Illinois Tool Works Inc. & Subsidiaries v. Commissioner , 2018 T.C. Memo. 121 ( 2018 )

T.C. Memo. 2018-121
UNITED STATES TAX COURT
ILLINOIS TOOL WORKS INC. & SUBSIDIARIES, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 10418-14. Filed 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.
MEMORANDUM FINDINGS OF FACT AND OPINION
LAUBER, Judge: With respect to petitioner’s Federal income tax for 2006,
the Internal Revenue Service (IRS or respondent) determined a deficiency of
-2-
[*2] $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 most-
ly 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 dis-
tribution 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 up-
per-tier CFC would be taxable as a dividend under section 301(c)(1). Second, if
1
All statutory references are to the Internal Revenue Code in effect for the
year at issue, and all Rule references are to the Tax Court Rules of Practice and
Procedure. We round all monetary amounts to the nearest dollar.
-3-
[*3] 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 distribu-
tion 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 re-
characterized, under one or more judicial anti-tax-avoidance doctrines, as a divi-
dend 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 peti-
tioner is liable for an accuracy-related penalty. We resolve all issues in petition-
er’s favor.
FINDINGS OF FACT
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.
-4-
[*4] 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 (internation-
al); (3) specialty systems (North America); and (4) speciality systems (interna-
tional). It had about 55,000 employees in that year.
Between 1999 and 2008 petitioner pursued a strategy of growth through ac-
quisitions. 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 out-
standing 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 Hold-
ings, 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
-5-
[*5] 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. Petition-
er 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 hold-
ing 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 Ber-
muda corporations. CSA, like CSE, was a holding company with no active busi-
ness operations.3 Directly and indirectly CSA held stock in about 100 foreign
operating companies, including the following: (1) ITW Group France; (2) Illinois
2
See Alan W. Granwell, “News Analysis: Contract Manufacturing Arrange-
ments and Subpart F,” 119 Tax Notes 381 (2008); Bret Wells, “What Corporate
Inversions Teach About International Tax Reform,” 59 Tax Notes Int’l 221
(2010).
3
Petitioner formed CSA in 2001 as part of a restructuring of its Australian
and Asian subsidiaries to achieve (among other things) Australian tax benefits.
Petitioner later contributed CSA to CSE as part of a separate project designed to
achieve (among other things) U.K. and U.S. tax benefits.
-6-
[*6] 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 sec-
tion 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 for-
eign 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
-7-
[*7] 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 bal-
ance (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 posi-
tive 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
4
From 2002 through 2012, CSA paid CSE more than $2.2 billion of divi-
dends including the $985,594,544 ($825,054,144 + $160,540,400) referred to in
the text.
-8-
[*8] participant (called the cash pool “header”) calculates a consolidated net
position by offsetting the cash surpluses against the cash deficits of the various
participants. Unlike a “zero balance” cash pool, in which offsets are implemented
by actual transfers of cash, a “notional” cash pool involves no physical movement
of money between participants’ accounts.
About 50 members of the ITW Group participated in the BMG cash pool
during 2006. CSA and CSE joined the cash pool in November 2006 using the
U.S. dollar as their functional currency. The cash pool was managed by an ITW
finance officer in the United States, whose duties included approving wire trans-
fers and investing funds. The cash pool operated as follows:
• An entity depositing money into the cash pool would receive deposit
credit on its separate BMG account.
• An entity withdrawing money from the cash pool would show a
corresponding debit on its separate BMG account.
• An entity could withdraw more funds from the cash pool than it had
deposited, provided the overall cash pool balance was positive.
• Any cash pool account with a credit balance would receive interest
from BMG, and any cash pool account with a debit balance would be
charged interest by BMG. BMG determined interest rates daily by re-
ference to market rates for the applicable country’s currency.
• Cash pool accounts with credit balances were pledged as security for
accounts with debit balances.
-9-
[*9] • ITW provided a $75 million guaranty to be fulfilled in the event one
or more participants in the cash pool defaulted.
BMG offered “netting” services in connection with this notional cash pool.
This enabled payments and receipts between participating entities to be offset.
After calculating the net amount due to or from each participant, BMG credited or
debited that participant’s cash pool account accordingly.
C. Repatriation Planning
Petitioner’s Capital Solutions Group (Capital Solutions) was responsible for
all tax planning, tax advice, and tax compliance during 2006. In September 2006
Capital Solutions began planning a repatriation of funds from petitioner’s CFCs to
facilitate the retirement of outstanding CP and to fund new acquisitions. Its first
step was to create a schedule titled “Cash Available for Repatriation,” which com-
piled excess funds held by CSE and its subsidiaries as of September 30, 2006.
Numerous individuals assisted with planning the repatriation, including:
(1) Allan Sutherland, petitioner’s senior vice president, who also served as presi-
dent and a director of CSE and CSA; (2) Lisa Hampton, manager of strategic tax
planning and project manager for the repatriation transaction; (3) Felix L. Rodri-
guez, Jr., petitioner’s treasurer, who also served as vice president and a director of
CSE and CSA; and (4) Ronald Kropp, petitioner’s senior vice president and chief
-10-
[*10] financial officer. At all relevant times, Mr. Sutherland and Mr. Rodriguez
signed documents on behalf of CSA and CSE in their capacities as directors.
On October 31, 2006, Ms. Hampton informed Mr. Sutherland that the Euro-
pean affiliates had substantial positive balances in the BMG cash pool that could
be used to fund part of a repatriation from CSE. Petitioner also considered having
CSE borrow from third-party banks or capital markets to fund the repatriation.
But in a follow-up email on November 7, 2006, Ms. Hampton informed Mr. Suth-
erland that CSE did not have audited financial statements, which would have been
necessary for a bank borrowing unless petitioner agreed to guarantee the loan. Be-
cause petitioner did not wish to guarantee such a large loan, and because there was
insufficient time before the end of the year to secure audited financials, Mr. Suth-
erland decided that the best course of action was for CSE to secure an intercom-
pany loan. Petitioner desired to complete the repatriation before year-end 2006 in
order to pay down its outstanding CP.
On December 6, 2006, Mr. Sutherland and Ms. Hampton discussed the
terms for a loan from CSA to CSE. After considering prevailing market rates for
similar intercompany debt, they decided upon 6% as the appropriate interest rate
and five years as the appropriate term. In selecting these loan terms, they also
compared the cost of intercompany borrowing by the CFCs with interest rates on
-11-
[*11] short-term CP borrowing by petitioner. Lending funds to CSE would
require CSA temporarily to “go negative” in the cash pool and pay interest on its
debit balance at 5.875%.
Sometime in early December 2006 Ms. Hampton prepared a plan for exe-
cuting the repatriation, which was summarized in a Tax Planning Project Approval
Form (TPPAF). This document noted that petitioner had been “borrowing on
short term CP” to fund its domestic acquisitions and that the European subsidiaries
had excess cash. It explained that petitioner would cause certain of its foreign
subsidiaries to borrow from their local banks, deposit the proceeds into the BMG
cash pool, and have CSA borrow from the pool to fund a loan to CSE, which
would distribute the loan proceeds to Paradym. The TPPAF noted that “for US tax
purposes the distribution is being treated as return of capital and is not taxable.”
The TPPAF projected that the proposed repatriation strategy would yield tax sav-
ings of about $47 million for the ITW Group.
Mr. Kropp presented the TPPAF to petitioner’s board of directors on De-
cember 8, 2006. He explained that combining an intercompany loan to CSE with a
distribution of the loan proceeds as a return of capital would be the most tax-effi-
cient method of repatriating funds. Mr. Kropp also presented a proposal to “in-
-12-
[*12] crease guarantees for European borrowings” in connection with the
repatriation. The board approved the TPPAF and Mr. Kropp’s proposal.
D. Repatriation Transactions
Petitioner’s repatriation plan proceeded as follows:
• Between November 30 and December 4, Italy Holding and its subsidiaries
executed a series of transactions designed to enable them to lend to the other Euro-
pean Borrowers while maintaining their ability to deduct interest on indebtedness
under Italy’s recently enacted “thin capitalization” rules. These transactions cul-
minated in a $95 million loan from Italy Finance to a European affiliate, which
BMG deducted from Italy Holding’s cash pool account and credited to CSE’s cash
pool account.5
• Between December 11 and 13, the European Borrowers secured from
local banks loans of $140 million, of which $125 million was from new short-term
credit facilities and $15 million was from existing facilities. Petitioner guaranteed
the borrowing for the new credit facilities.
• Between December 13 and 15, the European Borrowers deposited the
loan proceeds described above into the BMG cash pool. They concurrently liqui-
5
This loan, which had a five-year term, was later extended twice. The loan
was repaid in full (with interest) on August 30, 2012.
-13-
[*13] dated $155 million of money market funds and deposited the proceeds into
the BMG cash pool.
• On December 13 Mr. Sutherland and Mr. Rodriguez, acting in their capa-
cities as officers and directors of CSE and CSA, authorized CSE to borrow
$356,778,000 from CSA. This loan was documented in a one-page promissory
note that provided for 6% simple interest and a five-year repayment term (2006
note). No principal payments were due until maturity, and there was no premium
or penalty for early repayment. The note stipulated that CSA could enforce pay-
ment of principal and interest, made no provision for subordinating the debt to
CSE’s other obligations, and stated that Delaware law would govern its interpreta-
tion. CSA recorded this note on its books as an intercompany note receivable, and
CSE recorded it as an intercompany note payable.
• Mr. Sutherland and Mr. Rodriguez concurrently authorized the distribu-
tion of the $356,778,000 loan proceeds from CSE to Paradym. To avoid multiple
currency conversions, they directed CSE to transfer this amount directly to InHold,
Paradym’s parent.
• On December 15 the euro equivalent of $356,778,000 was transferred
from CSA’s cash pool account at BMG to CSE’s cash pool account. This caused
-14-
[*14] CSA temporarily to have a negative cash pool balance of $356,778,000,
which accrued interest at 5.875% annually.
• Later that day BMG transferred $356,778,000 from CSE’s cash pool ac-
count to InHold’s bank account in the United States. Petitioner used these funds
to pay down its outstanding CP balance, which was reduced from approximately
$726.9 million on December 1 to about $200.7 million on December 31.
E. Repayment of the CSE Note
During 2007-2011 petitioner considered a variety of options for repaying
the CSE note, including third-party borrowing, intercompany borrowing, and the
issuance of capital market debt or equity instruments. In late 2008 the IRS began
examining petitioner’s 2006 and 2007 tax returns, focusing chiefly on the repa-
triation transaction, and petitioner subsequently filed a protest with the IRS Ap-
peals Office. In December 2011, when the CSE note was due to mature, petition-
er’s case was still pending with the Appeals Office.
Petitioner believed that it would be inadvisable to repay the CSE note while
the Appeals Office was considering its 2006 tax liability. Petitioner accordingly
decided that CSA and CSE should extend for one year the maturity of the existing
loan. On December 15, 2011, CSE executed a new one-year promissory note for
$356,778,000, the outstanding principal balance of the 2006 note.
