Analog Devices, Inc. v. Comm'r

• Decision Date: 22 November 2016
• Docket Number: 147 T.C. No. 15,Docket No. 17380-12.
• Parties: ANALOG DEVICES, INC. & SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

ANALOG DEVICES, INC. & SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent

147 T.C. No. 15

Docket No. 17380-12.

UNITED STATES TAX COURT

November 22, 2016

P is a corporation that is a U.S. shareholder of a controlled foreign corporation (CFC). P repatriated cash dividends from the CFC and claimed an 85% I.R.C. sec. 965 dividends received deduction (DRD) for 2005. P reported no related party indebtedness during its testing period pursuant to I.R.C. sec. 965(b)(3) when it claimed the DRD.

R determined, and P agreed, that the annual 2% royalty from CFC to P should be increased to 6% for 2001-05 to reflect arm's-length pricing. See I.R.C. sec. 482. In 2009 P and R executed a closing agreement pursuant to Rev. Proc. 99-32, 1999-2 C.B. 296, to effect the secondary adjustments required after a primary I.R.C. sec. 482 allocation. The closing agreement established accounts receivable as described in Rev. Proc. 99-32, sec. 4.01, 1999-2 C.B. at 299, for 2001-05 and deemed them created as of the last day of the taxable year to which they relate. R subsequently determined that the accounts receivable constituted an increase in related party indebtedness under sec. I.R.C. 965(b)(3) during P's testing period, which R determined decreased P's I.R.C. sec. 965 DRD.

Held: The parties did not reach an agreement in the closing agreement with respect to the treatment of the accounts receivable under I.R.C. sec. 965.

Held, further, I.R.C. sec. 965(b)(3) does not provide that the accounts receivable constituted related party indebtedness arising during P's testing period.

Held, further, the accounts receivable did not increase CFC's related party indebtedness during the testing period.

Held, further, P is entitled to the full amount of its claimed DRD.

Kenneth B. Clark, James P. Fuller, Jennifer L. Fuller, Andrew J. Kim, and Larissa B. Neumann, for petitioner.

Michele J. Gormley and Curt M. Rubin, for respondent.

OPINION

MARVEL, Chief Judge: Respondent determined deficiencies in petitioner's Federal income tax of $3,997,804 and $22,112,640 for taxable years 2006 and 2007, respectively. The issue for decision is whether the accounts receivable that the parties established in a 2009 closing agreement pursuant to Rev. Proc. 99-32, 1999-2 C.B. 296, created retroactive indebtedness between petitioner and its controlled foreign corporation (CFC) under section 965(b)(3).¹ If so, the amount of petitioner's section 965(a) dividends received deduction (DRD) for 2005 would be reduced.²

Background

The parties submitted this case fully stipulated under Rule 122. The stipulated facts and facts drawn from the stipulated exhibits are incorporated herein by this reference.³ Petitioner is a U.S. corporation with its principal place of business in Norwood, Massachusetts.

Analog Devices, Inc. (petitioner), was founded in 1965. It is the common parent of a group of subsidiaries that joined in the timely filing of consolidated Federal income tax returns for the 2006-07 tax years. It is also the parent of nonconsolidated foreign affiliates.

Petitioner, its subsidiaries, and its affiliates design, develop, manufacture, and sell high-performance analog, mixed-signal, and digital signal processing integrated circuits. In 1976 petitioner incorporated Analog Devices B.V. (ADBV), which then built a fabrication facility of complementary metal oxide semiconductor technology. ADBV is organized under the laws of the Netherlands with its principal place of management and business in Limerick, Ireland. For all relevant times, petitioner owned 100% of the issued and outstanding shares of ADBV, which was a CFC pursuant to section 957(a).

I. The Intercompany Royalty

In 1982, in connection with a section 482 adjustment, petitioner entered into a closing agreement with the Internal Revenue Service (IRS) Appeals Office establishing an annual royalty from ADBV to petitioner equal to 2% of ADBV's net sales.⁴ ADBV paid the 2% royalty to petitioner every year through the end ofpetitioner's 1994 taxable year, at which time petitioner and ADBV concluded that the royalty was no longer necessary. After the IRS had conducted an audit and determined to reinstate the royalty, petitioner and ADBV entered into a cross-license agreement in 1998 (1998 license agreement) again reflecting a 2% royalty from ADBV to petitioner effective November 3, 1996. By its terms, the 1998 license agreement was valid for 20 years.

The IRS regularly conducted examinations for petitioner's tax years following the 1998 license agreement. In 2006 the IRS conducted an examination for petitioner's 2001-03 tax years. As a result of that examination, the IRS proposed under its authority pursuant to section 482 to increase the intercompany royalty to 6% beginning with the 2001 tax year. Petitioner's chief financial officer agreed to the proposed increase for 2001-03 by executing Form 4549, Income Tax Examination Changes, on May 22, 2006.

