Tax Court Overrules Its BMC Software Decision in Analog Devices

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December 5, 2016

In its recent reviewed decision in Analog Devices, the Tax Court revisited and overruled its decision in BMC Software. We previously covered the BMC Software decision and the Fifth Circuit’s reversal of the Tax Court here. Analog Devices involves facts nearly identical to those in BMC Software: The taxpayer claimed a one-time dividends received deduction under section 965 for its 2005 tax year. Pursuant to a 2009 closing agreement with respect to some section 482 adjustments, the taxpayer elected to establish accounts receivable via a closing agreement under Rev. Proc. 99-32 in order to repatriate amounts included in U.S. income for the 2005 tax year (among others). And just as it did in BMC Software, the IRS determined that the retroactive creation of those accounts receivable for 2005 constituted related party indebtedness under section 965(b)(3) for the 2005 tax year, thus reducing the taxpayer’s dividends received deduction for 2005.

Analog Devices is appealable to the First Circuit, and therefore the Fifth Circuit’s decision in BMC Software is not binding precedent under the Golsen rule. Nevertheless, the Tax Court’s decision begins with an explanation of why the court was willing to reconsider its prior decision in BMC Software. Acknowledging the importance of stare decisis, the Tax Court stated that it was “not capriciously disregarding” its prior analysis and held that the principles that it articulated in BMC Software are “not entrenched precedent.” The Tax Court also observed that while its BMC Software decision implicates contract rights (specifically, closing agreements under Rev. Proc. 99-32), it was “unlikely” that the IRS would have relied on BMC Software in structuring later closing agreements.

The Tax Court then proceeded to follow the Fifth Circuit on both issues presented in the case. One issue was whether, as a statutory matter, section 965 required the parties to treat the accounts receivable as related party indebtedness. Following the Fifth Circuit, the Tax Court held that there was no such statutory requirement because section 965(b)(3) looks only to indebtedness “as of the close of the taxable year for which the [section 965] election . . . is in effect.” Because the taxpayer’s closing agreement did not create the accounts receivable until 2009—long after the testing period for the taxpayer’s 2005 year—the Tax Court held that the accounts receivable did not constitute related party indebtedness under section 965.

The other issue was whether the parties had agreed to treat the accounts receivable as related party indebtedness under the closing agreement. In what the Tax Court termed an “introductory phrase,” the closing agreement provided that the accounts receivable were established “for all Federal income tax purposes.” The Commissioner argued that with this language, the parties had agreed to treat the accounts receivable as related party indebtedness for purposes of section 965. But looking to the facts and circumstances of the closing agreement, the Tax Court concluded that the taxpayer made no such agreement. The Tax Court cited law for the principle that each closing agreement is limited to the “matters specifically agreed upon and mentioned in the closing agreement” as well as some self-limiting language in the agreement itself. Since there is no specific mention of section 965 in the agreement, the Tax Court held that to treat the accounts receivable as related party indebtedness would be to ignore the intent of the parties.

But the introductory phrase in the closing agreement in BMC Software—which had the phrase “for Federal income tax purposes”— was different from that in Analog Devices—“for all Federal income tax purposes.” Four judges on the Tax Court concluded that this difference was material and dissented. The dissent invoked interpretive canons for giving effect to the word “all” and addressed the equities of the situation, stating that even if the parties did not bargain over the wording of the introductory phrase, the “wording was not foisted on an unrepresented or unsuspecting taxpayer, or rendered in fine print, or hidden in a footnote, or even inserted in the midst of other terms of the agreement.” Several judges joined in a concurring opinion stating that the dissent “points to a distinction without a difference” and observing that the phrase “for Federal income tax purposes” means the same thing as the phrase “for all Federal income tax purposes.”

If the government appeals Analog Devices (which it may well do given the dissent), we will cover that appeal.

Analog Devices Tax Court Opinion

Federal Circuit Decides Interest-Netting Dispute in Wells Fargo Case

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July 1, 2016

On Wednesday, the Federal Circuit issued its decision in the Wells Fargo interest netting case, affirming in part the trial court’s decision in favor of the taxpayer but also reversing in part. We previously covered the trial court decision and the oral argument here. As our prior coverage explained, the case presented three different fact patterns (termed “situations” in the decision) in which the taxpayer’s entitlement to interest netting hinged on the extent to which corporate mergers resulted in distinct corporations becoming the “same taxpayer” under the relevant Code section governing interest netting (§ 6621(d)). And as the questioning at oral argument had indicated, the Federal Circuit’s decision did not categorically adopt either party’s position, finding for the taxpayer in one situation and for the government in another.

The Federal Circuit did not have to address all three situations because in one of them—Situation Two—the government conceded that the taxpayer was entitled to interest netting. In Situation Two, the corporation that made the overpayment had the same Taxpayer Identification Number (TIN) as the corporation that had the later underpayment, even though the corporation had been through several intervening mergers between the time of the overpayment and the underpayment.

The government effectively had to make this concession—that interest netting is available when the underpaying corporation and overpaying corporation have the same TIN—in order to be consistent with its argument regarding Situation Three. In Situation Three, the corporation that had an overpayment (CoreStates) later merged into First Union, and after the merger the resulting First Union entity (which kept First Union’s TIN) had an underpayment. Relying on the decision in Magma Power (see our prior coverage of Magma Power here), the government argued that the taxpayer was not entitled to interest netting because CoreStates had a different TIN when it made its overpayment than First Union had at the time of the underpayment.