-15-
[*15] The 2011 note provided that CSE would pay interest at the 90-day LIBOR
rate plus 20 basis points, to be reset quarterly.6 Like the 2006 note, the 2011 note
made no provision for subordinating the debt to CSE’s other obligations. It stipu-
lated that principal and interest were due at maturity, that there was no premium or
penalty for early repayment, and that CSA could enforce payment of principal and
interest. The new loan was recorded on the books of both companies as an inter-
company note for $356,778,000.
In June 2012 CSE borrowed $15 million from Miller and received a divi-
dend of $15 million from it. In November 2012 CSE used this $30 million to re-
pay part of the principal on the 2011 note, reducing the outstanding balance to
$326,778,000. As of November 2012 the IRS Appeals Office had not concluded
its review of the repatriation transaction, and petitioner decided upon another one-
year extension of the maturity date.
On December 14, 2012, CSA and CSE executed a new one-year promissory
note for $326,778,000. The terms of 2012 note were identical to those of the 2011
6
LIBOR (London Interbank Offering Rate) is an average interest rate that
major international banks charge each other for large loans. It is considered one of
the primary benchmarks for short-term interest rates worldwide, and it was the
short-term rate at which petitioner itself could borrow. Using LIBOR as a baseline
rate, petitioner added 20 basis points to account for CSE’s position as a subsidiary
within the ITW Group.
-16-
[*16] note, except that the interest rate was set at 90-day LIBOR plus 50 basis
points, to be reset quarterly. CSA and CSE recorded the new loan on their books
as an intercompany note for $326,778,000.
During 2012-2013 petitioner divested itself of certain businesses, generating
substantial cash that could be used to reduce debt. On December 15, 2013, In-
Hold’s board authorized the contribution of $344,411,130 to Paradym, which
made (through a subsidiary) a capital contribution of the same amount to CSE.
That same day, CSE paid $329,324,880 to CSA, representing full payment of the
principal balance on the 2012 note plus accrued interest for 2013. After making
this payment, CSE had a debit balance in the BMG cash pool of $46,410,496.
The 2006, 2011, and 2012 notes did not mandate periodic interest payments,
permitting both principal and interest to be paid at maturity. However, CSE and
CSA reported annually on their books the payment and receipt of interest in the
following amounts:7
7
Interest on the 2011 and 2012 notes was keyed to the 90-day LIBOR rate,
which stayed below 1% during those years. See David Hou & David Skeie, Fed.
Reserve Bank of N.Y., Staff Report No. 667, LIBOR: Origins, Economics, Crisis,
Scandal, and Reform 5 (2014). Thus, the interest CSE paid during 2012 and 2013
was substantially less than the interest it paid on the 2006 note, which bore simple
interest of 6%.
-17-
[*17] Fiscal year Amount
2007 $20,514,735
2008 21,406,680
2009 21,406,680
2010 21,406,680
2010 (short year) 1,783,890
2011 20,455,272
2011 (short year) 124,005
2012 2,255,266
2012 (short year) 72,927
2013 2,546,880
On the dates on which CSE reported payment of this interest, it had (before paying
the interest) a debit balance in the BMG cash pool or a credit balance smaller than
the amount of interest paid, as follows:
CSE cash
Date pool balance
11/21/2007 $15,484
11/26/2008 (20,128,199)
11/25/2009 (7,520,210)
11/24/2010 1,800,340
12/22/2011 (21,053,997)
11/29/2012 (13,660,028)
12/20/2012 (43,670,457)
Besides the CSE loan, petitioner’s books on December 31, 2006, showed
122 other outstanding intercompany debts with an aggregate face amount of $74.5
-18-
[*18] billion. In response to respondent’s discovery requests, petitioner provided
information for a representative sample of 48 intercompany loans. Of these loans,
33 were fully repaid or settled via intercompany transfer, 12 remained outstanding,
2 were extinguished upon merger of the lender and borrower, and 1 was divested
when petitioner sold both entities to a third party.
F. Financial and Tax Reporting
At all relevant times petitioner and its domestic subsidiaries, including In-
Hold and Paradym, used the calendar year for tax and financial reporting purposes.
During 2006-2010 most of petitioner’s foreign subsidiaries reported using an FYE
November 30.8 Petitioner filed Forms 5471 as required for all tax years, reporting
each CFC’s balance sheet, income and expenses, and transactions with related en-
tities. Petitioner reported all relevant information about the 2006 repatriation on
its 2006 return. Because CSA and CSE used an FYE November 30, information
regarding the December 2006 repatriation was reported on their Forms 5471 for
FYE November 30, 2007.
To prepare its consolidated financial statements, petitioner used Hyperion,
an accounting software program, and then “mapped” these accounts into CorpTax,
8
Using an FYE November 30 allowed petitioner’s accounting personnel to
close out the foreign subsidiaries’ books before the end of petitioner’s taxable
year, which made it easier to produce consolidated financial statements.
-19-
[*19] its tax accounting software. “Mapping” the accounts involved a two-step
process by which the trial balances were first reviewed for accuracy and then
linked to specified accounts in CorpTax.
The 2006 CSE note was reported in petitioner’s Hyperion trial balance for
2006 as a $356,778,000 “Intercompany Note Payable” to CSA. CSE’s Form 5471
for FYE November 30, 2007, shows on line 15 of Schedule F current liabilities of
$356,807,169, which includes its indebtedness to CSA. The interest payment on
the 2006 note is reflected in the Hyperion trial balance on line I-43 (Intercompany
Interest), and the detail indicates that this interest was paid to CSA. CSE’s Form
5471 for FYE November 30, 2007, shows the interest payment on line 5 of Sched-
ule C (Income Statement). Petitioner used a similar process to report the promis-
sory notes and interest payments on CSA’s books and Forms 5471 for FYE No-
vember 30, 2007, and subsequent years.
G. IRS Examination
Petitioner timely filed Form 1120, U.S. Corporation Income Tax Return, for
2006. It attached to its Form 1120 pro forma returns for InHold and Paradym.
Neither of these pro forma returns reported as income the $356,778,000 distribu-
tion from CSE because petitioner treated it as a return of capital to Paradym.
-20-
[*20] The IRS selected petitioner’s return for examination and determined that the
December 2006 repatriation was taxable. The IRS first determined that the trans-
fer from CSA to CSE was a dividend rather than a loan; that E&P of $356,778,000
had thus “tiered up” to CSE; and that CSE’s distribution to Paradym was therefore
taxable as a dividend under sections 301(c)(1) and 316. Alternatively, the IRS de-
termined that petitioner had failed to substantiate Paradym’s basis in CSE, so that
the distribution, if not a dividend, was not a tax-free return of capital under section
301(c)(2) but rather was taxable capital gain under section 301(c)(3).
The IRS issued a timely notice of deficiency setting forth these adjustments,
and petitioner timely petitioned this Court for redetermination. In his answer re-
spondent asserted an accuracy-related penalty under section 6662(a). In an
amended answer respondent attacked the repatriation transaction on two alter-
native theories: (1) that the loan from CSA to CSE should be recharacterized as a
dividend under judicial anti-tax-avoidance doctrines and (2) that the transaction
was in substance a loan from CSA directly to petitioner or Paradym, generating a
taxable investment in U.S. property under section 956(a) and (c)(1).
-21-
[*21] H. Expert Testimony9
1. Robert C. Grien
Respondent offered, and the Court recognized, Robert C. Grien as an expert
in debt capital markets. He evaluated the terms of the 2006 note and opined that it
would not have been salable to a third party without substantial modifications. He
pointed out that the note did not contain restrictive covenants typically found in
publicly issued, investment-grade debt instruments, such as restrictions on invest-
ment activities, restrictions on payment of dividends, and negative pledges of as-
sets. For that reason, he opined that a third party would have been unwilling to
extend credit to CSE on the terms set forth in the 2006 note.
Mr. Grien also observed that the 2006 note: (1) was not guaranteed by pe-
titioner; (2) did not explicitly mandate periodic payment of interest; and (3) was in
his view “structurally subordinated” to debts of CSA’s operating subsidiaries. Mr.
Grien opined that the 2006 note, to be marketable to an independent investor,
would need to include, at a minimum, provisions mandating interest payments at
fixed times, acceleration of principal upon default or bankruptcy, and a restriction
9
An alphabetical listing of petitioner’s and respondent’s expert witnesses,
together with a short résumé of each, appears in the appendix beginning infra p.
74.
-22-
[*22] against mergers. While noting the absence of truly comparable companies,
he opined that CSE’s credit rating would be at most BBB+.
2. R. Glenn Hubbard
Respondent offered, and the Court recognized, R. Glenn Hubbard as an
expert in corporate finance and economics. Evaluating the “economic reality” of
the repatriation transaction, he opined that it lacked a valid business purpose. Spe-
cifically, he concluded that there was no business reason for CSA to lend money to
CSE to enable it to make a distribution to Paradym.
Dr. Hubbard also opined that CSE lacked an independent ability to repay
CSA. From an economic perspective, he believed, funds for repayment could only
come from CSA itself (via distributions to CSE) or from petitioner or its domestic
subsidiaries (none of which had guaranteed the note). And he observed that CSE
made its interest payments to CSA by borrowing money from the BMG cash pool,
which in his view represented a circular flow of funds.
3. Saul Froomkin
Petitioner offered, and the Court recognized, Saul Froomkin as an expert in
Bermuda commercial law. He opined that the 2006 note was enforceable under
Bermuda law; that CSA’s directors would violate their fiduciary duties under Ber-
muda law if they sought to prevent CSA from enforcing repayment of the note;
-23-
[*23] and that Mr. Sutherland and Mr. Rodriguez, as directors of CSA, would be
personally liable to it if they did not enforce repayment of the note. He also
opined that CSE’s obligation to repay CSA was not subordinated to CSE’s
obligations to third-party creditors.
4. Israel Shaked
Petitioner offered, and the Court recognized, Israel Shaked as an expert in
corporate finance. Dr. Shaked considered whether CSE could have obtained fi-
nancing from a third party. In his expert report he performed three analyses: (1) a
debt service analysis, which considers whether a borrower has sufficient cashflow
to make future principal and interest payments; (2) an equity cushion analysis,
which considers the amount by which the value of the borrower’s assets exceeds
its indebtedness; and (3) a capital adequacy analysis, which considers the borrow-
er’s leverage compared to industry benchmarks.
Applying these analyses, Dr. Shaked concluded that CSE and its subsidiar-
ies would have been expected to generate sufficient cash between 2007-2011 to
make payments on all of their outstanding debts when they became due. He speci-
fically found that: (1) CSE was projected to have free cashflow of about $1.5 bil-
lion during 2007-2011, more than enough to discharge all its debts; (2) CSE would
not require additional debt financing to repay the CSA loan; and (3) CSE’s equity
-24-
[*24] cushion was at least $6 billion.10 He concluded that CSE was adequately
capitalized and had substantial unused debt capacity.11 And whereas CSE’s peer
companies had debt-to-equity ratios between 19% and 31%, Dr. Shaked calculated
that CSE’s debt-to-equity ratio ranged between 4% and 6%.12 In a rebuttal report
he concluded that Dr. Hubbard had erred in opining: (1) that CSE lacked an
independent ability to repay the loan and (2) that CSA in effect had created a
liability to itself, on the theory that its funds were a likely source of repayment.
