The U.S. Court of Appeals for the Fifth Circuit recently overturned the U.S. Tax Court in a case that could have created significant additional hurdles for taxpayers electing to create an account receivable under Rev. Proc. 99-32. If the Tax Court's decision had been upheld, or if another circuit holds otherwise, many taxpayers could be forced to make a difficult decision: accept the implications of a secondary adjustment, such as a dividend inclusion or the imposition of withholding tax, or face a potential deficiency arising from the retroactive creation of a receivable under one of several statutory provisions. Rev. Proc. 99-32 was designed to ameliorate the negative consequences of a secondary adjustment. It should not be interpreted to require a taxpayer to navigate between a rock and a hard place.
In BMC Software, Inc. v. Comm'r., 115 AFTR 2d 2015-1092 (5th Cir. 2015), BMC signed a transfer pricing closing agreement to correct its net overpayment for royalties from its foreign subsidiary, BSEH. This income should have been taxable income retained by BMC, but in fact had been paid to BSEH. Pursuant to the closing agreement, BMC agreed to a primary adjustment for each tax year from 2003 to 2006, increasing its taxable income by approximately $102 million in total. However, the $102 million remained in the cash accounts of BSEH. Therefore, a secondary adjustment had to be made to explain the cash in the accounts of BSEH and to conform the tax accounts to the cash accounts.
BMC had two options to make the secondary adjustments: It could treat the $102 million overpayment as a deemed capital contribution from BMC to BSEH. Alternatively, BMC could elect pursuant to Rev. Proc. 99-32 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. BMC elected to treat the $102 million primary adjustment as a series of interest-bearing accounts receivable from BSEH, arising in each of the tax years in question. In 2011, on exam, the Internal Revenue Service (IRS) asserted that the account receivable that was created pursuant to Rev. Proc. 99-32 created a debt that should be taken into account in determining BMC's eligibility to claim a § 965 deduction for remittances made during the 2006 tax year.
Congress enacted § 965 as a temporary stimulus provision to encourage corporations to repatriate funds sitting in the accounts of their foreign subsidiaries. Accordingly, § 965 permitted a one-time tax deduction in the amount of 85 percent of certain dividends paid by a controlled foreign corporation (CFC) to its U.S.-based parent corporation. However, Congress included an anti-abuse provision preventing U.S. corporations from making loans to their foreign subsidiaries to fund § 965 dividends. The exception provides that the amount of repatriated dividends otherwise eligible for a § 965 dividends-received deduction is reduced by the amount of any increase in related-party indebtedness between October 3, 2004, and the end of the taxable year in which the dividend was paid (Testing Period).
In its 2006 tax year, BMC claimed a § 965 deduction and remitted $721 million from BSEH. BMC accurately reported no related-party indebtedness on its 2006 tax return. However, four years after the execution of the 99-32 Closing Agreement, IRS issued to BMC a notice of tax deficiency in the amount of approximately $13 million for the 2006 tax year, asserting that the accounts receivable that BMC established pursuant to Rev. Proc. 99-32 constituted related-party indebtedness during the Testing Period. As a result, IRS asserted that BMC was required to reduce the amount of the repatriated dividends eligible for the § 965 dividends-received deduction.
BMC challenged the deficiency in Tax Court. In holding for IRS, the Tax Court concluded, among other things, that the 99-32 receivable constituted "indebtedness" within the meaning of § 965 and existed during the Testing Period. In addition, the Tax Court rejected BMC's argument that because the accounts receivable were not actually created until 2007, after the conclusion of the Testing Period, BMC's § 965 dividends-received deduction should not be reduced. The Tax Court determined that "the accounts receivable qualify as indebtedness during the testing period because [BMC] and [IRS] agreed that they were established" during the Testing Period, albeit retroactively. Therefore, the Tax Court concluded that the retroactively established accounts receivable reduced the amount of BMC's 2006 § 965 dividend-received deduction.
