IRS Expert Questions Illinois Tool Works' Financing Deal

By Dolores W. Gregory

Aug. 1 — The structure of Illinois Tool Works' $356.7 million intercompany loan created an “asymmetric risk” that wasn't reflected in the pricing, a financial expert retained by the IRS testified in U.S. Tax Court ( Illinois Tool Works v. Commissioner, T.C., 10418-14, oral argument 8/1/16 ).

Robert Grien, managing director and head of the finance and restructuring group with TM Capital Corp. in New York, was called by the Internal Revenue Service as an expert on how lenders set interest rates for debt securities.

He testified Aug. 1 that he was asked to offer an opinion on whether the terms of the promissory note underlying the loan were such that the debt could be sold in the secondary market. Grien concluded that it couldn't be.

The one-page promissory note executed by two ITW subsidiaries included no covenants protecting the interests of the lender, he said. The loan carried a 6 percent simple interest rate, but payment of interest was deferred for five years. There was nothing to prevent the borrower from paying off the loan ahead of time, he said, and the loan was not guaranteed by the parent.

The case involves a $356.7 million transfer from CS (Australasia) Holdings Ltd. (CSA) to its parent company, CS (Europe) Holdings Ltd. (CSE), and a transfer in the same amount from CSE to its parent and sole shareholder, Paradym Investments Ltd. CSA, CSE and Paradym are all subsidiaries of ITW. Ultimately the funds ended up in the cash pool of the U.S. parent.

ITW maintains that the transfer from CSA to CSE constitutes bona fide debt for U.S. tax purposes and that the transfer from CSE to Paradym is a return-on-basis distribution. But the IRS argues that the industrial equipment maker used a series of complex intercompany transactions to disguise a $356.8 million cash repatriation as a tax-deductible intercompany loan. As a result, ITW understated its U.S. income tax liability by more than $70 million in tax year 2006, the IRS said (25 Transfer Pricing Report 373, 7/28/16).

ITW is challenging that assessment, along with $14 million in underpayment penalties.

Tension Among Competing Interests

In previous filings with the Tax Court, the IRS cast doubt on the validity of the loan because CSE, as the sole shareholder in CSA, has no earnings or profits on its own. Therefore, the lender was effectively relying on itself to repay the loan, the agency said.

Grien testified that there is a tension between the interests of the ITW bondholders and equity holders and the interests of its controlled foreign corporation subsidiaries. If the transfer between CSA and CSE had been structured as a bond issue, he said, it would not meet minimal standards for protecting investors.

Grien adjusted the cost of the loan to account for features that he said made it more risky and therefore more costly:

•  an adjustment for deferred interest,
•  an adjustment for the lack of restrictive covenants, and
•  an adjustment for the lack of liquidity under Rule 144a.

Rule 144a is the Securities and Exchange Commission rule that allows institutions to trade formerly restricted securities among themselves.

Grien said these adjustments led to an increase in basis points that would account for an additional cost of borrowing of between $5.4 million and $9.2 million on the $356 million loan.

He explained that a simple interest rate of 6 percent with a five-year deferral is unusual for a commercial bond issue. Under such terms, a bondholder would recoup $130 at the end of five years for every $100 of the security that it held.

In a typical bond issue, at a 6 percent rate, he said, there would be 10 payments of $3 over that period. The more frequent interest payments would lead to a greater return because the lender could reinvest the interest payments as they came in, he said. Therefore, there's an additional cost that must be paid to make up for that lost opportunity.

The lack of restrictions and the lack of liquidity also increase the risk to the lender and add to the cost of borrowing, he said.

Structure ‘Not Workable.'

Grien also included an adjustment for “credit risk” spread—an additional 75 basis points that accounted for the “discrete risk” that a particular borrower might fail to make timely interest and principal payments.

Robin L. Greenhouse of McDermott Will & Emery, an attorney for ITW, grilled Grien on his analysis, asking why he had failed to take into account the creditworthiness of CSE.

He responded that the structure of the transaction rendered that question irrelevant to his analysis.

“If you have a structure that's not workable, it doesn't matter,” he said. It is not necessary to consider how creditworthy the borrower is if “you can look at a bond and say that doesn't look like anything anyone in the bond market would buy.”

Presiding Judge Albert G. Lauber noted that the deal involves an unusual situation in which a subsidiary is lending to its parent.

For that reason, he said, “it doesn't surprise me that it would construct a loan on a simplified basis.”

If the company were to go into the bond market, Lauber said, it would have to undertake a much more rigorous and costly process that would involve more complex paperwork than a one-page promissory note. He asked Grien what would have to change in the transaction to render the debt a marketable security.

Grien responded that if the terms were adjusted to make up for the deficiencies he had noted, it would lead to that result.

To contact the reporter on this story: Dolores W. Gregory in Washington at dgregory@bna.com

To contact the editor responsible for this story: Molly Moses at mmoses@bna.com

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