5. William Chambers
Petitioner offered, and the Court recognized, William Chambers as an ex-
pert in assignment of credit ratings. In his report Dr. Chambers stated that he
would likely have assigned CSE, each time it executed a note in favor of CSA, an
investment grade rating of at least BBB+ under the Standard and Poor’s (S&P)
credit rating system. He based this conclusion on CSE’s strong cashflow and low
debt levels: Debt represented only 0.1% of CSE’s capital structure before the
10
Dr. Shaked found that for 2011 (the year in which the 2006 note matured)
the CSE group had an equity cushion of about $7.4 billion.
11
As of December 15, 2006, the assets of CSE and its subsidiaries exceeded
their liabilities by approximately $6.1 billion.
12
The debt-to-capital ratio was 6% when the 2006 note was issued and 4%
in 2011 when it matured.
-25-
[*25] 2006 note was issued and peaked at only 3.7% of capital in 2008. Dr.
Chambers further opined that: (1) CSE had at least a “satisfactory business risk
profile” in 2006; (2) CSE’s profit margins were relatively steady in 2006 and
subsequently; and (3) although CSE’s debt was “structurally subordinated,” this
fact was irrelevant because CSA had very little outstanding debt (CSA’s
consolidated indebtedness peaked at $251.6 million in 2009 and decreased to
$17.1 million in 2012).
6. Charles Chigas
Petitioner offered, and the Court recognized, Charles Chigas as an expert in
debt capital markets. In his report Mr. Chigas opined that a third-party investor
would have purchased the 2006 note on substantially similar terms. He based his
opinion on the following conclusions: (1) CSE’s strong credit profile supported
an S&P credit rating of at least BBB; (2) the financial terms of the 2006 note were
substantially similar to standard investment grade terms; and (3) CSE’s ratio of
debt to EBITDA (earnings before interest, taxes, depreciation, and amortization)
was extremely low.
Mr. Chigas observed that the note lacked restrictive nonfinancial covenants
but opined that this was typical of investment grade debt. While acknowledging
that CSE’s ability to defer interest payments until maturity was atypical of invest-
-26-
[*26] ment grade debt, he opined that an upward adjustment of 5 to 10 basis points
would be sufficient to account for that fact. Finally, Mr. Chigas noted that the
corporate bond market was extremely strong in 2006, which would have made
CSE’s loan attractive to investors.13
OPINION
I. Burden of Proof
The IRS’ determinations in a notice of deficiency are generally presumed
correct, and the taxpayer bears the burden of proving them erroneous. Rule
142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Respondent generally
bears the burden of proof “in respect of any new matter, increases in deficiency,
and affirmative defenses” pleaded in the answer or in an amended answer. Rule
142(a)(1). Because we decide all factual issues on a preponderance of the evi-
dence, we need not decide who has the burden of proof. See sec. 7491(a); Estate
of Turner v. Commissioner, 138 T.C. 306, 309 (2012).
13
Petitioner also offered as an expert witness Todd Miller, who prepared a
study to calculate Paradym’s basis in CSE. We have decided to treat Mr. Miller as
a summary witness rather than an expert witness. See infra pp. 65-69.
-27-
[*27] II. CSE Note
A. Bona Fide Debt
Petitioner contends that the loan from CSA to CSE constituted bona fide
debt that was used to fund a tax-free return-of-capital distribution from CSE to
Paradym. Respondent contends that the loan was not bona fide debt, that the
funds transferred from CSA to CSE constituted a disguised dividend, that CSE
was required to increase its E&P under section 312 by the amount of this dividend,
and that the subsequent distribution from CSE to Paradym was a taxable dividend
under sections 316(a) and 301(c)(1).
Whether an advance of funds is treated as genuine debt “must be considered
in the context of the overall transaction.” Hardman v. United States, 827 F.2d
1409, 1411 (9th Cir. 1987). Our inquiry typically focuses on whether the taxpayer
intended to create a debt with a reasonable expectation of repayment and (if so)
whether that intent comports with creating a debtor-creditor relationship. Litton
Bus. Sys., Inc. v. Commissioner, 61 T.C. 367, 377 (1973). The key to this deter-
mination is the taxpayer’s actual intent. Bauer v. Commissioner, 748 F.2d 1365,
1367-1368 (9th Cir. 1984), rev’g T.C. Memo. 1983-120; A.R. Lantz Co. v. United
States, 424 F.2d 1330, 1333-1334 (9th Cir. 1970).
-28-
[*28] Absent stipulation to the contrary, appeal of this case would lie to the U.S.
Court of Appeals for the Seventh Circuit. That court has held that “[w]hether
withdrawals by a shareholder from a corporation are treated for tax purposes as
loans or dividends turns on whether, at the time of the withdrawals, the taxpayer
intended to repay them.” Busch v. Commissioner, 728 F.2d 945, 948 (7th Cir.
1984), aff’g T.C. Memo. 1983-98. In determining whether the taxpayer intended
to repay the withdrawals, the Seventh Circuit considers objective factors as in-
dicative of intent but regards no single factor as dispositive. Ibid.; see also Frier-
dich v. Commissioner, 925 F.2d 180, 182-183 (7th Cir. 1991), aff’g T.C. Memo.
1989-393. This determination is “purely a question of fact.” Busch, 728 F.2d at
949. “[O]nce the taxpayer’s intent is found, that finding is conclusive of the legal
issue of loans versus dividends.” Ibid.
We will apply the factors the Seventh Circuit mentioned in Busch. We will
supplement that analysis with discussion of factors listed in Dixie Dairies Corp. v.
Commissioner, 74 T.C. 476, 493 (1980), to the extent the Seventh Circuit has sug-
gested (by citing opinions from this Court or other courts) that such additional
factors merit discussion. In applying these factors we recognize, as the Seventh
Circuit recognized in Busch, 728 F.2d at 951, that there can be “especially strong
support” for finding corporate advances to be dividends where the purported bor-
-29-
[*29] rower is the sole shareholder of the purported lender. This sole-shareholder
scenario creates “obvious difficulties to thinking of the shareholder and
corporation as debtor and creditor.” Ibid. (quoting Alterman Foods, Inc. v. United
States, 611 F.2d 866, 869-870 (Ct. Cl. 1979)); see also Kraft Foods Co. v.
Commissioner, 232 F.2d 118, 123-124 (2d Cir. 1956) (noting that an arrangement
is subject to “close scrutiny by the Commissioner” where it is “made between a
parent corporation and its wholly-owned subsidiary”), rev’g 21 T.C. 513 (1954).
We will consider in our analysis the following factors from Busch: (1) the
taxpayer’s statement of intent to repay; (2) the extent of the shareholder’s control
of the corporation; (3) the retained earnings and dividend history of the corpora-
tion; (4) the size of the transfer; (5) the presence of conventional indicia of debt,
such as a promissory note, collateral, and interest charges; (6) the treatment of ad-
vances in corporate records; (7) the history of repayment; and (8) the taxpayer’s
use of the funds. We will also consider the following factors from Dixie Dairies:
(9) participation in management as a result of advancing funds; (10) the status of
the advances in relation to regular corporate creditors; (11) “thinness” of the capi-
tal structure; (12) the risk involved in making the advances; (13) the identity of
interest between the creditor and the shareholder; and (14) the ability to obtain
loans from outside sources. Dixie Dairies, 74 T.C. at 493; see Fin Hay Realty Co.
-30-
[*30] v. United States, 398 F.2d 694, 697 (3d Cir. 1968) (noting that an advance
may not be a bona fide loan if an outside lender would not have advanced funds on
the same terms as did the corporate insider); Am. Offshore, Inc. v. Commissioner,
97 T.C. 579, 602-606 (1991); Shaw v. Commissioner, T.C. Memo. 2013-170, 106
T.C.M. 54, 56 (noting that, in determining whether an advance of funds
constitutes bona fide debt, “economic reality provides the touchstone”), aff’d, 623
F. App’x 467 (9th Cir. 2015).
1. Stated Intent to Repay
When analyzing intent we consider the parties’ actual intent at the time the
advances were made. See Busch, 728 F.2d at 949; A.R. Lantz Co., 424 F.2d at
1333; Spheeris v. Commissioner, 284 F.2d 928, 931 (7th Cir. 1960), aff’g T.C.
Memo. 1959-225. Our aim is to determine whether the parties intended to create a
“definite obligation, repayable in any event.” See Hewlett-Packard Co. v. Com-
missioner, T.C. Memo. 2012-135, 103 T.C.M. 1736, 1752, aff’d, 875 F.3d
494 (9th Cir. 2017). Intent is a factual issue that we decide on the basis of all the
circumstances. See Busch, 728 F.2d at 949-950; United States v. Uneco, Inc. (In
re Uneco, Inc.), 532 F.2d 1204, 1208 (8th Cir. 1976).
Petitioner’s actions strongly suggest that it intended to create a bona fide
debt. The 2006 note, evidencing the original advance, and the 2011 and 2012
-31-
[*31] notes, evidencing the refinanced advances, were legally binding documents.
Each loan document was reviewed and approved by CSA’s and CSE’s board of
directors before it was executed. The notes required payment of interest and
repayment of principal at fixed maturity dates. Each year CSE made interest
payments, which were properly recorded on its and CSA’s books. CSE repaid the
loan in full via cash transfers in 2012 and 2013.14
Although it may be challenging to prove intent to repay when the borrower
is the sole shareholder of the lender, Busch, 728 F.2d at 951, the ITW Group has a
good track record in this respect. At year-end 2006 ITW had on its books 122 oth-
er intercompany loans with an aggregate face amount of $74.5 billion. During dis-
covery petitioner provided information for a representative sample of 48 such
loans; of those, 33 were fully repaid, 3 were discharged in a merger or acquisition,
and 12 remained outstanding. Petitioner’s current and former employees credibly
testified that ITW always followed a “live by the agreement” principle for repay-
ing debt, including intercompany debt. This pattern suggests to us that petitioner
regarded its intercompany loans as bona fide debts that were intended to be repaid
and were in fact repaid.
14
Although respondent contends that petitioner failed properly to record the
advance, CSA recorded an asset and CSE recorded a liability in the amount of the
loan in their corporate records and on their Forms 5471. See supra p. 19.
-32-
[*32] Respondent contends that petitioner’s refinancing of the loan weighs against
a finding of genuine indebtedness. We disagree. CSE clearly had the financial
capacity to repay the loan at the original maturity date in December 2011. Be-
cause this case was then pending before IRS Appeals, petitioner believed it advis-
able to extend the maturity date. On these facts, we find that refinancing the loan
casts no doubt on CSE’s intent to repay. See Litton Bus. Sys., Inc., 61 T.C. at 380
n.9 (“We do not consider as particularly detrimental to petitioner’s case the fact
that payments of principal and interest were suspended when the Internal Revenue
Service challenged the propriety of the debt.”); Green Bay Structural Steel, Inc. v.
Commissioner, 53 T.C. 451, 457 (1969) (“Refinancing * * * is an accepted busi-
ness practice and we see nothing wrong with it if reasonable in the context of the
particular facts[.]”).
Respondent contends that CSE could have funded its distribution to Para-
dym in other ways, e.g., by “going negative” in the BMG cash pool or by borrow-
ing in the credit markets. We do not see the logic of this argument. The fact that
CSE might have secured other loans sheds no light on its intent to repay the loan it
actually secured. The relevant question is whether, at the time CSA advanced
funds, CSE intended to repay that debt in full. Because we find that CSE did evi-
dence its intent to repay the debt, the first Busch factor favors petitioner.
