Subsidiary’s loan to parent respected as debt for tax purposes
The Tax Court handed Illinois Tool Works (ITW) a victory in Illinois Tool Works, Inc. v. Commissioner, T.C. Memo 2018-121. In addition to the case law governing characterization of loans as debt or equity for tax purposes, the IRS presented arguments based on other judicial doctrines and tax policy arguments, all to no avail.
In 2006, ITW received about $357 million of cash from a wholly owned foreign subsidiary. That subsidiary, a holding company, had received the cash from its wholly owned subsidiary in exchange for a promissory note.
The IRS contended that the note should not be treated as debt for federal income tax purposes, and that the cash received in exchange for the note should be treated as a dividend rather than as loan proceeds. Under the IRS’ characterization, ITW’s receipt of $357 million of cash would be treated as dividend income rather than return of capital. The IRS asserted a tax deficiency of about $70 million.
The court rejected the IRS’s arguments, and held that the note was treated as debt for federal income tax purposes. Based on its opinion, it seems the court did not consider the question a close one.
Tax Court applied 14 debt-equity factors
In determining that the note was bona fide debt, the Tax Court relied on the factors enumerated in Busch v. Commissioner, 728 F.2d 945 (7th Cir. 1984) and Dixie Dairies Corp. v. Commissioner, 74 T.C. 476, 493 (1980) and embarked on a 14-factor analysis of the facts and circumstances. The Tax Court held that the IRS’ arguments were unsupported by the debt-equity case law. The court’s opinion indicated that only one factor of 14, the related party factor, supported the IRS’ argument.
The Tax Court focused on the conduct of the parties and the substance of the transaction in its analysis of the 14 factors. To summarize some of the more significant findings:
- The debt was evidenced by a legally binding agreement that had the conventional indicia of debt (i.e., fixed maturity date, interest payments at a specified rate, and creditor rights).
- The creditor’s expectation of repayment at the time the note was issued was reasonable given that the debtor had the capacity to service the debt with ample cash flow and a relatively low debt-to-equity ratio. Expert witnesses provided favorable testimony regarding the debtor’s creditworthiness.
- The parties treated the transaction as debt, as demonstrated by conduct consistent with that of a debtor and creditor. Each entity recorded the debt on their respective balance sheets, the debtor regularly made interest payments to the creditor, which the creditor recorded on its books, and the debtor eventually paid off the debt in full. In addition, the worldwide ITW group as a whole had a history of respecting and treating its intercompany loans as debt.
IRS’ additional theories rejected
After determining that the note should be treated as debt under the case law’s multi-factor test, the Tax Court turned to the IRS’ alternative arguments. The IRS asserted that the loan lacked economic substance, but he court disagreed. The court held that loan was executed to serve the business purpose of obtaining funds and was “a loan in substance as well as in form.” The court noted that the intercompany nature of the transfers does not mean that the parties’ economic positions did not change.
The IRS asserted step transaction and conduit theories that essentially repeated its argument for treating the loan as a dividend. The court rejected them, noting with respect to its step transaction conclusion that the IRS was “not seeking to collapse unnecessary steps, but to recharacterize the first step as a dividend rather than a loan.”
The court also rejected the IRS’ novel theory that the policy underlying Subpart F of the Tax Code (which subjects U.S. shareholders to tax as a result of certain types of transactions engaged in by foreign corporations they own) somehow required imposition of tax on ITW. The IRS asserted that the policies of these Subpart F rules, rather than the Subpart F rules themselves, could support its asserted tax deficiency. The IRS was essentially asking the Tax Court to create new law. The Tax court declined, stating that:
[the IRS] appears to contend that the policies underlying the Subpart F regime require us to recharacterize these transactions in an extraordinary way. We decline [the IRS’] invitation in the absence of a clear statutory directive supporting [its] position.
Section 385 regulations
The transactions addressed in the ITW case predate the April 2016 effective date of the Regulations under section 385 (section 385 regulations). In certain related party debt transactions, the section 385 regulations can now characterize debt as equity even where the debt would pass muster under the case law’s multi-factor approach. It would not appear that the section 385 regulations would have altered the result of the ITW case even if they had been effective for the tax years at issue. However, taxpayers issuing or modifying related party debt should consider the section 385 regulations in addition to the generally applicable case law.
The ITW debt-equity case shows that courts generally will apply principles debt-equity case law upheld a debt characterization of a properly a related party loan arrangement with a creditworthy borrower that is implemented and followed properly. It also indicates that the alternative theories asserted by the IRS to recharacterize the debt in this case, economic substance, step transaction, conduit, and policies of Subpart F should not be considered valid end runs around the governing case law that should recharacterize an otherwise valid borrowing and debt, absent specific transactions that trigger application these other doctrines or rules. Taxpayers entering or modifying related party debt generally should consult with their tax advisors regarding the expected tax treatment of their specific transactions.