BMC appealed this decision, and the Fifth Circuit reviewed the case under a de novo standard. BMC made two arguments: First, the 99-32 accounts receivable did not constitute "indebtedness" within the meaning of § 965(b)(3). Second, it did not contractually agree, in the 99-32 Closing Agreement, that the accounts receivable would be treated as indebtedness.
The Fifth Circuit, applying a plain language method of interpretation, first noted that the text of § 965(b)(3) specifically required that the determination of the amount of indebtedness be made "as of the close of the taxable year for which the election [under § 965] is in effect." Thus, the court reasoned that the accounts receivable could not have existed on March 31, 2006, the end of the Testing Period, because they were not created until after the parties executed the 99-32 Closing Agreement in 2007.
Next the Fifth Circuit addressed IRS's argument that BMC agreed in the 99-32 Closing Agreement to backdate the accounts receivable. The court reasoned that the fact that the accounts receivable were backdated did nothing to alter the reality that they did not exist during the Testing Period, noting that this was not a situation in which a subsequent adjustment was made in order to accurately reflect what actually happened in the taxable year. "Rather . . . 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." Thus the court concluded that because the accounts receivable were not created until 2007, they could not have existed "as of the close of" the applicable taxable year, and BMC's § 965 deduction could not be reduced under § 965(b)(3).
Finally, the Fifth Circuit noted that the dispute over the language of the Closing Agreement was an issue of contractual interpretation. IRS argued that the introductory clause, which states that "now it is hereby determined and agreed for federal income tax purposes . . . " contractually rendered the 99-32 account receivable indebtedness during the Testing Period. However, the court reasoned that this was a boilerplate provision required by IRS in every closing agreement. Further, the court applied the canon of construction expressio unius est exclusio alterius to hold that the Closing Agreement's expansive enumeration of tax consequences was exclusive. Since those terms did not require that the accounts receivable be treated as indebtedness for purposes of § 965, the court held that IRS's interpretation of the 99-32 Closing Agreement was foreclosed by its plain language. Accordingly, the Fifth Circuit held that under the 99-32 Closing Agreement, BMC did not agree to treat the accounts receivable as "indebtedness" for purposes of § 965.
Implications of the Case
This holding is good news for taxpayers. Had the Fifth Circuit held otherwise, taxpayers would be required to consider whether an election to create an account receivable under Rev. Proc. 99-32 in order to avoid the negative consequences of a secondary adjustment could result in negative consequences under another statutory provision. In fact, IRS could still assert this theory in other circuits or, albeit unlikely, seek certiorari from the Supreme Court.
There are a number of situations in which treating a 99-32 account receivable as indebtedness in an earlier year for all purposes of the Internal Revenue Code could create unfavorable tax results. Could IRS assert that a 99-32 account receivable in favor of a CFC creates an investment in U.S. property? If so, the taxpayer might avoid the treatment of a secondary adjustment as a dividend only to find that the deemed indebtedness created a taxable investment in U.S. property of the same or a similar amount. Might IRS assert that deemed interest on the account receivable created subpart F income? Would it assert that a 99-32 account receivable created to avoid treating a secondary adjustment as a dividend to a foreign parent subject to withholding retroactively increased the debt-to-equity ratio of the U.S. subsidiary, creating disqualified interest when an earnings stripping limitation would not otherwise have applied? What if the taxpayer had engaged in a corporate restructuring during a previous year? Would IRS assert that the 99-32 account receivable created boot in a previous reorganization, disqualified a reorganization or created a § 304 dividend? What other implications could the creation of an account receivable have on a previous tax year?
Perhaps some of these scenarios are fanciful. But so is the retroactive creation of a receivable for purposes of § 965. If IRS challenges similar cases in other venues, taxpayers will be forced to carefully review their prior period transactions in order to avoid creating one tax liability while trying to avoid another.
Fifth Circuit Ruling In BMC Software, Inc. v. Comm'r. Is Good News For Taxpayers
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