-33-
[*33] 2. Extent of Shareholder Control
Dividend treatment may be indicated where a shareholder has “complete
control over the corporate accounts,” so that he has “no fear that the corporation
would demand repayment.” See Busch, 728 F.2d at 951. CSE was the sole share-
holder of CSA at all relevant times. We accordingly find that the second Busch
factor favors respondent.
Although this factor favors dividend treatment, we find that it carries some-
what less weight here. In the Busch case the sole shareholder was an individual
who extracted cash from his corporation and used that cash for his personal pur-
poses. ITW is a publicly traded company that, like many of its peers, had a sub-
stantial amount of intercompany debt on its consolidated financial statements. In
any multinational group such as this, the borrowing and lending entities will typi-
cally be related through common ownership by the ultimate parent.
Notwithstanding this common ownership, the record establishes that CSE
and CSA took all steps required to create genuine indebtedness. The promissory
notes were legally binding documents. Like the borrowers in the 122 other inter-
company loans on ITW’s books, CSE was required to fulfill its obligations to its
creditors. As Mr. Froomkin testified, CSA’s directors (Mr. Sutherland and Mr.
Rodriguez) had a fiduciary duty to demand repayment from CSE. If they breached
-34-
[*34] those duties, they would subject themselves to legal repercussions under
Bermuda and U.S. law. For these reasons, we find that the second Busch factor,
while favoring respondent, weighs somewhat less heavily in the balance.
3. Retained Earnings and Dividend History
If a corporation has substantial earnings over many years but pays no divi-
dends, recurring loans to a shareholder may suggest dividend treatment. See
Busch, 728 F.2d at 950. On the other hand, where a company pays regular divi-
dends and adheres to formal requirements for both dividends and debt, loans to
shareholders may properly be treated as debt where the advances are intended as
such. See, e.g., Page v. Haverty, 129 F.2d 512, 514 (5th Cir. 1942).
CSA advanced funds to CSE in December 2006. During the four preceding
years and the six subsequent years, CSA paid CSE in the aggregate more than $2.2
billion of dividends. The parties have stipulated that these dividends were record-
ed on both companies’ books and Forms 5471 for all years. CSA thus had a sub-
stantial dividend-paying history.
Respondent notes that CSA did not pay any dividends to CSE during 2006
in particular. But we decline to draw a negative inference from this; many corpor-
ations do not pay dividends in every year of their existence. The Seventh Circuit
has directed us to consider the “dividend history of the corporation.” Busch, 728
-35-
[*35] F.2d at 948. We find that CSA’s payment of $2.2 billion of dividends
during the 10 years surrounding the year of the loan favors treating that advance as
debt.
4. Size of the Advance
This factor overlaps with the “ability to repay” factor. As Dr. Shaked cred-
ibly testified, the $356,778,000 loan was not particularly large relative to CSE’s
equity cushion of $6 billion. CSE had ample cashflow from which to repay the
loan. See infra pp. 39-42. We accordingly find that the fourth factor is neutral or
favors petitioner slightly.
5. Conventional Indicia of Debt
In applying this factor we consider whether there exist formal indicia of
debt, such as a promissory note, interest payments, a fixed maturity date, and a
right to enforce repayment. Because CSA and CSE strictly adhered to all loan
formalities, this fifth factor favors petitioner.
The issuance of a bond, debenture, or promissory note is generally required
to establish the existence of bona fide indebtedness. See Hardman, 827 F.2d at
1412. Compliance with such formalities may be accorded less weight when the
parties are related. See Fin Hay Realty Co., 398 F.2d at 697; Calumet Indus., Inc.
v. Commissioner, 95 T.C. 257, 286 (1990). But the note evidencing the CSE loan
-36-
[*36] was a legally binding debt instrument, and to that extent it supports debt
treatment.
Both the original 2006 note and the two successor notes required payment
of interest, at specified rates, upon maturity of the loan. CSE in fact paid all re-
quired interest on an annual basis. CSE and CSA recorded these payments on
their books as interest on intercompany indebtedness.
Both the original 2006 note and the two successor notes specified definite
dates for repayment of principal. “The presence of a fixed maturity date indicates
a fixed obligation to repay, a characteristic of a debt obligation.” Estate of Mixon
v. United States, 464 F.2d 394, 404 (5th Cir. 1972); see Monon R.R. v. Commis-
sioner, 55 T.C. 345, 359 (1970) (“[A] definite maturity date on which the principal
falls due for payment, without reservation or condition, * * * is a fundamental
characteristic of a debt.”).
“The right to enforce the payment of interest is one of the requisites of a
genuine indebtedness.” Gokey Props., Inc. v Commissioner, 34 T.C. 829, 835
(1960), aff’d, 290 F.2d 870 (2d Cir. 1961). The right to enforce payment of prin-
cipal upon maturity of the loan is likewise characteristic of true debt. Laidlaw
Transp., Inc. v. Commissioner, T.C. Memo. 1998-232, 75 T.C.M. 2598,
2619; see Kraft Foods Co., 232 F.2d at 122 (noting that an “unconditional obliga-
-37-
[*37] tion” to pay interest and principal are “necessary features of instruments of
indebtedness”).
Mr. Froomkin credibly testified that CSE’s promissory notes to CSA were
binding obligations under Bermuda law and that Bermuda law provided mech-
anisms by which CSA could enforce payment. He testified that CSA’s and CSE’s
directors had separate fiduciary duties to each entity that required them to act in
each entity’s best interest. This suggests that CSA would exercise its right to en-
force payment of interest and principal on the notes.
Respondent contends that CSA had no practical ability to enforce repayment
because CSE had no operating assets. But companies often borrow against capital
assets, including stock of their subsidiaries. As an intermediate holding company,
CSE borrowed against the value represented by the stock of CSA and its numerous
subsidiary operating companies.
Respondent’s argument confuses the obligation to repay with the source of
funds to be used for repayment. Like any holding company borrower, CSE had
three possible sources of funds for repayment of the loan: earnings from lower-
tier operating subsidiaries, capital contributions from its parent, or a third-party
refinancing. The evidence established that CSA had the legal ability to enforce
repayment under Bermuda law; how CSE might choose to fund the repayment is a
-38-
[*38] wholly separate question. We conclude that the CSE loan bore all
conventional indicia of debt, including the creditor’s ability to enforce payment of
interest and principal. The fifth Busch factor thus favors petitioner.
6. Treatment of Advances in Corporate Records
Respondent agrees that CSA and CSE recorded the loan as debt on their
books; that CSE reported the loan as a liability on its Forms 5471; and that both
parties “generally treated the Note as debt on [their] financial records.” Although
the loan was shown as a liability on CSE’s Form 5471 and as an asset on CSA’s
Form 5471, in neither case was it labeled a “loan to or from shareholders.” This
minor discrepancy does not support an inference that the note was a disguised
dividend. See Alterman Foods, Inc., 611 F.2d at 868 (emphasizing that the ad-
vance in question was recorded as an asset on the subsidiary-lender’s books and as
a liability on the parent-borrower’s books).
Respondent contends that petitioner did not adequately document the plan
for repayment of the loan in December 2006 when CSE borrowed the funds. We
know of no requirement that a borrower do this. When a homeowner takes out a
mortgage loan with a five-year balloon, he may have no concrete plan for repaying
the loan five years later. He may liquidate other assets to pay off the loan, he may
refinance it, or he may sell the house. For present purposes, the relevant question
-39-
[*39] is whether the $356,778,000 loan was consistently treated as debt on CSA’s
and CSE’s books. Because it was, this sixth factor favors debt treatment.
7. Repayment History and Source
A borrower’s ability to repay principal and interest out of projected cash-
flow supports debt characterization. See NA Gen. P’ship & Subs. v. Commis-
sioner, T.C. Memo. 2012-172, 103 T.C.M. 1916, 1921 (characterizing ad-
vance from parent to subsidiary as debt where subsidiary had sufficient cashflow
to make all payments). A borrower’s timely payment of interest and principal,
consistently with the terms of the underlying instrument, likewise supports debt
treatment. See PepsiCo Puerto Rico, Inc. v. Commissioner, T.C. Memo. 2012-
269, 104 T.C.M. 322, 339-340.
CSE’s cashflow could easily satisfy its debt obligations. As a holding com-
pany, CSE’s projected cashflow consisted principally of earnings expected to be
generated by its lower-tier operating subsidiaries. Dr. Shaked testified that these
subsidiaries were expected to generate during 2007-2011 at least $1.5 billion of
free cash, and the record supports his testimony. He concluded (and we agree)
that CSE had potential debt capacity of at least $6 billion. Thus, it could easily
have secured third-party refinancing for the $356,778,000 loan if operating earn-
ings ever fell short.
-40-
[*40] CSE in fact made annual interest payments on the loan. The principal was
originally due to be repaid in December 2011, but petitioner refinanced the loan
twice while the IRS was auditing its 2006 return. As noted earlier, we do not
think this refinancing casts any doubt on the transaction’s debt status. CSE repaid
$30 million of principal in late 2012 and repaid the remaining principal balance in
full (together with accrued interest for 2013) in December 2013.
When making interest payments before maturity, CSE initially borrowed
funds from the BMG cash pool. It later repaid those borrowings by depositing
into the BMG cash pool dividends paid by the lower-tier operating companies.
While acknowledging that CSE paid interest to CSA, respondent contends that
these payments were “circular” because they were ultimately funded by dividends
from CSA’s subsidiaries.
We do not find this argument persuasive. As a holding company, CSE’s
projected cashflow would necessarily be expected to derive chiefly from the earn-
ings of its lower-tier operating subsidiaries. Respondent appears to contend that a
payment of interest should be respected as such only if it is funded by earnings
from the debtor’s own operations. This theory, if accepted, would appear to make
a holding company incapable of incurring genuine intercompany debt. We are
aware of no legal support for that theory. Cf. Al Goodman, Inc v. Commissioner,
-41-
[*41] 23 T.C. 288, 301-302 (1954) (respecting advance to sole shareholder as
bona fide debt where shareholder pledged stock as security for loan and received a
dividend to repay part of loan balance); NA Gen. P’Ship & Subs., 103 T.C.M.
(CCH) at 1921 (respecting interest payments where debtor obtained a loan from a
third party that was repaid with dividends from debtor’s subsidiary).
In a related vein, respondent contends that CSE lacked “an independent
ability to repay the loan” because the source of funds for repayment would have to
come from CSE’s lower-tier operating subsidiaries, ITW, or a third-party borrow-
ing. But this will always be true for an intermediate holding company, and it does
not mean that CSE lacked an ability to repay the loan. As Drs. Shaked and Cham-
bers explained, any potential creditor would evaluate CSE’s creditworthiness by
taking into account the assets and future cashflows of its operating subsidiaries.15
On the basis of these financial facts, petitioner’s experts concluded that CSE
would likely receive an S&P credit rating of BBB or BBB+, both of which are
investment grade. With projected free cash of at least $1.5 billion from subsidi-
aries during 2007-2011 and potential debt capacity of at least $6 billion, CSE
plainly had the ability to repay the $356,778,000 loan. It actually paid all interest
15
Any potential creditor would also take into account the likelihood of sup-
port from ITW, CSE’s highly profitable ultimate parent, as Dr. Chambers stated in
his expert report.
