Fifth Circuit Reverses Tax Court in BMC Software
In a recent case, BMC Software v. Commissioner the Fifth Circuit Court of Appeals considered whether an account receivable created pursuant to Rev. Proc. 99-32 and a closing agreement entered into in connection with a transfer pricing adjustment was related-party indebtedness for purposes of section 965. Section 965 encouraged repatriation of funds from CFCs by providing for a one-time 85 percent dividends received deduction for cash dividends paid by a CFC to electing US shareholders. Section 965(b)(3) decreases the amount of the dividend eligible for the deduction by the amount of the increase in related party indebtedness of the CFC measured as of October 3, 2004. The Fifth Circuit’s decision reverses a 2013 decision of the Tax Court and concludes that the account receivable was not indebtedness for purposes of section 965(b)(3).
BMC is a U.S. computer software company with operations outside United States conducted by foreign affiliates. The IRS examined a royalty paid by BMC to a foreign affiliate, concluded that the royalty 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 the affiliate as a capital contribution. Instead, pursuant to Rev. Proc. 99-32 and the closing agreement, BMC elected to create interest-bearing accounts receivables with the affiliate for the years of the overpayment (2003 – 2006). These receivables are deemed to arise at the end of the taxable years for which the transfer pricing 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 BMC’s 2006 taxable year, the affiliate had paid a $709 million dividend to BMC, and BMC elected to reduce the U.S. tax on that dividend by claiming the benefit of section 965. Section 965(b)(3) requires 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 measured at October 3, 2004. This provision was intended to foreclose funding of a section 965 dividend by other members of the corporate group.
The IRS audited BMC and asserted a deficiency arguing that the accounts receivable created under Rev. Proc. 99-32 and the closing agreement in 2007 was indebtedness for purposes of section 965(b)(3) thereby increasing the 2006 dividend subject to full U.S. tax. In the Tax Court, BMC made several arguments why such an interpretation was incorrect, all of which were rejected. BMC appealed the Tax Court’s decision to the Court of Appeals for the Fifth Circuit, which found for BMC.
Reasoning of the Fifth Circuit
The Fifth Circuit notes initially that, during oral arguments, the Commissioner had conceded that he could not win the case based on the language of section 965 alone. Section 965(b)(3) refers to “the amount of indebtedness of the controlled foreign corporation to any related person . . . . as of the close of the taxable year for which the election under this section is in effect.” However, the dividend was paid during 2006 and the closing agreement creating the indebtedness was not entered into until 2007.
The Commissioner’s argument that the indebtedness was created earlier than 2007 was based primarily on the language of closing agreement which treats the accounts receivable as arising in the earlier taxable years, i.e., the years to which the primary transfer pricing adjustments related. He also pointed to the introductory language in the closing agreement: “now it is hereby determined and agreed for federal income tax purposes. . . .” The Fifth Circuit refused to rely on the introductory language to the closing agreement to make the indebtedness retroactive for purposes of section 965(b)(3) reasoning that to do so would render much of the closing agreement “superfluous, and also because the Agreement’s enumeration of tax consequences was exclusive.” The Fifth Circuit points out that the closing agreement describes the tax implications resulting from the interest payments on the account receivable. This description would not be necessary if the accounts receivable were treated as indebtedness for all federal income tax purposes:
[W] e conclude that the plain language of the 99-32 closing agreement precludes the Commissioner’s expansive interpretation of the agreement’s boiler plate provision, and the agreement covers only those tax consequences that it expressly enumerates. The agreement does not contain a term requiring that the accounts receivable be treated as indebtedness for purposes of section 965. Therefore, Commissioner’s interpretation of the 99-32 closing agreement is forclosed by its plain language.”
The Commissioner also sought to rely on Notice 2005-64 which states, inter alia, that accounts receivable created under Rev. Proc. 99-32 are indebtedness for purposes of section 965(b)(3). The Fifth Circuit refused to give that statement in the notice judicial deference, finding the statement to be conclusory and without supporting analysis or explanation. The court also points out that the IRS’s policy now requires closing agreements to explicitly define their section 965 consequences.
Finally, the Commissioner sought to rely on two cases, Smith v. United States and Schering Corp. v. United States to support the proposition that the account receivable should be treated as retroactively in existence for all federal income tax purposes unless the taxpayer negotiated limiting language in the closing agreement. The Fifth Circuit distinguished both cases and rejected that argument.
 No. 13-60684 (March 13, 2015). We discussed the Tax Court’s decision in our September 2013 post. 1999-34 I.R.B. 296. Under extensive case law, courts defer to an agency's interpretation of a statute the agency is charged with administering. A court’s degree of deference varies depending upon the circumstances. 850 F.2d 242 (Fifth Cir. 1988). 69 T.C. 579 (1978).KEYWORD: Transfer Pricing
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