Transfer Pricing Adjustment Has Unintended Consequences for Taxpayer
As illustrated in the recent case of Salem Financial, taxpayers often exploit the complexity of the Internal Revenue Code to their advantage, while the government is less likely to do so. In the recent case of BMC Software Inc. v. Commissioner, the tax law’s complexity proved to be an ally of the government, however. BMC involved a multi-year transfer pricing adjustment in favor of the government that, the Tax Court concluded, also reduced the taxpayer’s dividends received deduction for dividends paid to the taxpayer by a foreign subsidiary during one of the years for which the adjustment was made. We discuss below the convoluted path to this result.
BMC is a U.S. computer software company with operations outside United States conducted by foreign affiliates. Like similar U.S. companies, BMC had co-developed software with one of its foreign affiliates (“BSEH”) under a pair of cost-sharing arrangements. In 2002 BMC terminated one of the cost-sharing arrangements and acquired its foreign affiliate's intangible property rights in exchange for a royalty for a term of years. The IRS subsequently examined the arrangement, concluded that the royalty BMC had paid BSEH for the intangible property rights for the years 2002 through 2006 was too large, and increased BMC's income for those years. The parties entered into a closing agreement in 2007 to reflect the agreed transfer pricing adjustments.
BMC did not treat the excess royalties that it paid to BSEH as a capital contribution to the subsidiary. Instead, pursuant to Rev. Proc. 99-32 and the closing agreement, BMC elected to create interest-bearing accounts receivable with BSEH for the years of the overpayment. These receivables are deemed to arise at the end of the taxable years for which the adjustments are made. Pursuant to the revenue procedure, these obligations must be paid by the obligor within 90 days after the election is made.
The dispute in this case arose because, during the 2006 taxable year, BSEH paid a $709 million dividend to BMC and elected to reduce the U.S. tax on that dividend by claiming the benefit of section 965. That provision allowed BMC a dividends’ received deduction, which reduced the U.S. effective tax rate on the dividend to approximately 5 percent.
A provision of section 965 required that the amount of the dividend eligible for this benefit be reduced by the amount of the increase in indebtedness of the foreign corporation paying the dividend to any related person during a testing period. The issue in the case was whether the accounts receivable created under Rev. Proc. 99-32 should be treated as indebtedness for purposes of this rule of section 965.
The government argued that the effect of creating the accounts receivable was to increase the amount of the $709 million dividend subject to U.S. tax. In effect, the related-party debt rule in section 965 turned, what BMC probably had believed was a tax-free repatriation of the excess royalties in 2007, into a taxable dividend in an earlier year.
Law and Analysis
The taxpayer made several arguments as to why the accounts receivable created under Rev. Proc. 99-32 should not be treated as related-party indebtedness for purposes of section 965. First, BMC argued that the related-party indebtedness rule should apply only when a U.S. shareholder intentionally finances the dividend through an abusive transaction. Reviewing the legislative history of section 965 and subsequent statutory amendments, the Tax Court concluded that there is no such limitation. BMC also argued that the accounts receivable were not "indebtedness." Defining indebtedness as "the condition of owing money or being indebted" the Tax Court also rejected that argument.
Notice 2005-38, which provided guidance on the implementation of section 965 excludes "trade payables" from the scope of the section 965’s related-party indebtedness rule, and the taxpayer argued the accounts receivable should be treated as trade payables. The Tax Court found that the accounts receivable did not satisfy the definition of trade payables because they were not established in the ordinary course of business and were not paid within 183 days after they were created.
The taxpayer also pointed to language in the closing agreement that "such payment will be free of the Federal income tax consequences of the secondary adjustment that would otherwise result from the primary adjustment . . .” The Tax Court explains that this language is intended to avoid treating the payment of the accounts receivable as dividends. The court also points out that the language refers to the "payment" not to the indebtedness itself.
Finally, the taxpayer argued that the accounts receivable should not be treated as related-party indebtedness for purposes of section 965 because they were established retroactively, i.e., after the testing period described in section 965. The court resolved this issue in favor of the government because the closing agreement stated that the accounts receivable were created during the testing period.
Having agreed to the transfer pricing adjustment, BMC had paid tax on the excess royalties in the hands of BSEH. Although the record is not clear, repatriating that cash to the United States in 2007 or a later year probably would have resulted in a substantial U.S. tax liability to BMC. Creating the account receivable under Rev. Proc. 99-32 probably was a reasonable action for BMC to take because the lack of clarity of the related-party indebtedness rule in section 965 gave BMC an opportunity to argue it should avoid fall outside that rule. Unfortunately for BMC, the Tax Court resolved these issues in favor of the government.
 141 T.C. No. 5 (Decided September 18, 2013). 1999-34 I.R.B. 296. Section 965 was added to the Internal Revenue Code by the American Jobs Creation Act of 2004. It allowed U.S. companies to elect, for one taxable year, to receive an 85percent deduction for eligible dividends from their foreign subsidiaries. If BMC had not made the election under the Revenue Procedure, and BSEH had repaid the excess royalties, the United States would treat the payments as a dividend to the extent of the earnings and profits of BSEH in the year paid. The record does not include sufficient detail to determine the tax consequences of this hypothetical transaction.KEYWORD: Transfer Pricing
Tax Insights Blog