U.S. multinationals literally have trillions of dollars of untaxed earnings purportedly “trapped” offshore because of the associated high U.S. corporate income taxes that would be incurred if these earnings were repatriated to the United States. While a number of strategies have been marketed to, and used by, U.S. multinationals in an attempt to repatriate these earnings in the most tax-efficient manner, one by one the IRS and Treasury effectively are shutting down these transactions through the issuance of new regulations.

For example, in April of this year, the IRS and Treasury released Notice 2014-32, announcing plans to issue revised regulations under Section 367(b) that would limit the ability of U.S. multinationals from engaging in so-called “Killer B” transactions. In general, a Killer B transaction is a triangular reorganization in which a foreign subsidiary purchases shares of its parent stock for cash or a note, and has the effect of repatriating untaxed profits from a foreign subsidiary to its U.S. parent without triggering a taxable dividend to the U.S. parent. (See Rubinger and Kruler, “Notice 2014-32 Takes Further Sting Out of ‘Killer B’ Transactions,” Journal of Taxation, August 2014).

In March of 2013, the IRS and Treasury issued temporary regulations under Section 367(a)(5) preventing the tax-free repatriation of foreign-source profits to the United States without gain recognition under Section 367(a) or Section 367(d) in an “outbound F” reorganization. An outbound F reorganization typically involves the conversion of a recently acquired U.S. target company into a foreign company, and at the same time allows for the tax-free repatriation of profits through a combination of a dividends received deduction and a return of basis.

The IRS is now challenging in Tax Court the purported tax-free repatriation of $357 million by Illinois Tool Works (the “Taxpayer”) from its wholly owned subsidiary in Europe. The Taxpayer is arguing that the distribution should be a non-taxable return of basis because it was paid by a holding company with no earnings and profits (“E&P”), and the amount of the distribution was less than the Taxpayer’s basis in the subsidiary’s shares.

Return of Basis Transactions, in General

A distribution by a corporation to a shareholder out of the corporation’s E&P will be taxable as a dividend. The portion of the distribution that is not a dividend is applied against and reduces the adjusted basis of the stock of the corporation. To the extent that the distribution exceeds the adjusted basis of the stock, such excess is treated as gain from the sale or exchange of the stock.

In a typical return of basis transaction, a U.S. parent corporation transfers the shares (generally with a high basis) of a foreign subsidiary to a foreign holding company in a non-taxable exchange. The foreign holding company borrows money from a third party. The foreign holding company then makes a distribution to the U.S. parent before the end of the taxable year and prior to the time that the foreign holding company has any E&P. In the following year, the foreign subsidiary makes a distribution to the foreign holding company, who then uses the cash to repay the loan.

The U.S. parent argues that the distribution received from the foreign holding company is non-taxable because the holding company has no E&P, and the amount of the distribution is less than the adjusted basis of the foreign holding company shares.

Illinois Tool Works

Illinois Tool Works, Inc. (the “Taxpayer”) is a U.S. corporation that wholly-owned Paradym Investments Ltd. (“Paradym”), a U.S. subsidiary. Paradym owned a holding company in Europe (“European HoldCo”), which, in turn, owned a holding company in Bermuda (“Bermuda HoldCo”). Paradym had a basis of $1.1 billion in its European HoldCo shares. Bermuda HoldCo had numerous operating subsidiaries that had approximately $6.5 billion of E&P. European HoldCo had no current or accumulated E&P.

In 2006, needing cash in the United States to retire outstanding commercial paper and fund acquisitions, Bermuda HoldCo lent $357 million to European HoldCo. The loan was unsecured, had a term of five years, and provided for a fixed rate of interest at 6 percent. The loan was properly documented and $20 million of interest was paid each year as required by the loan documents. European HoldCo then made a distribution of the same $357 million to Paradym.

Paradym treated the distribution as a return of basis. The Taxpayer argued that the distribution was not a dividend because European HoldCo had no E&P and therefore the distribution should offset Paradym’s $1.1 billion basis in its European HoldCo shares.

In 2010, the IRS issued a notice of deficiency to the Taxpayer and recharacterized the Bermuda HoldCo loan as a dividend. This would cause European HoldCo to have $357 million of E&P and the distribution to Paradym to be treated as a taxable dividend.

In the alternative, the IRS argued that Paradym had a zero basis in its European HoldCo shares. That would result in the European HoldCo’s distribution being treated as a taxable capital gain (i.e., as a distribution in excess of basis).

Will the IRS be Successful?

As evidenced by the increasing number of inversions by U.S. multinationals, repatriation of offshore profits has been, and will continue to be, a significant issue. Should the IRS be successful in Illinois Tool Works, a large number of U.S. multinationals will be affected, as this type of repatriation strategy is a common planning technique.

As noted above, the IRS’s primary argument is that the purported loan from Bermuda HoldCo to European HoldCo should be recast as a dividend rather than a loan. The loan satisfied most of the formal factors that typically support debt treatment, including the existence of a written instrument, a fixed maturity date, and fixed rate of interest (which was paid annually). A key feature that likely cannot be satisfied, however, is European HoldCo’s willingness or ability to repay the loan as evidenced by its lack of E&P. This factor certainly will weigh against the characterization of the amount as a loan.

The IRS also may attempt to argue that the Section 956 anti-abuse rule should apply and result in an investment in U.S. property. Section 956 treats a controlled foreign corporation’s (“CFC”) investment of earnings in U.S. property as a deemed distribution that is included in the gross income of the CFC’s U.S. shareholders. Section 956(c)(1)(C) defines U.S. property to include an obligation of a U.S. person, which would include a loan to the CFC’s U.S. parent.

While the purported loan from Bermuda HoldCo to European HoldCo was not a loan to a U.S. shareholder, Regulation Section 1.956-1T(b)(4) contains a broad anti-abuse rule which gives the IRS discretionary authority to apply Section 956 to an investment in U.S. property by a nominee, or by a foreign corporation controlled by a CFC if a principal purpose of creating or funding the foreign corporation was to avoid Section 956. While not directly on point, based on the facts of the case, it would not seem to be such a stretch for the IRS to contend that the anti-abuse rule nevertheless should apply because the manner in which European HoldCo was funded was arguably to avoid Section 956.

Finally, the IRS may take the position that the “step transaction” doctrine should apply to collapse the series of steps into either a distribution or a loan directly from Bermuda HoldCo to Paradym. This would result in a taxable event in either situation.