U.S. Court of Appeals Rejects IRS Attempt to Apply Closing Agreement Retroactively to Support an Unrelated Proposed Adjustment to Tax

SUMMARY

From 2003 to 2006, U.S. corporations were entitled, in certain circumstances, to elect a one-time dividends-received deduction for dividends from controlled foreign corporations. BMC Software, Inc. made this election for its 2006 tax year and received a dividend from a foreign subsidiary. In connection with a subsequent transfer-pricing audit, BMC agreed that it overpaid royalties to the foreign subsidiary that paid the dividend. Under guidance provided by the IRS, BMC elected to treat the overpaid amounts as accounts receivables from the foreign subsidiary that related back to earlier years. Although BMC did not create the receivables until 2007, the IRS argued that the receivables should be treated as in place in 2006, thereby reducing BMC’s dividends-received deduction for 2006. The U.S. Tax Court agreed with the IRS, and BMC appealed. The U.S. Court of Appeals for the Fifth Circuit reversed the Tax Court and held that the receivables did not reduce BMC’s dividends-received deduction for 2006.

DISCUSSION

BMC Software, Inc. is a U.S. corporation that develops and licenses computer software. During its 2006 tax year, BMC received $700 million from a foreign subsidiary (i.e., BMC repatriated $700 million) and claimed an 85% dividends-received deduction under Section 965.1 However, that section also reduces the allowable deduction by any increase in the related-party debt of the taxpayer’s controlled foreign corporations during a prescribed testing period. Congress intended this anti-abuse rule to prevent a taxpayer from claiming a dividends-received deduction if the taxpayer directly or indirectly financed a dividend from a controlled foreign corporation.2  BMC’s controlled foreign corporations did not increase  their related-party debt during the testing period and so BMC concluded that the anti-abuse rule did not apply.

The IRS subsequently audited BMC’s 2006 tax year and asserted that BMC had overpaid royalties to the foreign subsidiary that paid the dividend. BMC eventually agreed to transfer-pricing adjustments. To account for the fact that the cash from BMC’s overpaid royalties remained on the foreign subsidiary’s balance sheet, U.S. transfer-pricing regulations required BMC to make a secondary adjustment.3 Although BMC could have treated that cash as a deemed capital contribution to the foreign subsidiary, BMC instead elected to treat the cash as an account receivable from the foreign subsidiary.4  To reflect that election, BMC entered into a closing agreement with the IRS in 2007 (the “Closing Agreement”).

After signing the Closing Agreement, the IRS asserted that BMC’s newly created receivables were related-party debt for purposes of Section 965’s anti-abuse rule. Because the Closing Agreement made certain of those receivables retroactive to the relevant testing period, the IRS took the position that those receivables reduced BMC’s dividends-received deduction. After losing in the Tax Court,5 BMC appealed to the U.S. Court of Appeals for the Fifth Circuit.

On March 13, 2015, the Fifth Circuit reversed the Tax Court and held that neither (1) the text of Section 965 nor (2) the provisions of BMC’s Closing Agreement supported the IRS’s position.6 Regarding the statute’s text, the court observed that the anti-abuse rule looks to controlled foreign corporations’ related-party debt “as of the close of the taxable year” in which the taxpayer claimed the dividends- received deduction. Because BMC did not create the receivables until 2007, the court concluded that those receivables did not exist “as of the close” of the 2006 tax year in which BMC claimed the dividends- received deduction. That BMC agreed to backdate the receivables to the testing period, said the court, “does nothing to alter the reality that [the receivables] did not exist during the testing period.”

The court then turned to BMC’s Closing Agreement and considered whether BMC had agreed to the tax consequences asserted by the IRS. The court viewed this as an “issue of contract interpretation” and began by observing that the Closing Agreement neither cites nor refers to Section 965. The IRS had nevertheless asserted that the Closing Agreement’s introductory clause—“now it is hereby determined and agreed for federal income tax purposes”—demonstrates that the parties agreed the receivables would be related-party debt for all federal income tax purposes. The court rejected that “expansive interpretation of [a] boilerplate provision” and instead concluded that the Closing Agreement’s detailed discussion of the tax consequences of the accounts receivable was exclusive. The court also noted that after BMC’s Closing Agreement, the IRS Office of Chief Counsel recommended that closing agreements explicitly state the tax consequences that the IRS asserted in BMC Software.7 According to the court, that suggests that if a closing agreement does not explicitly state those tax consequences, then the closing agreement does not contemplate those tax consequences.

Nearly 900 corporations claimed more than $300 billion of dividends-received deductions  under Section 965.8 At least one of those corporations—Analog Devices Inc.—is facing the same issue as BMC and is currently litigating in the Tax Court.9 For others that have agreed to adverse transfer-pricing adjustments in the year of the dividends-received deduction, the pending status of BMC Software has chilled the prospect of creating receivables like BMC. Even corporations that continue to dispute adverse transfer-pricing adjustments are facing “protective” disallowances of dividends-received deductions which will become relevant if (1) the transfer-pricing adjustments are upheld and (2) the corporation elects to create receivables like BMC.10 While it is too early to tell whether the IRS will appeal the Fifth Circuit’s decision or nonacquiesce in an Action on Decision, taxpayers that claimed a Section 965 dividends- received deduction can be cautiously optimistic that the Fifth Circuit’s decision will eventually resolve this issue favorably.

More generally, BMC Software shows the importance of considering any correlative effects before agreeing to adjustments in a closing agreement. As in BMC’s case, the closing agreement may not identify those correlative effects and the IRS may not raise them until after the taxpayer signs the closing agreement. In this regard, BMC Software is instructive even for taxpayers who never claimed a Section 965 dividends-received deduction.