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By Lowell D. Yoder, Esq.
McDermott Will & Emery, Chicago, IL
An investment by a controlled foreign corporation (CFC) of its earnings in U.S. property can result in a deemed dividend to its "United States shareholders" (U.S. shareholders) under §956. The definition of U.S. property includes a loan made by the CFC to its U.S. parent.
Pursuant to Rev. Proc. 99-32,1 a CFC can be treated as temporarily holding an account receivable from a U.S. parent to correct a cash imbalance resulting from the settlement of a transfer pricing dispute. The receivable is deemed to arise retroactively in the year to which the primary adjustment relates. A recent case supports the proposition that such receivable is not an investment in U.S. property prior to entering a closing agreement because it did not exist.
As background, §951(a)(1)(B) requires a U.S. shareholder to include in its gross income the amount determined under §956. The amount determined under §956 is the "average of the amounts of U.S. property held (directly or indirectly) by the controlled foreign corporation as of the close of each quarter… ." The amount included in income for a year is reduced by previously taxed earnings and profits, and limited to the amount of the CFC's non-previously taxed earnings and profits.
For example, a CFC loans $10 million to its U.S. parent on July 15th and the loan is outstanding at the end of the taxable year. The CFC has a calendar taxable year and has $100 million of earnings and profits, none of which is previously taxed earnings and profits. The $10 million loan would result in a $5,000,000 inclusion in the income of the U.S. parent for the current year [($0 + $0 + $10,000,000 + $10,000,000) ÷ 4].
The Code and regulations define U.S. property as including an "obligation" of a related U.S. person.2 The regulations make it clear that the definition of the term "obligation" for purposes of §956 means "indebtedness." The regulations state that the term obligation "includes any bond, note, debenture, certificate, bill receivable, account receivable, note receivable, open account, or other indebtedness, whether or not issued at a discount and whether or not bearing interest."3 By defining the term "obligation" with a list of items that are all items of indebtedness, the plain meaning of the regulations is that an item is an "obligation" for §956 purposes only if the item is indebtedness.
Section 956 does not elaborate on the meaning of the term "indebtedness." The courts have consistently defined "indebtedness" for tax purposes as an "unconditional and legally enforceable obligation for the payment of money."4 Where such an unconditional and legally enforceable obligation is absent, the courts have consistently ruled that no indebtedness exists.5 Thus, in order for an obligation to constitute indebtedness for purpose of §956, it must be an unconditional obligation to pay money.6
When a pricing adjustment results from a finding that a U.S. company has underpaid a foreign affiliate, or that a foreign company has overpaid a U.S. affiliate, the adjustment reduces the income of the U.S. company. For example, assume a U.S. parent agrees pursuant to a Competent Authority proceeding that for 2011 it underpaid its U.K. subsidiary $50 million of royalties for intangible property it licensed. The U.K. subsidiary would have $50 million of additional royalty income. The U.S. parent would make a correlative adjustment increasing its royalty expense by $50 million.7
Since the U.S. parent would not have paid the $50 million to the U.K. subsidiary, there would be a cash imbalance. Generally, the U.K. subsidiary would be considered as making a $50 million distribution to its U.S. parent.8 This deemed distribution would generally be treated as a taxable dividend under §301.9
Rev. Proc. 99-32 permits the U.S. parent to make a secondary adjustment to properly redistribute the cash in a manner that avoids further tax consequences. If elected, in the above example a deemed $50 million payable would be created on the books of the U.S. parent, and a deemed $50 million receivable on the books of the U.K. subsidiary. The receivable and payable are deemed to arise on December 31, 2011, the last day of the year for which the transfer pricing adjustment is made (and an interest charge is imposed). With this election, the U.K. subsidiary will not be treated as distributing a dividend to the U.S. parent as long as the $50 million receivable is paid within 90 days.
The deemed receivable that is treated as arising on December 31, 2011, arguably presents a §956 issue—specifically, whether such receivable constitutes an obligation of a U.S. person for purposes of §956 and, if so, whether it is treated as arising in 2011, thereby causing a retroactive §956 investment in U.S. property.
A recent Subpart F case, BMC Software v. Commissioner,10 held that, for purposes of §965, a deemed payable resulting under Rev. Proc. 99-32 would not be treated as indebtedness retroactively in the year of the transfer pricing adjustment. The holding and rationale of that case support a similar conclusion for purposes of §956.
Section 965 provided an exclusion of 85% of qualifying dividends received by a U.S. shareholder from a CFC. Section 965(b)(3) states that the amount of dividends that qualify is reduced by an "increase in related party indebtedness." For this purpose, a determination is made of the amount of indebtedness of the CFC to any related U.S. person as of the close of the taxable year for which the §965 election is in effect, and this amount is compared with the amount outstanding as of the close of October 3, 2004. The purpose of this rule is to prevent a U.S. related party from funding a §965 dividend.
