U.S. v. Cox
| Decision Date | 08 January 1999 |
| Docket Number | No. Civ.A. H-98-2363.,Civ.A. H-98-2363. |
| Parties | UNITED STATES of America, Petitioner, v. John COX, Tax Director of BMC Software, Inc. and Subsidiaries, Respondent. |
| Court | U.S. District Court — Southern District of Texas |
Karl S Stern, Vinson & Elkins, Houston, TX, for John Cox, Tax Director, Respondent.
The Internal Revenue Service asks this court to enforce a summons issued to John Cox, the tax director of BMC Software, Inc. ("BMC") and its subsidiaries, in connection with the audit of BMC's 1993 tax return. The IRS seeks the production of computer source code for twenty-seven BMC enhancement software products marketed in Europe in fiscal year 1993. The IRS asserts that the source code will help ensure that in its 1993 tax return, BMC properly accounted for revenues it received from its European affiliate.
The primary issue in the audit is the proper valuation of intangibles transferred between BMC and its European affiliate. The IRS is examining whether BMC's taxable income reflects arms-length consideration for the transactions between BMC and its European affiliate. The issue in this summons enforcement action is whether the IRS can obtain BMC's source code for the software enhancement products distributed by its European affiliate in tax year 1993 as part of this inquiry.
BMC moves to quash the summons on a number of grounds. This court held a show cause hearing on the motion to quash. After careful consideration of the motions, the briefs, the parties' submissions, the testimony and exhibits presented at the show cause hearing, and the applicable law, this court DENIES the IRS's motion to enforce the summons and GRANTS Cox's motion to quash. The reasons are stated below.
BMC designs and manufactures software products to support widely-used mainframe databases produced by other companies, such as IBM. BMC's software facilitates business operations by improving the performance of computer databases, safeguarding their structural integrity, and allowing users to load, unload, reorganize, and save data. (Tr. 24)1. BMC sells most of its products by "perpetual license." A customer pays a one-time license fee for the right to use a BMC software product. (Tr.79). BMC also offers maintenance agreements to purchasers of perpetual licenses. The one-time perpetual license fee includes one year of the maintenance plan. (Tr. 84-85). A customer seeking to renew its enrollment in the maintenance plan pays BMC an annual fee of twenty percent (eighteen percent in Europe) of the current perpetual license fee for that product. (Tr.82). Customers who renew the maintenance plan receive functional and performance enhancements to the software, including maintenance modifications to improve the product, newly released versions of the product, as well as technical support by telephone. (Tr. 55, 80).
In 1993, in response to growing sales in Europe, BMC created a subsidiary, based in Holland, to distribute its products in Europe. Through an intermediate entity,2 BMC and its Dutch affiliate, BMC Software Distribution, B.V. ("BV1"), entered into a software manufacturing and distribution license agreement (the "Licensing Agreement"). Under the Licensing Agreement, BMC granted BV1 the nonexclusive right to reproduce and distribute in Europe all BMC software products that existed or were in development as of April 1, 1992. BV1 agreed to pay BMC a royalty of thirty-five percent of net European sales of the pre-April 1992 products. BMC and BV1 also entered into an agreement as to products developed after April 1992. Under a Cost Sharing Agreement, BV1 agreed to share in BMC's software development costs from and after April 1, 1992. In return, BV1 received the European intellectual property rights to the products created from this joint development effort. (R.Ex. 9)3. Both the Licensing Agreement and the Cost Sharing Agreement had five year terms and could be renewed in one year increments upon agreement by both parties. (R.Ex. 8, ¶ 6.1; R.Ex. 9, ¶ 3.1).
Under these two agreements, BMC kept exclusive ownership of pre-April 1, 1992 products. The European affiliate received the European ownership rights for enhancements and products developed after April 1, 1992, for which BMC and BV1 shared development costs.
In preparing its 1993 tax return, BMC accounted for the transactions under the two agreements with its European affiliate. BMC assumed that all the European licensing revenues generated in tax year 1993 were attributable to pre-April 1, 1992 products. BMC included all the license revenues in the royalty base and applied a thirty-five percent royalty that BV1 paid BMC. BMC's assumption put all of the 1993 license fees into the royalty base, despite the fact that some of the license fees received late in the fiscal year included enhanced or improved products attributable in part to cost-shared technology developed after April 1, 1992. (Tr. 116-18). On the other hand, BMC excluded all the maintenance fees paid in tax year 1993 from the royalty base. BMC concluded that the maintenance fees covered enhancements and improvements resulting from the post-April 1992 joint development work done under the Cost Sharing Agreement.
