BMC Software, Inc. v. Comm'r

• Decision Date: 13 March 2015
• Docket Number: No. 13–60684.,13–60684.
• Parties: BMC SOFTWARE, INC., Petitioner–Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent–Appellee.
• Court: U.S. Court of Appeals — Fifth Circuit

780 F.3d 669

BMC SOFTWARE, INC., Petitioner–Appellant
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent–Appellee.

No. 13–60684.

United States Court of Appeals, Fifth Circuit.

March 13, 2015.

780 F.3d 670

Gwendolyn Johnson Samora, Lina Ginan Dimachkieh, George Matthew Gerachis, Christine L. Vaughn, Vinson & Elkins, L.L.P., Washington, DC, for Petitioner–Appellant.

Ellen Page DelSole, Esq., Trial Attorney, Jonathan S. Cohen,

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Kathryn Keneally, U.S. Department of Justice, Washington, DC, Daniel L. Tirnrnons, Internal Revenue Service, Dallas, TX, William J. Wilkins, Internal Revenue Service, Washington, DC, for Respondent–Appellee.

Appeal from a Decision of the United States Tax Court.

Before REAVLEY, ELROD, and SOUTHWICK, Circuit Judges.

Opinion

JENNIFER WALKER ELROD, Circuit Judge:

This case involves a decision by the Commissioner of Internal Revenue (Commissioner) to partially disallow BMC Software, Inc.'s (BMC) repatriated-dividends tax deduction under 26 U.S.C. § 965(b)(3) on the ground that subsequently created accounts receivable constituted “indebtedness” and reduced BMC's eligibility for the deduction. Because the plain text of § 965 does not support the Commissioner's interpretation, and because BMC never agreed to treat the relevant accounts receivable as indebtedness, we REVERSE.

I.

A.

This case involves the intersection of §§ 482 and 965 of the United States Tax Code. Foreign subsidiaries of United States-based companies often pay dividends to their United States-based parent companies. These dividends constitute taxable income for the United States-based parent company. However, rather than pay these dividends, and the accompanying taxes, many United States-based multinational corporations park large sums of earnings in accounts owned by their foreign subsidiaries. Doing so allows these corporations to avoid federal income taxes, but only insofar as the cash remains overseas.

As a temporary stimulus provision, Congress enacted § 965 of the United States Tax Code to encourage such corporations to repatriate to the United States, through dividends, the funds sitting in the accounts of their foreign subsidiaries. Accordingly, § 965 permits a one-time tax deduction in the amount of eighty-five percent of certain dividends paid by a controlled foreign corporation to its United States-based parent corporation. The relevant text of § 965 states:

In the case of a corporation which is a United States shareholder and for which the election under this section is in effect for the taxable year, there shall be allowed as a deduction an amount equal to 85 percent of the cash dividends which are received during such taxable year by such shareholder from controlled foreign corporations.

26 U.S.C. § 965.

To prevent abuse of § 965, Congress included an exception to § 965, written into § 965(b)(3). This § 965(b)(3) exception prevents United States corporations from making loans to their foreign subsidiaries—“related parties”—to fund repatriated § 965 dividends. Such “round-tripping” would defeat Congress's purpose of inducing fresh investment of foreign cash into the United States. H.R.Rep. No. 108–755, at 315 (2004). The exception provides that the amount of repatriated dividends otherwise eligible for a § 965 dividends-received deduction must be reduced by the amount of any increase in related-party indebtedness between October 3, 2004 (§ 965's effective date) and the end of the taxable year in which the dividend was paid. The window between these two dates is known as the “testing period.”

Section 482 of the United States Tax Code prevents a domestic corporation from artificially deflating its profits that

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are subject to United States income tax by inflating the profits of its foreign subsidiaries, which are not subject to United States income tax. See 26 U.S.C. § 482. When a foreign subsidiary sells goods or services to its United States-based parent corporation, or vice versa, the setting of the price for those goods or services is known as “transfer pricing.” Although the two parties are related, the “transfer price” should match that of an arm's length transaction. Otherwise, by inflating or deflating transfer prices, a domestic taxpaying corporation could artificially increase the profits of its foreign subsidiaries that are located in tax havens and, at the same time, artificially decrease its income subject to United States federal income tax.