Petitioner filed an amended 2004 Federal income tax return on July 18, 2006, to reflect the increased royalty rate. Petitioner timely filed its 2005 Federal income tax return on July 13, 2006, and reported a 6% royalty from ADBV.⁵ For 2001-05 the total increase in petitioner's royalty income due to the application of a 6% royalty as opposed to a 2% royalty was $429,175,634 (additional royalty amount). The transfer pricing adjustments giving rise to the additional royalty amount did not create indebtedness for Federal income tax purposes.

In July 2006 ADBV and petitioner credited and debited their respective intercompany accounts by the royalty adjustment amount. ADBV paid the additional royalty amount in a series of payments to petitioner between July 25 and October 26, 2006. Petitioner did not make an election under Rev. Proc. 99-32, supra,⁶ in 2006 with respect to the payments.

II. Petitioner's Repatriation and Section 965 Election

In 2005 petitioner's and ADBV's boards of directors approved a domestic reinvestment plan to repatriate a cash dividend to take advantage of a limited 85% DRD under section 965. See infra pp. 13-14. Petitioner's representatives at this time were aware of guidance that the IRS had issued in the form of three IRS notices with respect to section 965. See infra p. 18 (describing the IRS notices).

ADBV declared the dividend and paid it to petitioner on October 24, 2005.⁷ At the time of the payment of the dividend, ADBV's cash balance, including marketable securities and short-term investments, was approximately $1.6 billion. Its cash balance at the end of its 2005 taxable year, after it paid the dividend, was $485,306,732.

Petitioner attached a Form 8895, One-Time Dividends Received Deduction for Certain Cash Dividends from Controlled Foreign Corporations, to its timely filed Federal income tax return for 2005. On the Form 8895 petitioner claimed a section 965 DRD of $879,629,844. Form 8895 requires the taxpayer claiming a section 965 DRD to report the related party indebtedness of its CFCs as of the beginning and end of the testing period. Generally, an increase in the related partyindebtedness of its CFCs during the testing period decreases the amount of the dividends eligible for the DRD. See sec. 965(b)(3). Petitioner's testing period was between October 3, 2004, and October 29, 2005.⁸ Petitioner reported zero related party indebtedness for both the beginning and the end of the testing period.

III. The IRS' Examination for Petitioner's 2004-05 Taxable Years, Petitioner's Rev. Proc. 99-32 Election, and the Notice of Deficiency

The IRS commenced an examination for petitioner's 2004 and 2005 taxable years in May 2006. The IRS commenced an examination for petitioner's 2006-07 taxable years around May 2006 and April 2007, respectively.⁹

On May 3, 2007, the IRS faxed to petitioner an issue resolution agreement stating that ADBV's payments of the additional royalty amount resulted in aconstructive dividend to petitioner.¹⁰ In a letter to the IRS dated July 17, 2007, petitioner's chief financial officer requested relief under Rev. Proc. 99-32, supra, with respect to the additional royalty amount (Rev. Proc. 99-32 election). The election would permit petitioner to establish interest-bearing accounts receivable from ADBV instead of treating the transfer pricing adjustments as a constructive dividend to petitioner. See infra pp. 16-18.

Petitioner's treasurer, William Martin, also attached a "Statement Pursuant to Revenue Procedure 99-32" to petitioner's timely filed 2006 tax return to ensure that the IRS would not treat ADBV's payment of the additional royalty amount as a dividend. The statement reiterated petitioner's Rev. Proc. 99-32 election and stated that petitioner was permitted to establish interest-bearing accounts receivable from ADBV.

In October 2007, during the course of the examinations, the IRS raised section 965(b)(3) as an issue. On or around December 5, 2007, respondent issued a notice of proposed adjustment (NOPA) asserting that the Rev. Proc. 99-32 election resulted in an increase in related party indebtedness of $162,166,710during petitioner's testing period, which required a reduction of the amount of the DRD that petitioner had claimed of $137,841,704.¹¹

In May 2009 petitioner and the IRS signed a Form 906, Closing Agreement on Final Determination Covering Specific Matters, finalizing petitioner's Rev. Proc. 99-32 election. Petitioner's chief financial officer signed the closing agreement on petitioner's behalf. He did not have signatory authority for ADBV, and no one with signatory authority for ADBV signed the agreement.

The parties' closing agreement is titled "Closing Agreement on Final Determination Covering Specific Matters" (sometimes, Rev. Proc. 99-32 closing agreement). The first section of that agreement includes the recitals, which are introductory, explanatory clauses beginning with the word "whereas". Some recitals in the closing agreement are specifically negotiated, while others borrow standard terms from the...