Tax Court upholds ITW’s return of basis repatriation transaction

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August 2018


On August 6, the Tax Court (the court) released a technical memorandum in Illinois Tool Works, Inc. v. Commissioner, T.C. Memo. 2018-121, ruling in favor of the taxpayer, Illinois Tool Works, Inc. (ITW). The court’s decision upholds ITW’s foreign subsidiary financed return of basis repatriation transaction undertaken in 2006. This transaction involved an upstream loan from a foreign subsidiary to its foreign parent and a subsequent distribution of the loan proceeds from the foreign parent to its US parent. The court first (and importantly) determined that the upstream loan was bona fide debt, applying common law debt-versus-equity principles developed by the Seventh Circuit. While acknowledging that related-party loans should be given close scrutiny, the court also recognized that in situations in which the debtor and creditor are related, the lender may understandably offer more flexible terms than could be obtained elsewhere and concluded that the loan constituted bona fide debt under the facts presented.  

After concluding that the loan was debt, the court rejected each of the IRS’s assertions--including that the economic substance, step transaction, and conduit doctrines should apply to recharacterize the transaction as a taxable dividend--as not consistent with the tax law that applies to loans and distributions to shareholders. As expected, the court discussed the Falkoff v. Comm’r, 604 F.2d 1045 (7th Cir. 1979), rev’g and remanding T.C. Memo. 1977-93, decision, which both parties asserted in support of their respective positions. The court, finding the basic transaction in Falkoff and the instant case to be the same despite certain factual differences, specifically concluded that the Falkoff decision was more supportive of ITW’s position. In doing so, the court stated that whether a loan that funds a distribution is from a related party (as is the case in ITW) or a third party (as was the case in Falkoff) is immaterial to reaching the conclusion that the transaction should be respected so long as the loan is respected as indebtedness.

As of the date of this PwC Insight, the IRS has not yet indicated whether it may appeal the Tax Court’s ruling.

The takeaway

The court’s decision in ITW reinforces the legitimacy of Falkoff transactions.  The extent to which this decision will have meaningful impact outside of the Seventh Circuit, however, is up for debate, as the court was required to follow Seventh Circuit precedent. Nevertheless, the court’s analysis relating to its conclusion that the CSE Note, an intercompany debt used to finance a distribution and funded through cash pool netting, constituted bona fide debt and its conclusion that an incomplete basis calculation can substantiate a shareholder’s basis in its subsidiary, is instructive as it illustrates the court’s understanding of modern business practices and how multinational companies operate in today’s environment.

Taxpayers may also find the analysis in the case helpful as they look to mobilize cash post-tax reform, where dividend distributions may not be possible due to local country restrictions or other constraints.

Contact us

Doug McHoney

International Tax Services Co-Leader, PwC US

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