In a new ruling, the Tax Court has
held that accounts receivable constituted related party debt under Code section
965(b)(3), and therefore part of the deduction claimed by the taxpayer, BMC
Software, Inc., was disallowed.
The section 965(b)(3) related party
debt rule reduces the dividends otherwise eligible for the 85 percent dividends
received deduction by any increase in the indebtedness of a controlled foreign
corporation to any related person. The one-time dividend received deduction was
created in 2004 to encourage U.S. corporations to repatriate their foreign
earnings and increase investment in the U.S.
BMC Software, Inc., is a U.S.
corporation that develops and licenses computer software, and is the common
parent of a group of subsidiaries that joined in the filing of a consolidated
federal income tax return. BMC has a wholly-owned controlled foreign
corporation, BMC Software European Holding (BSEH).
Under cost-sharing agreements BMC
and BSEH co-owned software and each held exclusive distribution rights for
certain territories. BMC terminated the CSAs in 2002 and took sole ownership of
the software, agreeing to pay future royalties to BSEH and licensed to BSEH the
software for distribution.
The IRS concluded that the royalty
payments from 2002 through 2006 were not arm’s length. BMC entered a transfer
pricing closing agreement, under which the IRS increased BMC‘s income by $102
million for the four years, representing net reductions in royalties BMC paid
to BSEH.
The primary adjustments required BMC
to make secondary adjustments to conform its accounts. These secondary
adjustments would have been treated as deemed capital contributions from petitioner
to BSEH except that BMC elected to establish accounts receivable under Rev.
Proc. 99-32 for repayment. This resulted in a second closing agreement between
BMC and the IRS that established interest-bearing accounts receivable from BSEH
to BMC. The accounts receivable bore interest at the applicable federal rate,
which was deductible from BSEH’s taxable income and includible in BMC’s taxable
income.
Before it entered the closing
agreements, BMC repatriated from BSEH $721 million. On its 2006 federal corporate
return, BMC claimed $709 million in repatriated dividends as qualifying for the
one-time dividends received deduction under Code section 965.
Under Code section 965, the amount
of the deduction is reduced by increased indebtedness during a testing period
running from the close of the taxable year in which the election is in effect
and October 3, 2004. The IRS determined that $43 million of the repatriated
dividends was ineligible for the dividends received deduction, since they were
deemed established during the testing period and constituted increased related
party indebtedness.
The Tax Court held that the accounts
receivable deemed established during the testing period are increased related
party indebtedness for purposed of section 965.
Although BMC contended that the
related party debt rule only applies to abusive transactions, the court
disagreed. It found that the accounts receivable constitute indebtedness for
purposes of section 965(b)(3).
Circular 230 Disclosure
Pursuant to the requirements of the Internal Revenue Service Circular 230, we inform you that, to the extent any advice relating to a Federal tax issue is contained in this communication, including in any attachments, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication
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