Taxation - Bona Fide Debt - Tax Court Holds in Favor of Taxpayer on Loan between Foreign Subsidiaries

Harvard Law Review, June 2019 | Go to article overview

Taxation - Bona Fide Debt - Tax Court Holds in Favor of Taxpayer on Loan between Foreign Subsidiaries


Taxation--Bona Fide Debt--Tax Court Holds in Favor of Taxpayer on Loan Between Foreign Subsidiaries.--Illinois Tool Works Inc. v. Commissioner, 116 T.C.M. (CCH) 124 (2018).

Tax law struggles to distinguish debt from equity. (1) Yet the distinction has far-reaching consequences, particularly for corporate taxation. (2) Critically, because corporations can generally deduct interest payments on debt (3) but cannot deduct dividend payments to equity holders, firms have a distorted incentive to raise capital through debt. (4) For the same reason, firms strive to classify nonstandard financial contracts as debt rather than equity. Recently, in Illinois Tool Works Inc. v. Commissioner ((5) ITW), the U.S. Tax Court held that a transaction between two foreign subsidiaries was a loan, not a dividend, for tax purposes. (6) In reaching its conclusion, the court applied a fourteen-factor test for ascertaining whether a loan should be treated as "bona fide debt," (7) and declined to invoke a series of "judicial anti-tax-avoidance doctrines." (8) Although the court analyzed the transaction appropriately, its reasoning highlights several problems of theory and practice associated with distinguishing debt from equity. To ameliorate these problems, Congress should jettison the debt-equity distinction.

Illinois Tool Works Inc. (ITW) is a publicly traded Fortune 500 corporation that, along with its many subsidiaries, manufactures industrial products and equipment. (9) In 2006, ITW pursued a plan to repatriate funds from certain of its controlled foreign corporations (10CFCs) to finance its "strategy of growth through acquisitions." (11) Three subsidiaries in particular were crucial to ITW's plan: (1) a lower-tier CFC, CS (Australasia) Holdings, Ltd. (CSA); (2) an upper-tier CFC, CS (Europe) Holdings, Ltd. (CSE), a holding company with no "earnings and profits" from which to pay a dividend; (12) and (3) a domestic subsidiary, Paradym Investments Ltd. (Paradym), which fully owned CSE. (13) At its core, ITW's plan involved CSA lending $356,778,000 to CSE, (14) after which CSE distributed the funds to Paradym, (15) "which reported the distribution as a nontaxable return of capital." (16) The net effect of these transactions was to make foreign capital fully available to ITW for domestic acquisitions without any tax being due.

After ITW filed its 2006 tax return, the Internal Revenue Service (IRS) issued a notice of deficiency for $70,174,594 in connection with the repatriation transactions. (17) Subsequently, ITW "petitioned [the U.S. Tax Court] for redetermination." (18) In its answer to ITW's petition, the IRS further asserted an accuracy-related penalty of $14,034,919. (19) The IRS based its determination that ITW owed taxes on three main theories. First, the Service argued that the transfer of funds between CSA and CSE was a dividend payment, rather than a loan that created bona fide debt. (20) If that were the case, the subsequent distribution from CSE to Paradym would be a taxable dividend under sections 301(c)(1) and 316 of the Internal Revenue Code. (21) Second, the IRS insisted that, even if the transaction did involve bona fide debt, the court should use existing anti-tax-avoidance doctrine to recharacterize the transaction and prevent tax avoidance. (22) Finally, it contended that ITW had not proven that the payment from CSE to Paradym was a tax-free return of capital, and that the court should therefore treat it as a (taxable) capital gain. (23) In a memorandum opinion, the U.S. Tax Court ruled in favor of ITW, holding that the company did not owe any taxes in connection with the repatriation transactions. (24) Judge Lauber began his analysis by briefly explaining that taxpayers generally have the burden of proving the IRS's determinations incorrect. (25) He then turned to the key question of the case: whether the loan from CSA to CSE (the "CSE Note") was bona fide debt, which was a question of the company's true intent. …

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