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Court of Appeals Reverses Tax Court on §965's Application to Receivables Created As Part of Transfer Pricing Closing Agreement

In the case of BMC Software Inc. v. Commissioner, 141 TC No. 5, reversed CA5, Case No. 13-60684, 115 AFTR 2d ¶2015-528, the Fifth Circuit Court of Appeals and the U.S. Tax Court had to consider whether there was an intent requirement imposed by the language of what would reasonably be seen as an anti-abuse provision.  The Tax Court ruled that since no “bad intent” requirement was found in the statute, the statute had to be applied mechanically even if both the IRS and the taxpayer agreed that there was no “bad faith” on the part of the taxpayer.  The Fifth Circuit disagreed with that conclusion.

The Tax Court Ruling

The provisions in question arose under IRC §965 which allows an 85% dividend received deductions for certain dividends received by a corporation from a controlled foreign corporation (CFC).  Such dividends must be “extraordinary” as defined in IRC §965(b)(2), which at dividends paid in excess of prior periods.

In order to prevent a corporation from essentially “funding” a repatriation by loaning the controlled corporation the funds to make the “extraordinary” dividend payment, IRC §965(b)(3) requires that such dividends must be reduced by an increase in related party indebtedness.

In the case in question, the taxpayer had been the subject of an IRS examination regarding royalty payments made to the CFC.  The IRS asserted that the dividends were no arms-length and the taxpayer and the IRS entered into a closing agreement in 2007 that reduced the royalty payment.

The taxpayer elected under Revenue Procedure 99-32 to treat the excess payments as loans, resulting in two separate $22 million increases in accounts receivable between the U.S. entity and the CFC.  The CFC repaid the U.S. entity the $44 million plus interest.  Had the taxpayer not elected this treatment, the payment would have been treated as a contribution of capital to the CFC.

However, the taxpayer had received $709 million of dividends in its fiscal year ended March 31, 2006 eligible for the 85% reduction.  The IRS now contended that those eligible dividends must be reduced by $44 million, representing the increase in related party debt during the testing period.  That was true even though, clearly, the taxpayer was not even aware the “loan” existed during that period and, as the IRS agreed, did not act in bad faith to “pump up” the repatriation distribution.

The Tax Court ruled that the law had to be applied mechanically, finding there was no requirement of a showing of intent to avoid tax or enter into an abusive transaction.  The ruling, issued as a published Tax Court ruling, is meant to provide binding precedent that the Tax Court will apply in similar situations in what the Court considered to be a matter of law that had not previously been addressed.

The Fifth Circuit Ruling

BMC Software was, not unsurprisingly, displeased with the Tax Court’s view and elected to appeal the case.  The appeals court with jurisdiction in this case was the Fifth Circuit Court of Appeals, an appellate court whose jurisdiction covers Louisiana, Mississippi and Texas.  Thus, under the Golsen rule (54 TC 742 (1970)), the decision of this court is binding in those states to which it would hear an appeal on the Tax Court, though the Tax Court will not necessarily follow its rulings when cases would be appealed to other courts of appeal.

In this case the Fifth Circuit did not agree with the Tax Court’s reading of the statute and its application to the situation at hand.

The Fifth Circuit opinion found that, at the end of the testing period (the end of the tax year in which the dividend was paid) there was no increase in indebtedness. The Court notes:

BMC accurately reported no related-party indebtedness on its 2006 tax return. Thus, it is undisputed that at the time BSEH paid its $721 million cash dividend to BMC, the §965(b)(3) related-party indebtedness exception had no relevance or effect.

The Court then turned to the transfer pricing closing agreement signed with the IRS in 2007.  The Court notes:

In 2007, BMC and the Commissioner signed a transfer-pricing closing agreement (Transfer Pricing Closing Agreement) to correct BMC's net overpayment for royalties from its foreign subsidiary, BSEH, which should have been taxable income retained by BMC, but in fact had been paid to BSEH. This was completely unrelated to the 2006 repatriation under § 965.

The agreement provided that $102 million had been overpaid to BMC by the related foreign operation.  The court notes that the regulations gave BMC two options in this case:

Because the $102 million BMC had "overpaid" BSEH remained in the cash accounts of BSEH, BMC was also required to make secondary adjustments to conform its books and records to reflect that fact. Pursuant to Treasury Regulation § 1.482­1(g)(3), BMC had two options in making the secondary adjustments.

Under the first alternative, BMC could treat the $102 million overpayment as a deemed capital contribution from BMC to BSEH. If, thereafter, BSEH chose to repatriate the $102 million to BMC to correct the cash imbalance, that repatriation would be taxed as a dividend to BMC in the year of repatriation.