To prevent such abuse, § 482 grants the Commissioner authority to adjust a corporation's transfer prices if he determines that the adjustment is necessary to “clearly reflect the income” of the related parties. § 482. When the Commissioner disagrees with the transfer prices set by a taxpaying corporation, pursuant to § 482 the corporation and Commissioner may negotiate the dispute, frequently resulting in a “transfer price closing agreement.” Where the transfer price closing agreement results in an increase in taxable income, such increases are called “primary adjustments.”

When a corporation makes a primary adjustment, this alters the parent's and subsidiary's income on their books, even though the cash at issue is not actually moved from the foreign subsidiary's accounts to the parent corporation's accounts. Because a primary adjustment only shifts taxable income from one related party to another—i.e., from a foreign subsidiary to its United States-based parent corporation—both entities must also make “secondary adjustments” to their cash accounts so that their taxable income and cash accounts are not imbalanced. To make the secondary adjustment both parties revise their books to show that the foreign subsidiary holds cash that, due to the primary adjustment, is now effectively owned by the United States-based parent.

B.

We now turn to the BMC transactions. In the 2006 tax year, BMC decided to take a § 965 deduction. It did so by repatriating $721 million from its wholly-owned foreign subsidiary, BMC Software European Holding (BSEH), in the form of a cash dividend. Of this sum, roughly $709 million qualified for the § 965 dividends-received deduction, which permitted BMC to deduct eighty-five percent of that amount, $603 million, from its taxable income on its 2006 tax return.

BMC accurately reported no related-party indebtedness on its 2006 tax return. Thus, it is undisputed that at the time BSEH paid its $721 million cash dividend to BMC, the § 965(b)(3) related-party indebtedness exception had no relevance or effect.

In 2007, BMC and the Commissioner signed a transfer pricing closing agreement (Transfer Pricing Closing Agreement) to correct BMC's net overpayment for royalties from its foreign subsidiary, BSEH, which should have been taxable income retained by BMC, but in fact had been paid to BSEH. This was completely unrelated to the 2006 repatriation under § 965. In the 2007 Transfer Price Closing Agreement, BMC agreed to a primary adjustment for each tax year from 2003 to 2006, increasing its taxable income by approximately $102 million in total. Because the $102 million BMC had “overpaid” BSEH remained in the cash accounts of BSEH, BMC was also required to make secondary adjustments to conform its

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books and records to reflect that fact. Pursuant to Treasury Regulation § 1.482–1(g)(3), BMC had two options in making the secondary adjustments. Under the first alternative, BMC could treat the $102 million overpayment as a deemed capital contribution from BMC to BSEH. If, thereafter, BSEH chose to repatriate the $102 million to BMC to correct the cash imbalance, that repatriation would be taxed as a dividend to BMC in the year of repatriation. Under the second alternative, also authorized by Treasury Regulation § 1.482–1(g)(3) and provided for in IRS Revenue Procedure 99–32, BMC could elect to treat the $102 million as an account receivable, payable by BSEH to BMC, with interest accruing from the date of deemed creation of the account. If, thereafter, BSEH paid the account receivable, BMC would not be taxed on the receipt of those funds. In essence, the $102 million would be treated as a loan from BMC to BSEH.

BMC elected to use this second alternative to balance its cash accounts. Pursuant to Revenue Procedure 99–32, BMC treated the $102 million “overpayment” to BSEH as a series of interest-bearing accounts receivable, one for each tax year, rather than a capital contribution. As Mr. Price, BMC's tax director and negotiator, explained the transaction, “we have now the cash in the wrong place.... And we want to be able to square the cash accounts, bring the cash back without any adverse tax consequences.... [b]ecause we have already picked up the primary adjustments in taxable income.” Thus, BMC's stated goal was to put the company in the same place that it would have occupied had the primary adjustments been reflected on its original tax returns.

BMC and the Commissioner then executed another...