US Outbound: US Tax Court reduces section 965 dividends received deduction in BMC Software
On September 18, the US Tax Court upheld a $13 million tax deficiency against BMC Software in connection with the company's section 965 dividends received deduction on the repatriation of about $721 million from its non-US subsidiaries (BMC Software Inc v Commissioner, 141 TC.No 5). Shortly after the decision was released, BMC filed an appeal with the US Court of Appeals for the Fifth Circuit. As background, Congress enacted section 965 in 2004 to encourage US corporations to repatriate cash invested in controlled foreign corporations (CFCs). Very broadly, section 965 provided that a US corporation could elect for a single taxable year to deduct 85% of certain cash dividends it received from a CFC. The amount of the dividend eligible for this deduction was however limited by section 965(b)(3), which provided that the amount of the cash dividend subject to the deduction would be reduced by any increase in related-party debt during a defined testing period. This limitation was put in place to help prevent US taxpayers from financing deductible cash dividends with related-party debt.
In 2005 and 2006, BMC repatriated about $721 million from a CFC. On its 2006 tax return, BMC reported that the CFC did not have increased related-party debt, and claimed an 85% dividends received deduction for $709 million of the repatriated dividend. Subsequently, in 2007, BMC entered into an unrelated transfer-pricing closing agreement with the IRS for the taxable years 2003 to 2006. As a part of the closing agreement, significant primary adjustments were made resulting in a net reduction in royalties BMC paid to the CFC. BMC elected to treat the corresponding secondary adjustments as accounts receivable from the CFC that were deemed established during each of BMC's taxable years ending 2003 to 2006 under Revenue Procedure 99-32.
At trial, the IRS argued that the Revenue Procedure 99-32 accounts receivable deemed established in 2005 and 2006 constituted increased related-party debt incurred during the testing period. As a result, the amount of repatriated dividends eligible for the section 965 deduction was reduced by about $43 million. BMC countered that section 965(b)(3) applied only to abusive transactions where related-party debt is actually used to finance cash dividends. Moreover, BMC argued that the Revenue Procedure 99-32 accounts receivable did not constitute debt within the meaning of section 965(b)(3).
In its opinion, the Tax Court held in favour of the IRS noting that nothing in the legislative history of section 965 indicates that section 965(b)(3) applies only to abusive transactions. Moreover, the court also held that Revenue Procedure 99-32 accounts receivable are debt within the meaning of section 965(b)(3).
As noted above, BMC has already filed an appeal to the Fifth Circuit. Though this decision may have limited application because section 965 was a temporary measure, it remains an interesting case to follow as other taxpayers may be in similar situations. The case may also be instructive in determining how the IRS could view Revenue Procedure 99-32 accounts receivable in other contexts.
The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.
This article represents the views of the authors only, and does not necessarily represent the views or professional advice of KPMG LLP.
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