A divided Tax Court has overruled its previous decision in the BMC Software, Inc. v. Commissioner, 141 TC No. 5, a case that was overturned on appeal by the Fifth Circuit, and found that accounts receivable established in a Revenue Procedure 99-32 closing agreement didn’t create related party indebtedness in the case of Analog Devices Inc., et al, v. Commissioner, 147 TC No. 15. The Court therefore allowed the company’s entire dividends received deduction under IRC §965.
The issue at hand was the impact of IRC §965(b)(3) on the entity’s ability to claim a deduction for dividends received from a Controlled Foreign Corporation (CFC). As the Court explained:
Although section 965 imposes several limitations on the availability and the amount of the DRD, this case concerns only the limitation provided by section 965(b)(3). Section 965(b)(3) reduces the amount of the eligible dividend by any increase in the amount of indebtedness of the CFC to any related party during the testing period (related party indebtedness). The testing period is generally the period between October 3, 2004, and the close of the taxable year for which the taxpayer makes the election. Sec. 965(b)(3)(A) and (B).
The issue at hand deals with the case where the IRS has required the taxpayer to book an adjustment under §482 for income from a related entity. In this case the IRS required the U.S. parent to report additional income and its CFC subsidiary to report less income. The issue becomes booking that adjustment, and the regulations allow for a choice of adjustments.
As the Court continues:
Where, as here, a U.S. parent corporation's income has been increased and its CFC's income has been decreased as a result of a transfer pricing adjustment, the methods include: treating the allocated amount as a deemed dividend from the CFC to the U.S. parent; or "in appropriate cases, pursuant to such applicable revenue procedures as may be provided by the Commissioner * * * repayment of the allocated amount without further income tax consequences." Id.
The Commissioner promulgated Rev. Proc. 99-32, supra, pursuant to the above-quoted regulation. Rev. Proc. 99-32, supra, permits qualifying U.S. taxpayers to make secondary adjustments by establishing an interest-bearing account receivable from, or payable to, its CFC in the amount of the primary transfer pricing adjustment in lieu of treating the adjustment as a deemed dividend or a capital contribution. Rev. Proc. 99-32, secs. 1, 4.01, 1999-2 C.B. at 297, 299.
The Revenue Procedure describes the impact of making this election (which the taxpayer did make in this case):
Rev. Proc. 99-32, sec. 4.01, describes the features of an account established under these procedures. The account may be established and paid "without the Federal income tax consequences of the secondary adjustments that would otherwise result from the primary adjustment." The account is deemed to have been created as of the last day of the taxable year for which the primary adjustment was made. It bears interest computed pursuant to section 1.482-2(a)(2), Income Tax Regs., from the day after the deemed establishment date. For purposes of section 1.482-2(a)(2)(iii), Income Tax Regs., dealing with safe haven interest rates, the account "shall be considered to be a loan or advance having a term extending from the day after the date the account is deemed to have been created through the expiration of" 90 days after execution of the closing agreement on behalf of the Commissioner. Rev. Proc. 99-32, secs. 4.01(2), 5.01(4)(e).
Rev. Proc. 99-32, sec. 4.03, clarifies that electing treatment under that revenue procedure does not affect the primary adjustment but affects the taxpayer's taxable income and credits to the extent indicated in Rev. Proc. 99-32, sec. 4.01.19 Rev. Proc. 99-32, sec. 4.03, further states that the election eliminates "the collateral effects of secondary adjustments, such as those described in section 2 [regarding deemed dividend treatment]."
While the IRS has not issued any statutory or regulatory guidance on how the election under Rev. Proc. 99-32 impacts the debt calculation under IRC §965, the IRS issued three notices in 2005 holding that the receivable established under a closing agreement and Rev. Proc. 99-32 election is debt for purposes of IRC §965 and, therefore, could result in a reduction of an otherwise allowable dividend exclusion for dividends received from a CFC.
Originally the Tax Court had agreed with the IRS that the establishment of this account receivable in prior years, and therefore sustained a downward adjustment in the amount of dividends that could be excluded. But on appeal, the Fifth Circuit Court of Appeals overturned the result (BMC Software, Inc. v. Commissioner (CA5), 780 F.3d at 674-675).
The Tax Court summarized the Fifth Circuit’s ruling as follows:
The Court concluded that: (1) because section 965(b)(3) provides that the final calculation of the amount of related party indebtedness is to be made "as of the close of the taxable year for which the election * * * is in effect" and (2) because BMC's accounts receivable did not exist until the parties executed the closing agreement in 2007, the accounts receivable were not related party indebtedness under section 965(b)(3). See id. at 675. Moreover, the Court of Appeals stated that "[t]he fact that the accounts receivable * * * [were] backdated does nothing to alter the reality that they did not exist during the testing period" because the accounts were secondary adjustments to correct cash account imbalances and not a correction of a prior year's accounts.