The IRS challenges BMC's tax treatment, primarily as to the maintenance fees. The IRS is concerned that by excluding maintenance revenues from the royalty base, BMC understated the compensation it received for the European distribution rights transferred to BV1. The IRS believes that BV1 retained income from maintenance products properly attributable to BMC, resulting in understated income tax liability for BMC.
The IRS began auditing BMC's 1993 tax return in October 1994, focusing on BMC's intercompany transfer pricing. Under the Internal Revenue Code and accompanying regulations, the IRS is authorized to allocate income or deductions between commonly-controlled entities to prevent tax evasion or more clearly to reflect the income of those entities. See I.R.C. § 482. Transactions between such entities must take place at prices equivalent to those that would be charged in an arms-length transaction between unrelated parties under similar circumstances. See Treas.Reg. § 1.482-1(b).
The IRS has taken a primary and an alternative position on this issue. In its primary audit position, the IRS agreed with BMC that all revenues generated by BMC's licensing agreements with European customers in the 1993 tax year should be included in the royalty base. (Tr. 161; Tr. II. 39). Under its primary position, the IRS proposed to disregard the Cost Sharing Agreement between BV1 and BMC and increase the percentage of royalties paid to BMC out of all the European revenues from thirty-five to forty-five percent. The result would be an additional tax liability of $13,347,588.00. (R.Ex. 11, Tab I, Form 886A, p. 1). The IRS does not assert that source code is relevant to, or summonsed in connection with, the primary position in the audit.
The IRS does assert that source code is relevant to its alternative audit position. Under its alternative position, the IRS recognized the Cost Sharing Agreement between BMC and BV1. The IRS proposed that (1) ninety-five percent of all maintenance fees (excluding only five percent attributable to telephone support to customers) would be viewed as part of the license fee and included in the royalty base; (2) the initial royalty rate would be forty-five percent instead of thirty-five percent; (3) the rate of decline in the royalty rate in the four years after 1993 would be adjusted; and (4) a deferred royalty provision in the License Agreement would be ignored. (R.Ex. 11, Tab J, Form 886A, p. 1). The net effect of this position on BMC's 1993 tax liability is an increase of $24,124,945.00. (Id.). BMC emphasizes the fact that the IRS issued the proposed adjustments to the 1993 tax return without access to BMC's source code for any of the 1993 software products distributed in Europe.
BMC first learned that the IRS intended to make adjustments to its transfer pricing structure in May 1996. (Tr. 124; R.Ex. 47). BMC provided the IRS with an internal intercompany pricing study BMC had prepared in connection with the creation of the Licensing Agreement and Cost Sharing Agreement; made the authors of the study available to the IRS; and responded to over one hundred Information Document Requests ("IDRs"). In September 1996, the IRS sent BMC its Notice of Proposed Adjustment ("NOPA").4 (R.Ex. 11, Tabs I & J). With the NOPA, the IRS sent reports from an IRS international examiner, Timothy Marion (R.Ex. 11, Tab G); an IRS engineer, Bill Johnson (R.Ex. 11, Tab F); and an IRS economist, Dr. Peter Balash (R.Ex. 11, Tab E). In the NOPA, the IRS team told BMC of the proposed adjustments to BMC's gross income, based on recalculations of BMC's transfer pricing.
In September 1996, the IRS also issued the IDR seeking BMC's source code. BMC vigorously resisted, on the grounds that the source code was irrelevant to any issue in the audit and that any production carried an intolerable risk that BMC's valuable trade secrets would be revealed. This summons enforcement action followed almost two years of unsuccessful discussions. These discussions ended with the IRS maintaining the same proposed tax adjustments it had issued in September 1996 and insisting on the production of source code as relevant to part of the IRS's alternative audit position. The IRS maintains that the source code will help it refine the calculation of the maintenance fees that the IRS contends should be included in the royalty base.
The only issue in this proceeding is whether BMC must provide its source code for twenty-seven software enhancement products distributed in Europe in the 1993 tax year.5
To continue reading
Request your trial