-42-
[*42] and principal due on that loan. We find that the seventh factor favors debt
treatment.16
8. Use of Advanced Funds
In Busch, 728 F.2d at 950, the Seventh Circuit affirmed this Court’s holding
that advances of corporate funds to a sole shareholder, an individual, were
constructive dividends where the individual used those advances largely “for
purely personal purposes.” How funds are used may also be relevant in deter-
mining whether a particular investment constitutes debt or equity. Where a cor-
poration uses a shareholder advance to acquire capital assets, the advance is more
likely to be characterized as equity. Estate of Mixon, 464 F.2d at 410. Where
such advances are used to meet the corporation’s daily operating needs, debt
treatment may be indicated. Stinnett’s Pontiac Serv., Inc. v. Commissioner, 730
16
Respondent contends that CSA had “an implied liability” to fund repay-
ment of the loan because CSE, as a holding company, had no significant operating
assets. In respondent’s view, this created an off-the-books liability on CSA’s part
that precisely offset the asset represented by the CSE note, supposedly rendering
the loan transaction circular. But CSA did not in fact have any liability (implied
or otherwise) to fund CSE’s repayment of the loan. CSE could have repaid the
loan in at least two other ways: by receiving a capital contribution from ITW (as it
in fact did) or by refinancing the loan with a third-party borrowing. Again, the
upshot of respondent’s argument is that an intermediate holding company cannot
incur genuine intercompany indebtedness. We find no support in law or logic for
that theory.
-43-
[*43] F.2d 634, 640 (11th Cir. 1984), aff’g T.C. Memo. 1982-314; Raymond v.
United States, 511 F.2d 185, 191 (6th Cir. 1975); Estate of Mixon, 464 F.2d at
410.
CSE used the $356,778,000 loan proceeds to make a return-of-capital distri-
bution to Paradym, and those funds were ultimately used to pay down petitioner’s
CP balance. Respondent contends that this scenario is at odds with debt treatment
because the loan proceeds were not used in CSE’s business. He analogizes this
case to cases in which purported loan proceeds were used for the shareholder’s
individual purposes. See Busch, 728 F.2d at 950; Bergersen v. Commissioner,
T.C. Memo. 1995-424, 70 T.C.M. 568, 586 (finding advance used for con-
struction of shareholder’s residence to be a dividend), aff’d, 109 F.3d 56 (1st Cir.
1997).
It is not clear how the “use of funds” factor should be evaluated here. The
shareholder-debtor in this case is a corporation, not an individual, and corpora-
tions do not have “personal purposes.” Nor is this a debt/equity case. One might
say that the immediate use of the lent funds--to make a corporate distribution--has
the feel of a dividend. But the ultimate use of the lent funds--to repay short-term
CP indebtedness--may suggest a back-to-back loan driven by operational business
-44-
[*44] necessities. On balance, we conclude that this eighth factor is best regarded
as neutral and in any event is not entitled to great weight.
9. Participation in Management
This factor may be relevant in determining whether a taxpayer’s advance to
a corporation constitutes debt or equity. If the advance entitles the taxpayer to
participate in (or to a greater participation in) management of the company, the ad-
vance is more likely to be treated as equity. See, e.g., Am. Offshore, Inc., 97 T.C.
at 603. But this is not a debt/equity case. And the advance here was made to the
shareholder, not by the shareholder. CSA’s advance could not entitle it to partici-
pate in the management of CSE, its parent corporation. We accordingly find this
factor unhelpful here.
10. Status of Advances Relative to Other Debt
If a corporation advances funds to a shareholder, and if the corporation’s
right to repayment is subordinated to claims of the shareholder’s other creditors,
the argument may be weaker for characterizing the advance as true debt. See, e.g.,
Estate of Mixon, 464 F.2d at 406; CMA Consol., Inc. v. Commissioner, T.C.
Memo. 2005-16, 89 T.C.M. 701, 725. Neither the 2006 note nor the 2011
and 2012 notes subordinated CSA’s right to repayment to the rights of CSE’s
-45-
[*45] other creditors. Nor, as Mr. Froomkin testified, would Bermuda law require
subordination by reason of CSA’s being wholly owned by CSE.
Respondent notes that CSA’s right to repayment was structurally subordi-
nated to any debt (including trade debt) of CSA’s operating subsidiaries. “With
holding companies,” however, “any debt issued is necessarily subordinated to the
creditors of its operating company.” NA Gen. P’Ship & Subs., 103 T.C.M. (CCH)
at 1921. Since this type of subordination arises automatically, it has little rele-
vance in assessing whether the parties intended to create genuine indebtedness that
CSE would repay. See ibid. (noting that structural subordination in these circum-
stances “is to be expected and does not in and of itself cast doubt on the legitimacy
of debt issued by a holding company”). Structural subordination would be rele-
vant, not in assessing CSE’s intent to repay the loan, but in determining whether
the creditors of CSA’s operating subsidiaries would stand first in line to access the
subsidiaries’ assets if the assets were sought to be used as a source of repayment.
In any event, as Dr. Chambers and Mr. Chigas noted, CSA and its operating
subsidiaries had very low debt levels during the relevant period. CSA’s consoli-
dated indebtedness peaked at $251.6 million in 2009 and decreased to $17.1 mil-
lion in 2012. Given that the operating subsidiaries had projected free cashflows of
at least $1.5 billion during 2007-2011, structural subordination would not mean-
-46-
[*46] ingfully impact the likelihood of CSA’s getting repaid. We find that this
factor supports debt characterization.
11. Adequacy of Capitalization
The purpose of examining the borrower’s debt-to-equity ratio is to deter-
mine whether it is so thinly capitalized as to make questionable its ability to repay.
CMA Consol., Inc., 89 T.C.M. (CCH) at 725. If a corporation is too thinly capital-
ized, a purported loan may be recharacterized as a dividend or as an equity invest-
ment. See, e.g., In re Larson, 862 F.2d 112, 117 (7th Cir. 1988); Bauer, 748 F.2d
at 1369; Hubert Enters., Inc. v. Commissioner, 125 T.C. 72, 96-97 (2005), aff’d in
part, vacated in part and remanded on other grounds, 230 F. App’x 526 (6th Cir.
2007).
CSE was strongly capitalized between 2006 and 2012. Dr. Shaked noted
that, as of December 15, 2006, the assets of CSE and its subsidiaries exceeded
their total liabilities by roughly $6.1 billion. CSE’s debt-to-capital ratio, taking
the CSA loan into account, was 6% at that time. This ratio, which was lower than
the debt-to-capital ratios of all but one of the companies that Dr. Shaked regarded
as CSE’s peers, indicates very robust capitalization. Dr. Shaked reached the same
conclusion about CSE’s capital structure in 2011, when the five-year note matur-
ed. At that point the CSE group had an equity cushion of about $7.4 billion and a
-47-
[*47] debt-to-capital ratio of around 4%. Because CSE was very far from thinly
capitalized, this factor supports debt treatment.
12. Risk Involved in Making Advances
In applying this factor we consider “whether the funds were advanced with
reasonable expectations of repayment regardless of the success of the venture or
were placed at the risk of the business.” Gilbert v. Commissioner, 248 F.2d 399,
406 (2d Cir. 1957), remanding T.C. Memo. 1956-137. If funds are advanced for a
risky purpose, an inference may arise that the parties did not contemplate repay-
ment in all events, and hence that the advance should not be treated as genuine
debt. See PepsiCo Puerto Rico, Inc.,104 T.C.M. (CCH) at 344.
This factor overlaps the “thin capitalization” factor, which also addresses
the risk that an advance will not be repaid. In both cases the same facts show that
the risk here was quite low. Far from being devoted to a risky or speculative pur-
pose, the CSE loan proceeds were ultimately used to repay petitioner’s outstanding
CP balance. By eliminating short-term commercial debt and replacing it with five-
year intercompany debt, the transaction ultimately reduced the risk profile of the
ITW worldwide group. This factor supports debt treatment.
-48-
[*48] 13. Identity of Interest Between Creditor and Shareholder
If shareholders advance funds to their corporation ratably to their percent-
age ownership interests, an inference arises that the advances may be capital con-
tributions rather than loans. Estate of Mixon, 464 F.2d at 409; Monon R.R., 55
T.C. at 358. This factor has little meaning here because this is not a debt/equity
case; the advances were made to the shareholder, not by the shareholder. As noted
earlier, the fact that CSE was CSA’s sole shareholder somewhat favors respond-
ent, given the extent of shareholder control. See supra pp. 33-34. But we regard
the “identity of interest” factor as essentially neutral here.
14. Ability to Obtain Outside Loans
In applying this factor we consider whether the purported borrower’s finan-
cial condition was such that a third-party lender would have lent funds on substan-
tially the same terms as did the related party. See Geftman v. Commissioner, 154
F.3d 61, 75-77 (3d Cir. 1998), rev’g in part, vacating in part T.C. Memo. 1996-
447. A borrower’s ability to secure a third-party loan to refinance the related-
party loan similarly supports debt characterization. See NA Gen. P’ship & Subs.,
103 T.C.M. (CCH) at 1923; Nestlé Holdings, Inc. v. Commissioner, T.C. Memo.
1995-441, 70 T.C.M. 682, 702, vacated and remanded on another issue,
152 F.3d 83 (2d Cir. 1998). “[T]he touchstone of economic reality is whether an
-49-
[*49] outside lender would have made the payments in the same form and on the
same terms.” Segel v. Commissioner, 89 T.C. 816, 828 (1987). An advance that
is “far more speculative than what an outsider would make * * * is obviously a
loan in name only.” Fin Hay Realty Co., 398 F.2d at 697; see Laidlaw Transp.,
Inc., 75 T.C.M. (CCH) at 2621, 2624 (finding advance to be equity where highly-
leveraged borrower could not have borrowed full amount from an outside lender).
The evidence shows that CSE could easily have borrowed $356.8 million
from an outside lender. Drs. Chambers and Shaked credibly testified that an out-
side lender would have evaluated CSE’s creditworthiness by considering all of its
assets, including the assets of its lower-tier operating subsidiaries. Dr. Shaked
explained that the CSE group at the relevant times had an equity cushion of $6
billion to $7 billion, with very little outside debt. Respondent’s experts, Mr. Grien
and Dr. Hubbard, agreed with this assessment. CSE would likely have qualified
for a S&P credit rating of at least BBB, which was investment grade. Mr. Chigas
accordingly opined that, if CSE in 2006 had sought to borrow $356.8 million in
the credit markets, investors would very likely have lent money to it on substan-
tially the same terms as did CSA.
Respondent points out that the CSE note lacked standard covenants that
would often appear in a bond sold to third-party investors. These might include
-50-
[*50] negative covenants restricting payment of dividends, requiring maintenance
of working capital, restricting mergers and sales of assets, or restricting future
issuance of senior debt. But for intercompany loans the absence of such
provisions is not surprising. CSA would logically rely on ITW, its ultimate parent,
to prevent CSE from taking steps that would endanger either company’s financial
integrity. As we have recognized previously, “certain credit protections are not as
important in the related-party context,” so that an intercompany loan “may
understandably offer more flexible terms than could be obtained elsewhere.” NA
Gen. P’ship & Subs., 103 T.C.M. (CCH) at 1921, 1923.