Under the facts of the case, BMC Software ("BMC-US") made an election under §965 for its taxable year ended March 31, 2006. It claimed a deduction with respect to $709 million of qualifying dividends from its CFC ("BMC-CFC"). BMC-US took the position that it did not have an increase in related party indebtedness.
The IRS and BMC subsequently agreed to an audit adjustment decreasing the amount of a royalty owed by BMC-US to BMC-CFC in the amount of $102 million for years including its 2006 taxable year. BMC-US elected to use Rev. Proc. 99-32 to balance its cash accounts by setting up accounts payable from BMC-CFC to BMC-US. The closing agreement was entered on August 30, 2007. Pursuant to Rev. Proc. 99-32, the accounts were established as of the last day of the taxable years to which the adjustments related.
The IRS compared the intercompany indebtedness as of October 3, 2004, with the intercompany indebtedness as of the end of March 31, 2006, and, taking into account the Rev. Proc. 99-32 deemed payables, it determined that there was an increase in indebtedness owed by BMC-CFC to BMC-US in the amount of $43 million. The IRS issued a notice of deficiency for approximately $13 million with respect to 2006, reducing the §965 deduction to reflect the existence of the Rev. Proc. 99-32 accounts payable.
The Tax Court agreed with the IRS, but the Fifth Circuit reversed, rejecting the IRS's position. The court stated that it must look at the plain meaning of the statute. If the language of the statute is "plain and unambiguous, it must be given effect."11 The court noted that §965(b)(3) requires a determination of an amount of indebtedness at the close of March 31, 2006. Since the Rev. Proc. 99-32 accounts payable did not exist on that date, BMC's §965 deduction cannot be reduced.
In reaching its conclusion, the Fifth Circuit set forth the following rationale:The Commissioner makes much of the fact that in the 99-32 Closing Agreement, BMC agreed to backdate the accounts receivable. This is an incorrect interpretation of the testing-period requirements of §965. The fact that the accounts receivable are backdated does nothing to alter the reality that they did not exist during the testing period. Even assuming arguendo that a correction of a prior year's accounts could create indebtedness for purposes of §965(b)(3), that is not what happened in this case. This is not a situation in which a subsequent adjustment was made in order to accurately reflect what actually happened in the taxable year ending on March 31, 2006. Rather, with the secondary adjustments, BMC agreed to create previously non-existent 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. The text of § 965(b)(3) requires that, to reduce the allowable deduction, there must have been indebtedness "as of the close of" the applicable taxable year. Because the accounts receivable were not created until 2007, BMC's § 965 deduction cannot be reduced under §965(b)(3).
The court also rejected the IRS's reliance on Notice 2005-6412 which supported the IRS' position. That Notice states that accounts created under Rev. Proc. 99-32 are to be treated as indebtedness for purposes of §965(b)(3). Among other things, the court stated that the position was "particularly problematic in light of the fact that the notice advocates a treatment of accounts receivable that runs counter to the plain language of §965." The court concluded that the Notice is "entirely unpersuasive and unworthy of deference."13
The conclusion and rationale of BMC Software should apply with equal force for purposes of §956. Section 956 applies to indebtedness of a U.S. person only when it is held by a CFC at the end of a quarter. The Fifth Circuit found that a receivable resulting from an election under Rev. Proc. 99-32 does not actually exist prior to signing a closing agreement. Without an indebtedness from a U.S. person, §956 could not apply to years preceding the signing of a closing agreement.14
Furthermore, the §956 regulations define "United States property" as certain property "acquired … by a foreign corporation … during any taxable year… ." For this purpose, property is considered as acquired when the corporation acquires an adjusted basis in the property.15 A CFC cannot acquire an adjusted basis in property retroactively. In the years prior to when a closing agreement is entered, there would be no actual accounts receivable from the U.S. parent on the books of the CFC, i.e., it would have no adjusted basis in such an asset. Therefore, under the rationale of BMC Software, §956 could not apply to a year prior to the year when a closing agreement is entered.
While not addressed in the BMC Software opinion, a deemed accounts payable arising under Rev. Proc. 99-32 would appear not even to constitute indebtedness for tax purposes. The receivable is merely a legal fiction to accommodate a limited purpose. The obligation is not unconditional, nor is it legally enforceable under the laws of any jurisdiction. Indeed, if a taxpayer decides not to pay the obligation within the time limits set in a closing agreement, the obligation disappears.16 The account payable is merely an administrative relief mechanism designed simply to conform a taxpayer's cash positions and accounts to the allocations made under the transfer pricing rules. Thus, the better view is that an accounts receivable resulting from an application of Rev. Proc. 99-32 does not constitute indebtedness for purposes of §956.17
Under the above example, the deemed $50 million receivable the U.K. subsidiary has from its U.S. parent would be treated under Rev. Proc. 99-32 as arising on December 31, 2011. If this were treated as a retroactive investment in U.S. property, the U.S. parent would have a $12.5 million inclusion for 2011. The remaining $37.5 million would be included in the income of the U.S. parent in 2012 (subject to earnings and profits limitations).
