Following the resolution of a transfer pricing adjustment, there are inevitable compensating adjustment issues to be addressed. Revenue Procedure 99-32 provides the guidelines. A frequent issue concerns whether the “account” that can be elected constitutes “related-party indebtedness” for other purposes of the Internal Revenue Code. One issue has related to the long-since expired provisions of Section 965 relating to repatriations (which may arise from the dead in the Trump administration). In Notice 2005-64, the IRS indicated that it does without any analysis.
In BMC Software, Inc. v. Commissioner, 115 AFTR 2d 2015-1092 (5th Cir. 2015), the Fifth Circuit reversed a US Tax Court decision in favor of the IRS, finding, in essence, that the transfer pricing closing agreement entered long-after the taxable years in question was not indebtedness for Section 965 purposes. Its plain language interpretation was that under Section 965, “the determination of the amount of indebtedness was to be made as of the close of the taxable year for which the election under Section 965 was in effect.” Accordingly, the accounts receivable could not have existed at the end of the testing period. The court also noted that the taxpayer had not agreed to “backdate” the accounts receivable.
The Tax Court has just agreed to follow the Fifth Circuit opinion in BMC Software. In Analog Devices, Inc. v. Commissioner, 147 T.C. No. 15 (Nov. 22 2016), the Tax Court essentially followed the logic of the Fifth Circuit in a similar situation involving a IRS assertion of the same Section 965 consequence of a subsequent year closing agreement in a transfer pricing case.
Practice Point: The relationship of closing agreement in transfer pricing cases and compensating adjustments is inevitably complex, especially in situations where there are other debt-related issues in the years in question. If the anticipated tax reform bill again introduces a repatriation incentive, these issues will arise once again. The key will be to address them in closing agreements as best as possible.