Illinois Tool Works Inc. & Subsidiaries v. Commissioner of Internal Revenue, 080618 FEDTAX, 10418-14

Docket Nº:10418-14
Opinion Judge:LAUBER, JUDGE.
Attorney:Caroline H. Ngo, Thomas Kevin Spencer, Kathryn C. Vouri, and Justin E. Jesse, for petitioner. H. Barton Thomas, Jr., Justin D. Scheid, Mindy Y. Chou, and John P. Healy, for respondent.
Case Date:August 06, 2018
Court:United States Tax Court

T.C. Memo. 2018-121




No. 10418-14

United States Tax Court

August 6, 2018

Caroline H. Ngo, Thomas Kevin Spencer, Kathryn C. Vouri, and Justin E. Jesse, for petitioner.

H. Barton Thomas, Jr., Justin D. Scheid, Mindy Y. Chou, and John P. Healy, for respondent.



With respect to petitioner's Federal income tax for 2006, the Internal Revenue Service (IRS or respondent) determined a deficiency of $70, 174, 594. In his answer respondent asserted that petitioner is also liable for an accuracy-related penalty of $14, 034, 919 under section 6662(a).1

In September 2006 the worldwide group headed by Illinois Tool Works Inc. (ITW or petitioner) had on its balance sheet about $618 million of cash, held mostly by European affiliates. ITW desired to bring a portion of this cash back to the United States. To do so, it employed a plan that combined intercompany debt with a return-of-capital distribution.

This repatriation plan worked as follows. One of petitioner's lower-tier controlled foreign corporations (CFCs) lent money to an upper-tier CFC. The upper-tier CFC was a holding company with no current or accumulated earnings and profits (E&P). The upper-tier CFC then distributed the loan proceeds of $356, 778, 000 to one of petitioner's domestic subsidiaries, which reported the distribution as a nontaxable return of capital.

The IRS attacked this strategy on two grounds. First, it contended that the loan between the CFCs was actually a dividend. If that were so, the E&P of the lower-tier CFC would move to the upper-tier CFC, and the distribution by the upper-tier CFC would be taxable as a dividend under section 301(c)(1). Second, if the form of the intercompany loan were respected, the IRS contended that the domestic parent had insufficient basis in the upper-tier CFC to absorb the distribution as a return of capital. If that were so, a portion of the distribution would be taxable as capital gain under section 301(c)(3).

There are four principal issues that we must decide: (1) whether the loan from the lower-tier CFC to the upper-tier CFC should be treated as bona fide debt; (2) if we find the loan to be bona fide debt, whether it should nevertheless be recharacterized, under one or more judicial anti-tax-avoidance doctrines, as a dividend to the upper-tier CFC or to petitioner; (3) if the loan is not recharacterized as a dividend, whether the domestic parent had sufficient basis in the upper-tier CFC to treat the entirety of the distribution as a return of capital; and (4) whether petitioner is liable for an accuracy-related penalty. We resolve all issues in petitioner's favor.


The parties filed stipulations of facts with attached exhibits and stipulations of settled issues, all of which are incorporated by this reference. ITW is a publicly held C corporation founded in 1912. It had its principal office and principal place of business in Illinois when it filed its petition.

A. Company Background and Ownership Structure

ITW is the parent of a group of more than 100 companies that manufacture industrial products and equipment. Petitioner and its domestic subsidiaries have filed consolidated Federal income tax returns at all relevant times. During 2006 petitioner's foreign subsidiaries did business in 49 countries. We will refer to these companies collectively as the ITW Group.

In 2006 the ITW Group had operating revenue of about $14.1 billion and net income of $1.7 billion. It divided its business operations into four segments: (1) engineering products (North America); (2) engineering products (international); (3) specialty systems (North America); and (4) speciality systems (international). It had about 55, 000 employees in that year.

Between 1999 and 2008 petitioner pursued a strategy of growth through acquisitions. To raise cash for these acquisitions and for a $447 million stock buy-back in August 2006, petitioner substantially increased its short-term debt. Its outstanding commercial paper (CP) obligations, which stood at $20 million in June 2006, grew to $770 million by December 2006.

During 2006 petitioner was the sole shareholder of ITW International Holdings, Inc. (InHold), a Delaware corporation. (In July 2007 InHold changed its name to ITW Global Investments, Inc.) InHold in turn was the sole shareholder of Paradym Investments Ltd. (Paradym), which was originally organized in Bermuda. In August 2005 Paradym became a domestic corporation and a member of petitioner's consolidated group.

During 2006 Paradym was the sole shareholder of CS (Europe) Holdings, Ltd. (CSE), a Bermuda corporation with its registered office in Bermuda. Petitioner formed CSE in 2001 as part of a project to place the ITW Group's European subsidiaries under several tiers of foreign holding companies. CSE, situated at the top of this structure, is what some commentators have described as a "super holding company."2

In 2006 CSE was the sole shareholder of Miller Insurance, Ltd. (Miller), a captive insurance company, and CS (Australasia) Holdings, Ltd. (CSA), both Bermuda corporations. CSA, like CSE, was a holding company with no active business operations.3 Directly and indirectly CSA held stock in about 100 foreign operating companies, including the following: (1) ITW Group France; (2) Illinois Tool Works Nederland B.V.; (3) ITW (Deutschland) GmbH; (4) ITW Italy Holding S.r.l. (Italy Holding); and (5) ITW Belgium S.p.r.l. We will refer to these five operating companies collectively as the European Borrowers. Italy Holding was the sole shareholder of several Italian subsidiaries and disregarded entities, including Italy Finance Srl (Italy Finance).

At all relevant times CSE and CSA were CFCs within the meaning of section 957(a). Petitioner, InHold, and Paradym were U.S. shareholders of these CFCs under section 951(b) because they owned (directly or indirectly) 100% of the total combined voting power of all classes of the CFCs' stock. The parties have stipulated that CSA had the following amounts of E&P for its fiscal years ending (FYE) November 30, 2006 and 2007:

FYE Nov. 30 Current E&P Accumulated E&P
2006 $306, 339, 452 $749, 554, 212
2007 319, 317, 329 1, 043, 397, 544
In 2004 Congress enacted a "tax holiday" that enabled U.S. shareholders of CFCs to enjoy a reduced tax rate of 5.25% on dividends received from their foreign affiliates. American Jobs Creation Act of 2004, Pub. L. No. 108-357, sec. 422(a), 118 Stat. at 1514-1515. To take advantage of this tax holiday, petitioner caused CSA and other affiliates to pay substantial dividends to CSE, which in turn paid substantial dividends to Paradym. During its FYE November 30, 2005, CSE paid Paradym dividends of $825, 054, 144, and during its FYE November 30, 2006, CSE paid Paradym dividends of $160, 540, 400. Petitioner reported all of these dividends on the relevant Forms 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. As of November 30, 2006, CSE had no remaining E&P.4 B. Cash Pool Most borrowing by the European members of the ITW Group was done by holding companies using bank lines of credit. Within each country the operating companies would maintain funds in operating accounts. Any excess positive balance (i.e., amounts above what was needed for current operations) would be swept into the holding company within that country and aggregated with the excess positive balances of the other operating companies. When it needed to borrow, the holding company would draw on a line of credit with a local bank and transfer the loan proceeds into that country's cash pool. Beginning in 2001 the ITW Group used a "notional" cash pool operated by Bank Mendes Gans N.V. (BMG), a Dutch bank. In a "notional" cash pool, one...

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