Treating the deemed receivable as an investment in U.S. property effectively denies a taxpayer the very relief intended to be provided by Rev. Proc. 99-32. The purpose of the revenue procedure is to allow the U.S. parent to avoid a taxable dividend from the U.K. subsidiary following from the transfer pricing adjustment. If the deemed receivable were treated as a §956 obligation in 2011, there would be a deemed dividend of the $50 million adjustment, contrary to the intent of Rev. Proc. 99-32.
A taxpayer in this situation should seek to enter a closing agreement that states that the deemed receivable arising under Rev. Proc. 99-32 is not indebtedness at all for purposes of §956. If the agreement instead does not treat the account receivable as indebtedness retroactively but treats it as indebtedness when the closing agreement is entered, §956 could be avoided by having the U.S. parent pay the receivable sufficiently quickly so that it is not outstanding over the end of a quarter.18
In sum, the Fifth Circuit's opinion in BMC Software held that for purposes of §965(b)(3)—a provision of the Subpart F rules that provides a measurement date for indebtedness—the deemed account receivable arising under Rev. Proc. 99-32 is not treated as actually in existence retroactively. This plain meaning conclusion should apply equally for purposes of §956, which also is triggered by looking at actual indebtedness in existence on a particular date (i.e., the last day of a CFC's quarter). Nevertheless, in light of the strange positions recently taken by both the IRS and the Tax Court on these issues, it is recommended that taxpayers be mindful of potential collateral consequences that the IRS may assert with respect to Rev. Proc. 99-32 accounts, and that taxpayers take proactive measures to address these issues to the extent possible, whether via direct negotiation of these issues with the IRS or through careful planning.
This commentary also will appear in the August 2015 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Fried and Liss, 6260 T.M., CFCs — Investment of Earnings in United States Property, and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Income.
Copyright©2015 by The Bureau of National Affairs, Inc.
4 See Deputy v. Du Pont, 308 U.S. 488 (1940); First National Co. v. Commissioner, 289 F.2d 861, 864-65 (6th Cir. 1961); Autenreith v. Commissioner, 115 F.2d 856, 858 (3rd Cir. 1940); Hubert Enters. v. Commissioner, 125 T.C. 72, 91 (2005) (defining debt for purposes of §166), aff'd in part, vac'd in part, rem'd by 99 AFTR2d 2528 (6th Cir. 2007); see also Rev. Rul. 82-78, 1982-1 C.B. 30; TAM 200116008.
5 See, e.g., Milenbach v. Commissioner, 318 F.3d 924, 930 (9th Cir. 2003) (stating that the obligation on which interest is based must be an "existing, unconditional, and legally enforceable obligation for the payment of a principal sum") (quoting Noguchi v. Commissioner, 992 F.2d 226, 227 (9th Cir. 1993)).
6 The term "indebtedness" does not include executory contractual obligations, such as a supply contract, a services contract, or a license. Therefore, such obligations of U.S. related persons do not constitute U.S. property. See Yoder, Improving Efficiency of Global Cash Utilization: Accelerated Payments for Inventory, 38 Tax Mgmt. Int'l J. 171 (3/13/09).
9 The deemed dividend may be considered as distributed during the year for which the transfer pricing adjustment is made, but that is not clearly stated in the regulations, and the timing may be agreed upon in a closing agreement (absent an election under Rev. Proc. 99-32).
10 780 F.3d 669 (5th Cir. 2015), rev'g 141 T.C. 224 (2013). Under the Golsen rule, the Tax Court is not bound by this opinion in circuits other than the Fifth Circuit, although this well-reasoned opinion may influence the Tax Court if again confronted with the issue.
13 The Fifth Circuit also rejected the IRS's argument that the taxpayer agreed in the closing agreement to treat the deemed receivable as indebtedness. In doing so, the court stated, "§965(b)(3) provides the governing default rule, and under that statute's plain language, the accounts receivable that BMC created in 2007 do not reduce BMC's §965 deduction because they did not exist `as of' March 31, 2006."
14 The Fifth Circuitstated that the payables could not have existed in the prior years because "they were not created until after the parties executed the 99-32 Closing Agreement in 2007." The Court cites Midkiff v. Commissioner, 96 T.C. 724 (1991), aff'd sub nom.Noguchi v. Commissioner, 992 F.2d 226 (9th Cir. 1993) (holding that an agreement that included payment of the purchase price plus annual interest for prior years did not give rise to retroactive indebtedness in those prior years).
17 See also id., at 9 ("We have held that `The allocation of …income pursuant to section 482 does not create a debt obligation; such an allocation is designed merely to accurately reflect the taxpayer's income.' Eisenberg v. Commissioner, 78 T.C. 336, 347 (1982).").
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