In this case the matter returned to the Tax Court—but an appeal in this case would go to the First Circuit and not the Fifth, so the Tax Court was not bound by the Golsen rule to respect the Fifth Circuit’s decision. But the Court did reconsider its original decision, with a majority of the judges now deciding to reverse the Court’s prior position outlined in a published decision—a decision the Court would normally respect under the doctrine of stare decisis.
The majority opinion notes:
This case presents issues on which a Court of Appeals has reversed our prior decision. In such a scenario, "[c]learly * * * [we] must thoroughly reconsider the problem in the light of the reasoning of the reversing appellate court and, if convinced thereby, the obvious procedure is to follow the higher court." Bayer v. Commissioner, 98 T.C. 19, 22 (1992) (quoting Lawrence v. Commissioner, 27 T.C. 713, 716-717 (1957), rev'd on other grounds, 258 F.2d 562 (9th Cir. 1958)); see also Trout v. Commissioner, 131 T.C. 239, 245 n.6 (2008) ("But nothing in Golsen or in Lawrence precludes us from revisiting an issue, as we do here, when the issue on which there has been an intervening reversal arises anew."). By revisiting the issues in BMC Software I, we are not capriciously disregarding our prior analysis but rather examining the issues in the light of a Court of Appeals' opinion, which deserves careful attention and reflection.
So the majority concludes, in deciding to revisit the matter:
On balance, we conclude that the importance of reaching the right result in this case outweighs the importance of following our precedent. But cf. Burnet v. Coronado Oil & Gas Co., 285 U.S. at 406 (Brandeis, J., dissenting) ("[I]n most matters it is more important that the applicable rule of law be settled than that it be settled right."). We therefore conclude that stare decisis does not prevent us from reconsidering BMC Software I, and we do so below.
First, the majority found that the parties had not resolved the treatment of IRC §965 in the closing agreement, noting:
Because the parties enumerated in considerable detail the tax consequences of the closing agreement, we find that these specific clauses must be interpreted to limit the phrase "for all Federal income tax purposes". We therefore hold that when the parties signed the closing agreement they did not manifest an intent with respect to section 965(b)(3). Instead we find that the parties' intent was to reconcile the cash accounts of petitioner and ADBV with their adjusted tax positions as a result of the section 482 primary adjustment. This was completely unrelated to the section 965 DRD.
While the taxpayer may have known about the IRS’s position, the IRS also knew the taxpayer took the opposite position—but the agreement didn’t deal with this matter. As the opinion notes:
Under Federal common law, one party is bound to the other party's understanding of an ambiguous term only if the other party did not know or have reason to know of the first party's understanding of that term. Even assuming that petitioner knew of respondent's interpretation of the closing agreement, respondent had reason to know of petitioner's understanding as well. Both parties were aware before the execution of the closing agreement that section 965(b)(3) was an issue, yet the closing agreement did not include any provision addressing it. The extrinsic evidence shows that the parties did not reach an agreement with respect to section 965(b)(3), and we will not read a term into the closing agreement to which the parties did not agree.
Having concluded that the parties had not agreed that these amounts were to be treated as retroactive accounts receivable, the majority decided to adopt the Fifth Circuit’s view of the law in this area to decide the proper applicable.
The majority concludes:
Upon consideration, we agree with the Court of Appeals' analysis that, under the plain meaning of section 965(b)(3), a CFC has an increase in related party indebtedness only if the indebtedness existed "as of" the close of the election year. Petitioner's testing period closed long before the execution of its Rev. Proc. 99-32 closing agreement, and the accounts receivable did not exist before the closing agreement. Respondent concedes that ADBV would not have an increase in related party indebtedness if petitioner did not make an election under Rev. Proc. 99-32, supra, and did not execute the closing agreement. Therefore, the only way in which the accounts receivable could have been established "as of" the close of petitioner's election year is if the closing agreement's deemed established dates applied to the application of section 965(b)(3). We held supra that the parties did not reach an agreement in their Rev. Proc. 99-32 closing agreement with respect to section 965(b)(3), and we do not take the deemed establishment dates of the accounts to alter subsection (b)(3).
We also find, as the Court of Appeals did, that Notice 2005-64, sec. 10.06, in which the IRS states that "accounts payable" are treated as debt under section 965(b)(3), is wholly unpersuasive because it lacks any analysis and runs counter to the plain meaning of subsection (b)(3). See BMC Software II, 780 F.3d at 676. It also conflicts with Notice 2005-38, sec. 7.05(b), 2005-1 C.B. at 1112, which comports with the statute, stating: "A U.S. shareholder determines the amount of the related party indebtedness of its CFC on the last measurement date"