Taxpayer victory on characterization of intercompany debt transaction

Intercompany financing and related-party transactions have been long-standing issues between corporate taxpayers and the IRS.   On August 6, 2018, the US Tax Court decided Illinois Tool Works Inc. & Subsidiaries v. Comm’r, upholding the taxpayer’s characterization of a cross-border, intercompany financing transaction as a loan creating a bona fide debt obligation, and thus supporting the taxpayer’s overall international tax structure and planning. Illinois Tool Works is the latest decision in the ongoing argument over the characterization of related-party financial instruments that has been a continuous theme between IRS and taxpayers which will likely continue. The decision is a strong taxpayer victory, provides valuable insight with respect to the planning and execution of cross-border intercompany transactions, and serves as a reminder that the choice by multinational companies to use equity or debt for cross-border, intercompany financing still matters.

Summary of Illinois Tool Works Case

It was decided that proceeds loaned between a wholly-owned foreign parent and foreign subsidiary funded a nontaxable return-of-capital distribution to the U.S. parent. The IRS made several arguments, all of which were rejected by the court, that the loan should be reclassified from debt to equity resulting in a taxable dividend. The arguments included (1) no dividends were paid in the year the funds were borrowed; (2) there was no practical ability to force repayment because the foreign parent had no operating assets; (3) when borrowed, there was no documented plan for repayment; (4) the loan proceeds weren’t used in the borrower’s business, being distributed to the U.S. parent; and (5) the loan lacked covenants often found in third-party financing. Economic substance, step transaction and conduit doctrines, tax avoidance, and lack of basis arguments were also rejected. Illinois Tool Works Inc., TC Memo 2018-121 (Tax Ct.).

Key Takeaway

The court’s opinion is a dismissal of a common argument presented by the IRS against a taxpayer’s treatment of an intercompany transaction creating bona fide debt.  In this case, as it has done in other cases, the IRS contended that the upper-tier foreign corporation lacked an independent ability to pay interest or repay the loan because the upper-tier foreign corporation was a holding company and relied on the operations of its subsidiaries to provide cash.  The court rejected this argument and provided that a potential creditor would evaluate a holding company’s ability to pay by taking into account the assets and future cash flows of its operating subsidiaries.

The Illinois Tool Works decision will present a valuable piece of guidance for taxpayers with respect to international tax structuring.  The insight it provides will be relevant for taxpayers and practitioners in planning new transactions, as well as practitioners who are currently engaged in disputes about the characterization of an intercompany transaction.

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