide debt.  Further, the court looked at not only ITW’s compliance with respect to the particular loan in question, but also to its actions with respect to a larger sample of intercompany loans.  The court noted testimony from employees that ITW had a “live by the agreement” policy, and they had an excellent track record of complying with the terms of their intercompany loans.  In implementing their own structures, taxpayers should note the importance the court placed on actually taking the steps outlined in their documents and adhering to the terms of their agreements.

It was also interesting that the court seemed to give little weight to the IRS’s expert testimony regarding the circularity of the funds in this transaction.  Dr. Glenn Hubbard, dean of the Columbia Business School, testified on behalf of the IRS that the upper-tier and lower-tier CFCs’ economic positions weren’t actually changed in this transaction, because the upper-tier CFC was entirely dependent on cash from the lower-tier CFC to repay the loan.  The court analyzed this testimony both in the context of the multi-factor balancing test with respect to the borrower’s ability to repay, as well as in relation to the application of the economic substance doctrine.  The court viewed Dr. Hubbard’s testimony as essentially arguing that a holding company could not issue bona fide debt.  Although the circularity of the cash flow here is an argument the IRS often uses, the court seemed to give it almost no weight.

Elizabeth Smith: So, given the ruling and the analysis the court followed in reaching its decision, what do you see as next steps?  Would you expect the IRS to appeal the case?

David Saltzman: This was a substantial loss for the IRS, and there are arguments available to the IRS to challenge the decision.  I think it will be an uphill battle, though.  If the IRS were to appeal, this case would go to the Seventh Circuit. Ultimately, reclassifying the upstream loan-based on the facts presented and the court’s findings will be challenging.

Elizabeth Smith: Well thank you for joining me, David.  It’ll be interesting to see how this case, and others like it, play out. Please visit the Tax Controversy Newsletter webpage at www.disputingtax.com, or of course, www.ropesgray.com for additional news and commentary about other notable tax developments as they arise.  Thank you for listening.

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