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).
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