In determining whether the purported borrower could have secured credit
from third parties, “we do not apply a mechanical test of absolute identity between
the related-party advances” and open-market credit transactions. Nestlé Holdings,
Inc., 70 T.C.M. (CCH) at 703 (sustaining debt characterization despite absence of
covenants requiring maintenance of working capital, restricting sales of assets, and
restricting dividend payments). Rather, our objective is to determine whether an
unrelated lender would have extended credit on substantially similar economic
terms. See NA Gen. P’ship & Subs., 103 T.C.M. (CCH) at 1924 (sustaining debt
-51-
[*51] characterization despite evidence that borrower would have paid an interest
rate up to 100 basis points higher if it had borrowed in the credit markets).17
Mr. Chigas credibly testified that investment grade debt generally need not
include financial covenants and that the addition of restrictive covenants like those
discussed above would have had no material effect on investor perceptions. A
third-party lender would have evaluated CSE’s creditworthiness by considering its
excellent capital structure, low debt profile, strong historical and projected earn-
ings, and eligibility for an investment grade credit rating. Concluding as we do
that a third-party lender would have extended credit to CSE on essentially the
same economic terms as CSA did, we find that this last factor favors character-
izing the advance as bona fide debt.
15. Conclusion
Our determination as to whether the CSE loan constituted genuine indebted-
ness rather than a dividend does not depend on a mechanical counting of factors,
but on evaluating the transaction as a whole. See Hardman, 827 F.2d at 1412.
17
While mandating interest at a rate of 6%, the 2006 note did not require that
CSE pay interest periodically. Petitioner’s experts agreed that in this respect the
CSE note differed from standard third-party debt. Mr. Chigas credibly testified
that this interest-deferral option equated to a fairly minor benefit, in the range of 5
to 10 basis points. CSE in fact paid interest annually at the rates required by the
2006, 2011, and 2012 notes.
-52-
[*52] The ultimate question we must decide is “whether, at the time of the
withdrawals, the taxpayer intended to repay them.” Busch, 728 F.2d at 948. In
making this determination we do not treat any single factor as dispositive.
Frierdich, 925 F.2d at 182.
We have considered 14 factors in our analysis. Nine factors favor debt
treatment, four seem neutral or unhelpful here, and only one factor favors dividend
treatment. Several factors--evidence of the intent to repay, CSE’s ability to repay,
the existence of all conventional indicia of debt, and CSE’s ability to borrow from
third parties on similar economic terms--favor petitioner rather strongly. The one
factor that favors respondent--CSE’s status as CSA’s sole shareholder--would ex-
ist in any holding-company structure and thus carries somewhat less weight here.
Evaluating these factors and the transaction overall, we find that the CSE note
constituted bona fide debt.
III. Application of Judicial Doctrines
Respondent urges that we deploy one or more judicial anti-tax-avoidance
doctrines to recharacterize the repatriation transaction as a dividend to petitioner
or Paradym. Petitioner replies that, once the Court has applied the traditional
debt-vs.-dividend analysis outlined above, the substance of the transaction is
-53-
[*53] established and cannot be recharacterized using common law theories. As
explained below, we agree with petitioner.18
A. Economic Substance Doctrine
Taxpayers may generally structure their business transactions in a manner
that minimizes tax liability. See Boulware v. United States, 552 U.S. 421, 429 n.7
(2008) (citing Gregory v. Helvering, 293 U.S. 465, 469 (1935)). However, as has
long been established, courts may look beyond the form of a transaction to its sub-
stance to determine how the transaction should be treated for tax purposes. See,
e.g., Frank Lyon Co. v. United States, 435 U.S. 561, 573 (1978); Grojean v. Com-
missioner, 248 F.3d 572, 574 (7th Cir. 2001), aff’g T.C. Memo. 1999-425.
The economic substance doctrine, as applied by most courts, has objective
and subjective components. The objective element considers whether a transac-
tion meaningfully changes the taxpayer’s economic position, and the subjective
element considers whether the taxpayer has a valid nontax business purpose. See
Feldman v. Commissioner, 779 F.3d 448, 455 (7th Cir. 2015), aff’g T.C. Memo.
18
Petitioner contends that respondent bears the burden of proof on this issue
because it is a “new matter * * * pleaded in the answer.” Rule 142(a)(1). Re-
spondent contends that, because the arguments discussed in the text do not require
“different evidence” or increase the deficiency, he did not raise a new matter in his
answer. See Shea v. Commissioner, 112 T.C. 183, 197 (1999). Because we de-
cide this issue on a preponderance of the evidence, we need not decide who has
the burden of proof. See sec. 7491(a); Estate of Turner, 138 T.C. at 309.
-54-
[*54] 2011-297; Grojean, 248 F.3d at 574. The Seventh Circuit has noted that,
“even when a transaction has some degree of nontax economic substance, the
substance-over-form principle may provide an independent justification for
recharacterizing it.” Feldman, 779 F.3d at 457.
We find both elements of the economic substance doctrine satisfied here.
The economic reality of the transaction is that CSA made a loan to CSE, and CSE
made a distribution to Paradym. This pair of transactions meaningfully changed
the parties’ economic positions: CSA now had a $356.8 million asset on its
books, CSE was obligated to repay a $356.8 million liability with interest, and
Paradym received a distribution that enabled petitioner to pay down its CP indebt-
edness. Because the transfer of funds from CSA to CSE was a loan in substance
as well as in form, neither the economic substance doctrine nor the substance-
over-form principle can be used to metamorphose the loan into a dividend.
Contrary to respondent’s assertions, the intercompany nature of the transfers
does not mean that the parties’ economic positions did not change. Respondent
relies heavily on Dr. Hubbard’s theory that CSA had an “implied liability” to fund
repayment of the CSE note--a liability that supposedly offset the loan asset on its
books--because CSE as a holding company lacked operating earnings of its own.
We have rejected those arguments in concluding that the CSE loan was bona fide
-55-
[*55] debt. See supra pp. 39-42 & n.16. Those arguments do not become any
more persuasive when tendered in support of an “economic substance” position.
We also find that the transaction was supported by a valid nontax business
purpose. As the Seventh Circuit has held, “[w]hether withdrawals by a share-
holder from a corporation are treated for tax purposes as loans or dividends turns
on whether * * * the taxpayer intended to repay them.” Busch, 728 F.2d at 948.
We have determined that CSE intended to repay the advance and that it was a
loan. Execution of that loan had a valid nontax business purpose: securing funds
for appropriate corporate use (here, paying down the parent’s outstanding CP bal-
ance). The fact that the parties used a debt transaction to fund this pay-down, in-
stead of a dividend that may have been more costly tax-wise, does not imbue the
transaction with an invalid purpose. See Gregory, 293 U.S. at 469 (“The legal
right of a taxpayer to decrease the amount of what otherwise would be his taxes, or
altogether avoid them, by means which the law permits, cannot be doubted.”). For
all these reasons, we see no possible application of the economic substance doc-
trine on these facts.
B. Step Transaction Doctrine
Under the step transaction doctrine formal steps in a transaction may be
“disregarded for tax purposes if the taxpayer could have achieved its objective
-56-
[*56] more directly, but instead included the step for no other purpose than to
avoid U.S. taxes.” Del Commercial Props., Inc. v. Commissioner, 251 F.3d 210,
213 (D.C. Cir. 2001), aff’g T.C. Memo. 1999-411; see Superior Trading, LLC v.
Commissioner, 137 T.C. 70, 88-90 (2011), aff’d, 728 F.3d 676 (7th Cir. 2013). As
we explained in Smith v. Commissioner, 78 T.C. 350, 389 (1982):
The step transaction doctrine generally applies in cases where a
taxpayer seeks to get from point A to point D and does so stopping in
between at points B and C. The whole purpose of the unnecessary
stops is to achieve tax consequences differing from those which a
direct path from A to D would have produced. In such a situation,
courts are not bound by the twisted path taken by the taxpayer, and
the intervening stops may be disregarded or rearranged. * * *
The step transaction doctrine has no application here. Respondent contends
that the advance by CSA to CSE and the distribution by CSE to Paradym were
mutually interdependent steps that should be collapsed into a dividend from CSA
to petitioner. But CSA could not have paid a dividend to Paradym or petitioner
because neither was a shareholder of CSA; any distribution by CSA would first
have to go to CSE, its parent corporation. In reality, respondent is not seeking to
collapse unnecessary steps, but to recharacterize the first step as a dividend rather
than a loan. We have rejected that argument for the reasons set forth above.19
19
Respondent erroneously cites Barnes Grp., Inc. v. Commissioner, T.C.
Memo. 2013-109, 105 T.C.M. 1654, aff’d, 593 F. App’x 7 (2d Cir. 2014),
(continued...)
-57-
[*57] Both parties seek support for their positions from Falkoff v. Commissioner,
604 F.2d 1045 (7th Cir. 1979), rev’g and remanding T.C. Memo. 1977-93, 36
T.C.M. 417. In that case, a subsidiary corporation (S) planned to sell an
appreciated asset and expected to recognize a large taxable gain. Its parent cor-
poration (P), which had no E&P at that point, obtained a loan from a third-party
bank and used the loan proceeds to make a return-of-capital distribution to its par-
ent, a partnership. The partnership used those funds to repay its own loan to the
same bank, in effect substituting P for itself as the bank’s obligor. S sold the ap-
preciated asset three days later, but that sale closed in P’s next taxable year. S
then used a portion of the sale proceeds to make a loan to P, which used those
funds to repay the loan it had obtained from the bank. Id. at 1047.
19
(...continued)
as support for his position. The taxpayer there caused a CFC to transfer cash to a
newly formed Bermuda entity in exchange for stock. That cash was then trans-
ferred to a newly formed Delaware corporation in exchange for stock, and the
Delaware corporation purportedly lent the cash to the U.S. parent. We ruled for
the Commissioner, finding that the separate steps in this transaction should be
collapsed and that the cash transferred by the CFC was in substance a dividend by
it to the U.S. parent. Id. at 1667. Our holding was based on the taxpayer’s failure
to respect the formalities of its own transactions, in particular the failure by the
U.S. parent to pay interest to the Delaware corporation. Ibid. Here, by contrast,
the formalities of the transaction were uniformly respected and were consistent
with the substance, viz., the execution of a loan from CSA to CSE. And whereas
the CFC in Barnes Grp. could have paid a dividend directly to its U.S. parent as
the first (and only) step of the transaction, CSA could not have paid a dividend
directly to Paradym because Paradym did not own any CSA stock.
-58-
[*58] The taxpayer treated these transactions as a loan followed by a return-of-
capital distribution in P’s first taxable year, which resulted in no taxable income to
the partnership. The Commissioner challenged this treatment under the step trans-
action doctrine, contending that all of the steps should be collapsed and be deemed
to have occurred in P’s second taxable year, concurrently with the asset sale. In
that event, the E&P generated by the asset sale would “tier up” to P, the intercom-
pany loan would disappear, and P’s distribution to the partnership would be a tax-
able dividend rather than a tax-free return of capital.