Under the second alternative, also authorized by Treasury Regulation § 1.482­1(g)(3) and provided for in IRS Revenue Procedure 99­32, BMC could elect to treat the $102 million as an account receivable, payable by BSEH to BMC, with interest accruing from the date of deemed creation of the account. If, thereafter, BSEH paid the account receivable, BMC would not be taxed on the receipt of those funds. In essence, the $102 million would be treated as a loan from BMC to BSEH.

In the IRS’s view (and that of the Tax Court), when BMC chose the second option it retroactively created related party debt at the end of the 2006 tax year, thus triggering the application of IRC §965(b)(3)’s related party debt rules.

The Fifth Circuit disagreed, finding that this was not a debt that existed at the end of the year in question, a key issue. 

The Court begins its analysis with the following:

At oral argument, the Commissioner correctly conceded that he cannot prevail on the language of the statute alone. This is because it is undisputed that, “as of the close of” BMC’s 2006 taxable year, the accounts receivable did not exist. Indeed, the Commissioner’s brief concedes that “ [n]either party contends that a loan was made from [BMC] to BSEH during the testing period” as a factual matter. Nor could the accounts receivable have existed at that time ­­ they were not created until after the parties executed the 99­32 Closing Agreement in 2007. See Midkiff v. Comm’r, 96 T.C. 724 (1991), aff’d, Noguchi v. Comm’r, 992 F.2d 226 (9th Cir. 1993) (holding that an agreement that included payment of the purchase price plus annual interest for prior years did not give rise to retroactive indebtedness in those prior years).

The Fifth Circuit found that this elective creation of accounts receivable did not mean that receivable existed as of end of 2006—a requirement for §965(b)(3).

The Court reasons:

The Commissioner makes much of the fact that in the 99­32 Closing Agreement, BMC agreed to backdate the accounts receivable. This is an incorrect interpretation of the testing-­period requirements of § 965. The fact that the accounts receivable are backdated does nothing to alter the reality that they did not exist during the testing period. Even assuming arguendo that a correction of a prior year’s accounts could create indebtedness for purposes of § 965(b)(3), that is not what happened in this case. This is not a situation in which a subsequent adjustment was made in order to accurately reflect what actually happened in the taxable year ending on March 31, 2006.

Rather, with the secondary adjustments, BMC agreed to create previously non­existent accounts receivable with fictional establishment dates for the purpose of calculating accrued interest and correcting the imbalance in its cash accounts that resulted from the primary adjustment. The text of § 965(b)(3) requires that, to reduce the allowable deduction, there must have been indebtedness “as of the close of” the applicable taxable year. Because the accounts receivable were not created until 2007, BMC’s § 965 deduction cannot be reduced under § 965(b) (3).

The IRS points to Notice 2005-64 in an attempt to bolster its argument, claiming it views such retroactive receivables as debts created at that date. 

The Fifth Circuit finds that the Notice simply fails to establish the case the IRS wishes to make, noting:

The Commissioner correctly conceded in his brief that Notice 2005­64 is not entitled to deference under Chevron USA, Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984). At most, the 2005 notice might be entitled to deference under Skidmore v. Swift & Co., 323 U.S. 134, 140 (1944). Under Skidmore, we defer to the agency only to the extent that the agency’s interpretation is persuasive. Id. We conclude that the 2005 notice is unpersuasive for several reasons. The notice contains only a single sentence regarding the treatment of accounts receivable as indebtedness. Moreover, the treatment of accounts receivable is entirely conclusory.

The notice contains no analysis or explanation. This is particularly problematic in light of the fact that the notice advocates a treatment of accounts receivable that runs counter to the plain language of § 965. Finally, the Commissioner has since changed his treatment of § 965 tax consequences in closing agreements, explicitly outlining the § 965 tax consequences in such agreements. With no reasoning or analysis to support its directive, and with the Commissioner’s subsequent decision to explicitly provide for § 965 tax consequences in later closing agreements, the notice is entirely unpersuasive and unworthy of deference.

Thus the Court concludes:

In sum, the plain language of § 965(b)(3) does not ask, “To be or not to be?” It instead asks, “To have been or not to have been?” And the answer to this question is clear: “as of” March 31, 2006, the accounts receivable did not exist. Therefore, § 965(b)(3), by its plain language, cannot sustain the judgment of the tax court.


Given the case was a published Tax Court opinion overturned on appeal, advisers are faced with the problem of divergent guidance.  The IRS can generally be expected to push for the Tax Court’s original decision outside the Fifth Circuit and, for now, advisers must assume the Tax Court will back them up.  Thus, taxpayers taking the position advanced by BMC outside of the three states that are part of the Fifth Circuit will need to be aware that in an IRS challenge they would need to be willing to take the case to the relevant court of appeals and hope that court agrees with the reasoning of the Fifth.