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By Philip Morrison, Esq.
McDermott Will & Emery, Washington, DC
Many practitioners probably ignored the Fifth Circuit's reversal of the Tax Court in BMC Software Inc. v. Commissioner.1 That case dealt with §965, the temporary repatriation provision effective only for a short period several years ago. Except for exhibiting the IRS's Scrooge-like approach to taxpayer-favorable provisions, and the Tax Court's penchant for literalism, at first blush the case has little to recommend it. Unless your company or client is subject to the same deficiency asserted against BMC, why pay attention to a case dealing with a long-expired provision?
The answer is two-fold: (1) the case provides insight and precedent regarding the status of Notices, generally; and (2) it is precedent for dealing with ancillary tax effects that may result, or not result, from a "secondary adjustment" provided for in a closing agreement under Rev. Proc. 99-32.2 Both aspects of the case are taxpayer-favorable. Each is a lesson to the IRS why it might consider being more circumspect in litigating cases where the equities are not more clearly on their side.
BMC claimed a $603 million §965 deduction on its 2006 return related to a $721 million cash dividend. It was undisputed that, at the time the dividend was paid, there was no related-party debt and, therefore, the §965(b)(3) related-party indebtedness reduction to the §965 benefit had no relevance or effect.3
In 2007, BMC and the IRS entered into a closing agreement to correct an overpayment of royalties over several years from the U.S. parent to the same controlled foreign corporation (CFC) that had made the §965 repatriation (though the royalty and the repatriation were unrelated). They also entered into a second closing agreement regarding the "secondary adjustment," creating an interest-bearing account receivable at the U.S. parent and an account payable at the CFC for each year's overpaid royalty (i.e., a loan from the U.S. parent to the CFC) and deeming the receivables/payables to have been created as of the end of each such year, all as provided for in Rev. Proc. 99-32.
Four years after the Rev. Proc. 99-32 closing agreement was signed, the IRS asserted that the accounts established retroactively under that closing agreement were related-party indebtedness for §965(b)(3) purposes. The IRS denied, therefore, a portion of the §965 deduction previously taken.
BMC contested the deficiency. The Tax Court held for the IRS; the Fifth Circuit reversed.
For the past 20 years, the volume of new Treasury/IRS guidance issued in the form of regulations appears to have declined while such guidance in the form of Notices has markedly increased. The most common explanation heard from current and past government officials is that Notices are easier to get reviewed and published and are, therefore, faster. Often having more guidance sooner is welcome; sometimes not.
Where, as is often the case, a Notice is followed within a few years by proposed and then final regulations, a principal effect of a Notice is to allow a retroactive effective date for the final regulations. Speed is a mixed bag in these cases — while some greater certainty, earlier, is usually welcome, unexpected anti-taxpayer interpretations of the Code generally are not. One of the biggest problems with such Notices is the potential retroactivity of the future regulations with respect to things that may have been ambiguous in the Notice. Notices are, by their nature, often less detailed and sometimes less clear than regulations. Typically, the follow-on regulations will not try to clarify ambiguities retroactively. Sometimes, however, they will. Such cases are an invitation for a lawsuit.
The Notice at issue in BMC Software — Notice 2005-644 — was never followed up by regulations. Given that §965 was temporary (and not extended, at least not yet), that is not terribly surprising. It probably never will be. Given the significant detail of the Notice (and its two companion Notices), however, it is mildly surprising that Notices, rather than regulations, were the route chosen for §965 guidance. Given the virtually complete lack of deference given Notice 2005-64 by the Fifth Circuit in BMC Software, the IRS might want to re-think that approach in the future.
Notice 2005-64 explicitly states that accounts such as those deemed retroactively created under Rev. Proc. 99-32 "are to be treated as indebtedness for purposes of section 965(b)(3)." The Fifth Circuit, however, brushed the Notice aside in a paragraph. Even the IRS conceded, on brief, that the Notice was not entitled to Chevron5 deference. "At most," the Fifth Circuit concluded, the 2005 Notice might be entitled to deference under Skidmore v. Swift & Co., 323 U.S. 134, 140 (1944). Under Skidmore, we defer to the agency only to the extent that the agency's interpretation is persuasive. Id.
The IRS's views on §965(b)(3) and the relation thereto of the debt created under Rev. Proc. 99-32 as expressed in the Notice were decidedly not persuasive. The court noted that there was only a single, conclusory sentence in the Notice, containing, like a regulation might, no analysis or explanation. Moreover, there was nothing in the statute that suggested that later-created debt with a retroactive effective date would be considered extant during the §965(b)(3) testing period. Clearly, trying to write a regulation in a Notice (i.e., filling in "holes" in the statute) was not an approach the court thought valid.6 The court concluded that the Notice "is entirely unpersuasive and unworthy of deference."