The Seventh Circuit, reversing this Court, held that the separate steps of the
transaction should be respected and that “[t]he transaction, viewed as a whole, did
have economic substance.” Id. at 1050. It viewed Falkoff as “a case where a cor-
poration without accrued or present earnings and profits borrowed against its own
appreciated assets and made a distribution in anticipation of future profits.” Ibid.
“[S]uch a distribution,” the court held, “does not result in taxable income to the
shareholder.” Ibid.
This Court in Falkoff had concluded that the partnership, rather than P, was
the true obligor on the bank loan; that the partnership had provided P with the
funds to make the distribution in year one; that the year-one distribution involved
a circular flow of funds and hence lacked economic substance; and that the rele-
-59-
[*59] vant distribution occurred after the asset sale in year two, when P--now flush
with E&P--issued a constructive dividend to the partnership by repaying the bank
loan. See Falkoff, 36 T.C.M. (CCH) at 422-423. The Seventh Circuit rejected
that analysis, concluding that P was the true obligor on the bank loan and that the
distributee partnership had not “provided funds enabling the corporation to make a
sham distribution” back to itself. Falkoff, 604 F.2d at 1050. But even if the bank
loans were thought to be shams, the Seventh Circuit held that the relevant taxable
event--the year-one distribution--occurred in a taxable year in which P had no
E&P. Thus, “no taxable income would be due in any event.” Id. at 1051.
Although there are factual differences between Falkoff and the instant case,
we think Falkoff helps petitioner much more than it helps respondent. The basic
transaction in both cases is the same: A corporation without accrued or current
E&P (here, CSE) borrowed against its appreciated assets and made a return-of-
capital distribution to its parent (here, Paradym) in anticipation of future profits
(here, earnings expected from CSA’s operating subsidiaries). See id. at 1050.
The main factual difference is that CSE borrowed from an affiliate, whereas
P, the distributing corporation in Falkoff, borrowed from a third-party bank. But
this factual difference requires, not that we collapse the transactions, but simply
that we subject them to greater scrutiny, i.e., determine whether the CSE loan was
-60-
[*60] a true loan. Having determined that it was a true loan, we regard it as
functionally equivalent to a bank loan. That being so, the basic facts of Falkoff
are essentially similar to those here.20
The Seventh Circuit unambiguously rejected the Commissioner’s applica-
tion of the step transaction doctrine to these facts. Indeed, it noted that our Court
had also “rejected, at least in part, the Commissioner’s step transaction approach.”
Id. at 1047. In Falkoff we observed that P, the distributing corporation, “had every
right to pay a dividend out of borrowed funds in the taxable year ending Septem-
ber 30, 1969, in anticipation of the realization of gain which would cover that dis-
tribution in the subsequent year.” Falkoff, 36 T.C.M. (CCH) at 422 (citing Gross
v. Commissioner, 23 T.C. 756 (1955), aff’d, 236 F.2d 612 (2d Cir. 1956)). That
observation is not helpful to respondent in this case. We ruled for the Commis-
sioner in Falkoff on a different theory, namely, that the distributee partnership ra-
20
Another factual difference is that the transactions in Falkoff were split be-
tween two tax years, whereas the key transactions here all occurred during 2006.
The split between two tax years, however, was relevant only to the Seventh Cir-
cuit’s alternative holding, under which it would have sustained the taxpayer’s
position even if the bank loans were thought to be shams. See Falkoff, 604 F.2d at
1050. The split between two tax years had no bearing on the Seventh Circuit’s
primary holding as set forth in the text. Respondent also notes that the parties in
Falkoff were domestic corporations, whereas CSA and CSE were CFCs. This
distinction relates to respondent’s “Subpart F avoidance” theory, which we discuss
below. See infra pp. 62-64.
-61-
[*61] ther than the distributing corporation was the true obligor on the bank loan.
That argument is not available to respondent here.
In sum, we are unpersuaded by respondent’s invocation of the step transac-
tion doctrine on the facts presented here. The Seventh Circuit in Falkoff clearly
rejected application of that doctrine. And the facts of this case are similar, in all
critical respects, to the facts of Falkoff.
C. Conduit Doctrine
Contending that CSE served no purpose in the repatriation transaction, re-
spondent invokes a conduit theory to reach the same bottom line as his step trans-
action theory, namely, that CSA in substance paid a dividend directly to Paradym
out of CSA’s accumulated E&P. Under the conduit doctrine, a court may disre-
gard an entity if it functions as a mere conduit in implementing a prearranged
transaction. See Commissioner v. Court Holding Co., 324 U.S. 331, 334 (1945);
Alphaco, Inc. v. Nelson, 385 F.2d 244, 245-246 (7th Cir. 1967). In Court Holding
Co., a corporation made a liquidating distribution of appreciated property to its
shareholders, who immediately sold the property to a buyer in a transaction that
the corporation had arranged in advance. The Supreme Court held that the corpor-
ation in reality had effected the sale and that the shareholders were mere conduits
employed in an effort to have the asset sale taxed at lower rates.
-62-
[*62] We reject respondent’s conduit theory for the same reasons we have rejected
his step transaction theory. CSA could not have paid a dividend directly to Para-
dym because Paradym owned no CSA stock. See supra p. 56. Because CSE own-
ed 100% of CSA’s stock, respondent errs in asserting that CSE “served no pur-
pose” in the transaction. And CSE cannot be regarded as a conduit for the trans-
mission of a dividend from CSA through it to Paradym because (as we have held)
the transfer from CSA to CSE was not a dividend but was a loan.
D. “Subpart F Avoidance”
Respondent contends that petitioner should not be allowed to repatriate the
earnings of its foreign subsidiaries and yet avoid U.S. income taxation under sub-
part F. According to respondent, it would “thwart the policies underlying the in-
ternational tax provisions” to permit a permanent repatriation of foreign earnings
without taxation. Allowing petitioner to repatriate funds in this manner would
produce (in respondent’s view) a disparate outcome compared to a similarly sit-
uated domestic shareholder that received a loan from a foreign subsidiary. See
sec. 956(a), (c)(1)(C) (requiring subpart F inclusion where CFC makes an invest-
ment in “United States property,” defined to include “an obligation of a United
States person”).
-63-
[*63] As petitioner correctly notes, neither section 951 nor section 956 applies to
the transactions at issue. The characterization of CSA’s advance to CSE is govern-
ed by familiar debt-vs.-dividend principles, which apply alike to foreign and to
domestic corporations. See, e.g., Taiyo Hawaii Co., Ltd. v. Commissioner, 108
T.C. 590, 601-603 (1997). And the distribution by CSE to Paradym is governed
entirely by section 301, which does not by itself implicate any international tax
concerns. Respondent appears to contend that the policies underlying the Subpart
F regime require us to recharacterize these transactions in an extraordinary way.
We decline respondent’s invitation in the absence of a clear statutory directive
supporting his position.21
Respondent seeks to distinguish Falkoff along similar lines, noting that the
entities involved there were domestic corporations as opposed to CFCs. But the
Commissioner advanced a similar policy argument in Falkoff, and the Seventh
Circuit rejected it:
The Commissioner, of course, has argued that to reverse the
Tax Court’s judgment would permit taxpayers to determine for
21
In his amended answer respondent contended that CSA’s loan to CSE
should be recharacterized as a loan directly to petitioner or one of its domestic
subsidiaries, yielding an investment in U.S. property under section 956. At trial
respondent abandoned this argument because the purported investment (if the
Court were to find it such) would have been made during CSA’s FYE November
30, 2007, and thus could not have affected petitioner’s tax liability for 2006.
-64-
[*64] themselves the time and manner of taxation, in frustration of
Congressional directive and with prejudice to the federal fisc. We
think our decision will have no such dire consequence. * * * We
believe the taxpayers here did no more than use the[] characteristics
of the tax system to their best advantage. The situation here is an
unusual one--a corporation without accrued or current earnings and
profits but with substantial assets against which it can borrow to make
a cash distribution to its shareholders. Yet, even here the effect is
only to delay, not escape, taxation. * * * The Corporation’s future
earnings and profits will be taxed as dividends when distributed.
[Falkoff, 604 F.2d at 1051-1052].
Respondent replies that we should be less sanguine about future distribu-
tions of profits where CFCs are involved. Profits may be held offshore indefinite-
ly, respondent notes, and E&P do not “tier up” to a foreign holding company as
they do inside a U.S. consolidated group. But “[i]f the draftsman’s handiwork fell
short of fully accomplishing the objectives sought, it must be left to Congress to
repair such shortfall.” Ludwig v. Commissioner, 68 T.C. 979, 991-992 (1977).22
22
On four occasions the Treasury Department has proposed changing the
law to reduce taxpayers’ ability to use leveraged distributions to effect repatria-
tions of foreign earnings. See Department of the Treasury, General Explanations
of the Administration’s Fiscal Year 2016 Revenue Proposals 119-121 (February
2015); General Explanations of the Administration’s Fiscal Year 2015 Revenue
Proposals 55 (March 2014); General Explanations of the Administration’s Fiscal
Year 2014 Revenue Proposals 59 (April 2013); General Explanations of the Ad-
ministration’s Fiscal Year 2013 Revenue Proposals 98 (February 2012). Congress
did not enact any of these proposals.
-65-
[*65] IV. Tax Consequences of Distribution
In December 2006 CSE distributed $356,778,000 to Paradym, a member of
petitioner’s U.S. consolidated group. Section 301(c)(1) provides that the portion
of a distribution “which is a dividend (as defined in section 316) shall be included
in gross income.” Section 316(a) provides that “the term ‘dividend’ means any
distribution of property made by a corporation to its shareholders” out of current
E&P or out of E&P “accumulated after February 28, 1913.” The parties agree that
CSE had no current or accumulated E&P for the year in which it made the distri-
bution to Paradym. Thus, no portion of the distribution was a dividend.
Section 301(c)(2) provides that the portion of a distribution which is not a
dividend “shall be applied against and reduce the adjusted basis of the stock.”
Section 301(c)(3) provides that the portion of a distribution which is not a divi-
dend, “to the extent that it exceeds the adjusted basis of the stock, shall be treated
as gain from the sale or exchange of property.” Paradym owned 100% of CSE’s
stock, and these provisions require that we determine its basis in that stock.
A. Todd Miller Report
The taxpayer generally bears the burden of substantiating its basis in pro-
perty. See O’Neill v. Commissioner, 271 F.2d 44, 50 (9th Cir. 1959), aff’g T.C.
Memo. 1957-193. With a view to discharging that burden, petitioner offered at
-66-
[*66] trial the expert testimony of Todd Miller, who performed a detailed basis
study for this purpose. Mr. Miller is a partner in the transaction advisory services
practice of Ernst & Young (EY). He has performed more than 50 basis studies
during his career, and he formerly headed the EY group that specializes in this
field.
Petitioner contends that Mr. Miller should be qualified as an expert because
he provided specialized knowledge in the area of basis calculation. Respondent
contends that Mr. Miller should be treated at most as a summary witness, whose
summary of transactions underlying Paradym’s basis in CSE might be useful to the
Court. Having reserved ruling on this at issue at trial, we now express our agree-
ment with respondent.
Rule 702 of the Federal Rules of Evidence defines an expert witness as one
who is “qualified as an expert by knowledge, skill, experience, training, or educa-
tion.” An expert witness may testify in the form of an opinion if his “scientific,
technical, or other specialized knowledge will help the trier of fact to understand
the evidence.” Id. para. (a); see Kumho Tire Co. v. Carmichael, 526 U.S. 137, 147
(1999); Daubert v. Merrell Dow Pharm., Inc., 509 U.S. 579, 589 (1993). A lay
witness may not offer an expert opinion. See Fed. R. Evid. 701.
-67-
[*67] This Court regularly hears testimony from IRS revenue agents who describe
the methodology they employed--e.g., the bank deposits method or the net worth
method--to reconstruct a taxpayer’s unreported income. We have generally treated
such witnesses as summary witnesses, not experts, reasoning that they are not pro-
viding an opinion based on scientific, technical, or other specialized knowledge.
See, e.g., Worth v. Commissioner, T.C. Memo. 2014-232, 108 T.C.M. 522,
528 (citing Gudenschwager v. Commissioner, T.C. Memo. 1989-6, 56 T.C.M.
(CCH) 1010, 1012)), aff’d, 666 F. App’x 692 (9th Cir. 2016). Like an IRS reve-
nue agent, Mr. Miller testified as to the data he collected, the observations he
made about those data, and the methodology he followed in calculating Paradym’s
basis. See Worth, 108 T.C.M. (CCH) at 529 (holding that revenue agent’s testi-
mony “would be accepted, not for the purpose of demonstrating the correctness of
her methodology, but solely for the purpose of explaining what she did”).
Mr. Miller’s methodology required him to characterize certain transactions
as taxable or tax-deferred. In doing this he was not offering a legal opinion as to
the appropriate tax treatment of these transactions. Rather, he was performing a
“mechanical sorting of entries” to compile and characterize the voluminous trans-
actions by which Paradym acquired basis in CSE. See, e.g., United States v. Stier-
hoff, 549 F.3d 19, 28 (1st Cir. 2008) (“The key to admissibility is that the sum-
-68-
[*68] mary witness’s testimony does no more than analyze facts already
introduced into evidence and spell out the tax consequences that necessarily flow
from those facts.”). Other courts have held that a lay witness may offer tax-related
calculations if they are “straightforward and transparent.” See, e.g., United States
v. Diez, 515 F.2d 892, 905 (5th Cir. 1975).23
Although Mr. Miller’s testimony fell outside the scope of rule 702, he was
competent to testify under rule 1006 of the Federal Rules of Evidence as a sum-
mary witness to explain how he performed his basis study. The latter Rule permits
the use of “a summary, chart, or calculation to prove the content of voluminous
writings * * * that cannot be conveniently examined in court,” provided that the
underlying information was disclosed to the opposing party. Respondent agrees
that the records underlying Mr. Miller’s basis study were properly disclosed to
him. We conclude that Mr. Miller appropriately testified as a summary witness to
23
We are unpersuaded by petitioner’s contention that Mr. Miller’s analysis
was akin to a forensic accountant’s. Although both types of witnesses rely on
books and records to make their determinations, forensic accountants go beyond
sorting book entries and may apply specialized knowledge to determine whether a
taxpayer has engaged in fraudulent activity. See WWP, Inc. v. Wounded Warriors
Family Support, Inc., 628 F.3d 1032, 1039-1040 (8th Cir. 2011).
-69-
[*69] summarize otherwise admissible data, and his testimony has been admitted
into evidence for that purpose.24
B. Basis Substantiation
Mr. Miller relied on a variety of business records to document the trans-
actions relevant in determining Paradym’s basis in CSE. These records included
(among other things) third-party purchase agreements, intercompany purchase
agreements, section 338 elections, and third-party valuation reports. Using these
records, he found 34 distinct transactions, occurring between March 2001 and
September 2006, that generated basis in CSE. Most of these transactions were
contributions by entities within the ITW Group; Mr. Miller noted that certain of
these transactions resulted in carryover basis rather than basis determined by the
current fair market value of property. After performing his analysis, Mr. Miller
concluded that Paradym’s basis in CSE exceeded $1.5 billion, more than four
times the amount needed to cover CSE’s distribution of $356,778,000.
Respondent contends that petitioner has failed to substantiate Paradym’s
basis in CSE because: (1) petitioner did not provide complete business records to
24
To the extent respondent contends that the documents on which Mr. Miller
relied to determine Paradym’s basis constituted inadmissible hearsay, we reject
that argument. All of Mr. Miller’s determinations were linked to documents and
data that were admitted or would be admissible into evidence, and he properly tes-
tified about how he used those documents to calculate Paradym’s basis.
-70-
[*70] Mr. Miller; (2) petitioner’s tax returns, standing alone, cannot substantiate
Paradym’s basis; and (3) certain distributions were improperly reflected on
information returns, which allegedly caused Mr. Miller’s basis calculations to be
inflated. At trial James Batory, a senior revenue agent in the IRS Large Business
and International Division, testified that he was unable to determine Paradym’s
basis in CSE because petitioner submitted inconsistent documentation to him and
because he had difficulty tracking basis-generating transactions. On account of
these supposed difficulties, he determined Paradym’s basis in CSE to be zero.
We find that petitioner has adequately substantiated basis of at least
$356,778,000. Contrary to respondent’s view, Mr. Miller relied on comprehensive
and reliable business records to determine basis. We need not parse each trans-
action he analyzed because we find that three of the transactions generated basis of
$393.2 million, which is sufficient to cover the distribution at issue:
• In September 2001 Premark FEG (Premark), then CSE’s sole shareholder,
made a $39.9 million capital contribution to CSE. This contribution was made in
cash. The record establishes that this transaction was properly treated as a section
351 contribution and recorded as such on all relevant books and records maintain-
ed by the ITW Group.
-71-
[*71] • In October 2001 Premark made a $15.8 million capital contribution to
CSE. This contribution took the form of a note issued by another ITW entity, with
CSE issuing shares in exchange for receiving the note with a carryover basis. The
record establishes that this transaction was properly treated as a section 351 contri-
bution and recorded as such on all relevant books and records maintained by the
ITW Group.
• In September 2003 InHold, then CSE’s sole shareholder, contributed to
CSE a $337.5 million credit facility that it had purchased from petitioner. CSE
issued shares in exchange for receiving this credit facility with a carryover basis.
The record establishes that this transaction was properly treated as a section 351
contribution and recorded as such on all relevant books and records maintained by
the ITW Group.
Taken together, these three transactions establish basis of $393.2 million in
CSE. Under the principle set forth in Johnson v. United States, 435 F.2d 1257(4th Cir. 1971), petitioner was required to apply the distribution to Paradym on a
pro rata basis across each block of CSE stock. In his analysis Mr. Miller conclud-
ed that CSE had 16 blocks of stock. He further concluded that each block of stock
had more than enough basis to absorb a return-of-capital distribution. We find this
analysis to be correct.
-72-
[*72] Respondent contends that petitioner’s tax returns and related workpapers
are unreliable sources to verify basis, but he does not point to any specific defects
in these documents. Although he asserts that petitioner has failed to provide suf-
ficient documentation, both parties stipulated all of the documents on which Mr.
Miller relied. Mr. Miller credibly testified that he went well beyond petitioner’s
tax returns to determine basis, consulting the ITW Group’s corporate records for
numerous transactions. And he explained that he made conservative assumptions
--viz, assumptions against petitioner’s interest--in several instances where he was
not entirely sure how to characterize a particular transaction.
Even if petitioner’s documentation were deemed inadequate in certain re-
spects, the parties agree that we may apply the Cohan rule to estimate basis. See
Cohan v. Commissioner, 39 F.2d 540, 544 (2d Cir. 1930); Shank v. Commission-
er, T.C. Memo. 2018-33, at *6-*7 (applying the Cohan rule to estimate basis in
stock); Kerr v. Commissioner, T.C. Memo. 1990-155 (same); cf. Ternovsky v.
Commissioner, 66 T.C. 695, 698 (1976) (applying similar principles to determine
basis in other property); Alameda Realty Corp. v. Commissioner, 42 T.C. 273, 283
(1964); Huzella v. Commissioner, T.C. Memo. 2017-210, at *7-*9; Wheeler v.
Commissioner, T.C. Memo. 2014-204, 108 T.C.M. 388, 390. Were we to
-73-
[*73] apply the Cohan rule, we would find that petitioner has adequately
substantiated that Paradym’s basis in CSE was at least $356,778,000.
In sum, we find that Paradym had sufficient basis in CSE to treat the entire
$356,778,000 distribution as a nontaxable return of capital under section
301(c)(2). Having determined that petitioner is not liable for any deficiency for
2006, we find that it is not liable for any accuracy-related penalty under section
6662 for that year. To reflect the foregoing,
Decision will be entered for
petitioner.
-74-
[*74] APPENDIX
Petitioner’s Expert Witnesses
1. William Chambers: Dr. Chambers earned his B.A. in history and eco-
nomics from the College of Wooster and his M.A. in philosophy and Ph.D. in eco-
nomics from Columbia University. Currently he is an associate professor emeritus
of finance at Boston University Metropolitan College. He has substantial experi-
ence as a debt ratings analyst, having rated hundreds of companies’ debt issuances.
He previously worked as a debt analyst and a corporate ratings and risk solutions
executive for S&P for 23 years.
2. Charles Chigas: Mr. Chigas earned his B.A. in economics from Tufts
University and his M.B.A. from Amos Tuck School. Currently he is the head of
the debt capital markets group at Natixis Securities America and the managing
partner of Orea Thea Advisory, a consulting firm. He has worked in the debt capi-
tal area for almost 30 years, during which time he has been involved with thous-
ands of corporate bond transactions.
3. Saul Froomkin: Mr. Froomkin earned his LL.B. and LL.M. from the
University of Manitoba Law School. He is currently serving as Queen’s Counsel
in Bermuda, is an Officer of the Most Excellent Order in the British Empire, and is
a justice of the peace and fellow for the Society of Advanced Legal Studies. Pre-
viously, he served as the Solicitor General of Bermuda from 1978 to 1981, where
he was senior counsel to the Government on civil and criminal matters. He also
served as attorney general of Bermuda from 1981 to 1991.
4. Israel Shaked: Dr. Shaked earned his B.A. in economics, B.A. in stat-
istics, M.B.A. in finance, and a Ph.D. in business administration finance from
Harvard University. Currently he is a finance and economics professor at Boston
University School of Management and a managing director of Michel-Shaked
Group where he works as a corporate adviser and litigation consultant. He has
published extensively in the area of corporate finance and valuation and serves on
the board of the American Bankruptcy Institute Journal.
-75-
[*75] Respondent’s Expert Witnesses
1. Robert C. Grien: Mr. Grien earned his B.A. in political science from
Tulane University and his M.B.A. with a concentration in finance from Columbia
University. Mr. Grien is currently the managing director and head of the finance
restructuring practice at TM Capital Corp., an investment banking firm.
2. R. Glenn Hubbard: Dr. Hubbard is a professor of economics and
finance and Dean of the Graduate School of Business at Columbia University. He
earned his B.A. and B.S. degrees from Central College of Florida and his M.A.
and Ph.D. in economics from Harvard University. He has authored three tax
textbooks, published articles in numerous peer-reviewed journals, has served on
several journal editorial boards, and was previously a member of the Council of
Economic Advisers.