This analysis of the lack of deference due an "un-reg-ified" Notice may be helpful to taxpayers in any case where the IRS tries to assert a deficiency based on a conclusory provision of a Notice. Without an analysis that a court can examine to test whether the Notice's rule is a persuasive interpretation of the Code, such provisions can be ignored. And even if eventually turned into a regulation with retroactive effect, query whether BMC Software doesn't give taxpayers a tool for challenging the retroactivity of such a regulation. While a taxpayer may have been on notice of the IRS's view as of the date of a Notice, BMC Software might provide ammunition for non-retroactivity given the lack of deference to be given Notices. That is, perhaps the taxpayer was on notice but was he on notice that the rule promulgated by the Notice was a valid, enforceable rule?7
In short, complicated and lengthy Notices are a lot of work for strained Treasury and IRS staff that may well be wasted. If they aren't consistent with what a court might conclude is the plain meaning of the statute and aren't accompanied by persuasive explanation and analysis, they might be given the deference afforded Notice 2005-64—i.e., none.
Rev. Proc. 99-32
Without Rev. Proc. 99-32's procedure for establishing and paying deemed debt, the "secondary" result of many §482 adjustments will be a deemed capital contribution from the U.S. parent to the CFC,8 and an actual return of the cash by the CFC would be a dividend to the extent of its earnings and profits. That would have been the case in BMC Software. If returning the cash will produce a dividend, §482 settlements often will be harder to reach.9 It is in everyone's interest, both the IRS and taxpayers, therefore, to keep Rev. Proc. 99-32 operating smoothly.
Assuming the Fifth Circuit's decision in BMC Software does not result in the IRS reconsidering Rev. Proc. 99-32, it may, however, encourage the IRS to revise how it writes the closing agreements under Rev. Proc. 99-32. Given that the closing agreement in BMC Software "lists the tax implications [of the deemed accounts and their payment] in considerable detail" (including the treatment of the interest payments thereon) but neglected to say that the accounts would be treated as related-party debt for all other purposes of the Code10 (or specifically for §965(b)(3) purposes), the Fifth Circuit invoked the expressio unius est exclusio alterius principle to conclude that the parties never agreed that the accounts deemed established would be treated as related-party debt for all tax purposes or for purposes of §965.
One approach to address this, an approach that the IRS appears to have already taken, is to be explicit about everything. As the Fifth Circuit noted in brushing off any deference to Notice 2005-64, the IRS has already started explicitly providing for §965 tax consequences in later Rev. Proc. 99-32 closing agreements. This will take care of §965 issues for those subject to new agreements, but what about other Code provisions in which the amount of related-party debt matters? If other courts follow the Fifth Circuit, the IRS will need to be quite careful, and closing agreements will need to be awfully lengthy, for all the possible impacts to be accounted for.
A second approach, under a "less-is-more" philosophy, would be simply to provide that accounts established under the Rev. Proc. are indebtedness between the parties, established as of their deemed effective date, for all purposes of the Code (unless explicitly provided otherwise). Presumably this would have forestalled any cases like BMC Software. Under such an agreement, a taxpayer would have likely understood that the accounts were related-party debt in the year such accounts were deemed established and that it must adjust its previously reported §965 consequences. If that had been clear, the taxpayer in BMC Software presumably would have foregone establishing accounts under Rev. Proc. 99-32 and simply have allowed the "secondary" adjustment of a deemed capital contribution.
If, as apparently is currently the case, the IRS takes the first approach, there may be unforeseen (and therefore unaddressed in the closing agreement) tax impacts of the establishment of the accounts under Rev. Proc. 99-32. When such impacts work to taxpayers' detriment, taxpayers can be expected to rely on BMC Software to claim they should be ignored.11 When they work to taxpayers' benefit, taxpayers can be expected to argue what the IRS argued in BMC Software — i.e., that the closing agreement's boilerplate allows them to take advantage of them. Obviously, BMC Software puts the IRS in a tough spot.
This commentary also will appear in the June 2015 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Maruca and Warner, 886 T.M., Transfer Pricing: The Code, the Regulations, and Selected Case Law, Yoder & Kemm, 930 T.M., CFCs—Sections 959-965 and 1248, and in Tax Practice Series, see ¶3600, Section 482 — Allocations of Income and Deductions Between Related Taxpayers, ¶7150, U.S. Persons — Worldwide Taxation.
3 While the relevance of the policy purpose for that exception was debated in the litigation, the legislative history made relatively clear that that provision was intended principally to prevent a U.S. parent from funding a controlled foreign corporation's (CFC's) §965-eligible dividend by lending the CFC the cash to pay the dividend. Literally, however, §965(b)(3) reduces the §965 benefit by the amount of all net related-party debt of CFCs.
6 In addition, the court noted that the Notice's treatment appeared to run counter to the plain meaning of §965(b)(3). Also, the court noted that the IRS subsequently decided to explicitly provide for §965 consequences in later closing agreements.
8 After the "primary" adjustment of reducing a royalty paid by the U.S. parent to the CFC, CFC would have had more cash than its adjusted accounts showed. Generally, it would be deemed in such a case to have received a capital contribution.
10 The Rev. Proc. states that the repayment of the account is treated as repayment of debt for all federal income tax purposes, not that the account itself is debt for all purposes (though that might be a reasonable inference for one to draw). Since the IRS and the Tax Court made a similar distinction between the establishment of the debt and its repayment for purposes of what the Rev. Proc. declared could be done "without further income tax consequences" — only the repayment had no further tax impact according to the IRS and the Tax Court — the Fifth Circuit appears to have cleverly taken this same hyper-technical approach to dispel the inference that a related-party debt existed in the first place.
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