As the Federal Circuit observed, however, the only difference between Situation Two and Situation Three was “the choice of who is the named surviving corporation.” The choice of the name (and TIN) of the surviving corporation in a merger is hardly the sort of thing that ought to determine whether a taxpayer is entitled to interest netting. As the Federal Circuit astutely observed, every merger results in the surviving corporation becoming “automatically liable for the underpayments and entitled to the overpayments of its predecessors,” regardless of which TIN the surviving corporation adopts. Hewing to Congress’s intent for the statute to serve a remedial purpose, the Federal Circuit concluded that the CoreStates-First Union merger made the surviving corporation the “same taxpayer” as either of the pre-merger entities under section 6621(d).

With respect to Situation One, however, the Federal Circuit drew a limit on how broadly it was willing to interpret the “same taxpayer” requirement. In Situation One, the 2001 merger of Old Wachovia and First Union came after both Old Wachovia’s overpayment (1993) and First Union’s underpayment (1999). The Federal Circuit agreed with the government that under the decision in Energy East, the “same taxpayer” requirement is applied by asking whether “the entity that made the underpayment at the time of the underpayment is the ‘same taxpayer’ as the entity who made the overpayment at the time of the overpayment.” And since the merger postdated both the underpayment and the overpayment in Situation One, the Federal Circuit denied the taxpayer’s netting claim.

But is the Energy East test correct that entitlement to netting should be measured at the time of the underpayment or overpayment? One might reasonably argue that in applying the “same taxpayer” requirement, it makes more sense to look the period of overlap. Consider Situation One: After the 2001 merger, the surviving corporation would have been entitled to Old Wachovia’s overpayment and liable for First Union’s underpayment. And since the period of overlap extended beyond the September 2001 merger into later periods, there was good reason to conclude that the surviving corporation was entitled to interest netting from the date of the merger until the overlap periods ended. While the taxpayer did not pursue such a partial resolution on appeal, perhaps a future case will present that issue for decision.

Wells Fargo Federal Circuit Opinion

 

Fifth Circuit Reverses Tax Court in BMC Software

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March 17, 2015

The Fifth Circuit reversed the Tax Court’s decision in BMC Software yesterday. As we speculated that it might at the outset of the case here, the Fifth Circuit’s decision hinged on how far to take the legal fiction that the taxpayer’s accounts receivable created under Rev. Proc. 99-32 were deemed to have been established during the taxpayer’s testing period under section 965(b)(3). While the Tax Court treated that legal fiction as a reality that reduced the taxpayer’s section 965 deduction accordingly, the Fifth Circuit treated that legal fiction as just that—a fiction that had no effect for purposes of section 965: “The fact that the accounts receivable are backdated does nothing to alter the reality that they did not exist during the testing period.” The Fifth Circuit based its decision on a straightforward reading of the plain language of the related-party-indebtedness rule under section 965, holding that for that rule “to reduce the allowable deduction, there must have been indebtedness ‘as of the close of’ the applicable year.” And since the deemed accounts receivable were not created until after the testing period, the Fifth Circuit held that the taxpayer’s deduction “cannot be reduced under § 965(b)(3).”

The Fifth Circuit also rejected the Commissioner’s argument that his closing agreement with the taxpayer mandated treating the deemed accounts receivable as related-party indebtedness. Here, the Fifth Circuit found that the interpretive canon that “things not enumerated are excluded” governed in this case. Because the closing agreement “lists the transaction’s tax implications in considerable detail,” the absence of “a term requiring that the accounts receivable be treated as indebtedness for purposes of § 965” meant that the closing agreement did not mandate such treatment.

BMC Software Fifth Circuit Opinion

Taxpayer’s Reply Brief Filed in BMC Software

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May 5, 2014

The taxpayer filed its reply brief in the BMC Software case last week. As in its opening brief, BMC cites Fifth Circuit precedent for the tax law definition of “indebtedness” as an “existing unconditional and legally enforceable obligation to pay.” BMC argues that it is undisputed that the accounts receivable created under Rev. Proc. 99-32 do not meet that definitionthey neither existed nor were legally enforceable during the testing period for related-party indebtedness under section 965. (BMC observes that instead of disputing this point, the Commissioner tried to distinguish that case law, much of which comes from the debt-equity context. And BMC points out that the Commissioner’s argument implies different definitions of “indebtedness” may apply depending on the posture of the case.) In our first post on this case, we speculated that the outcome in this case may depend on whether the Tax Court took the legal fictions in Rev. Proc. 99-32 too far. That issue lurks beneath this definitional dispute: That the accounts receivable are deemed to have arisen during the testing period does not settle whether those accounts were “indebtedness” during the testing period.

BMC then turns to the closing agreement, which makes no mention of section 965 or the term “indebtedness.” BMC therefore relies on the legal principle that closing agreements must be construed to bind the parties “only to the matters expressly agreed upon.” BMC also addresses the Commissioner’s other arguments based on the closing agreement.

Finally, BMC makes a strong policy argument against the result in the Tax Court. BMC observes that the Commissioner concedes that the clear purpose of the related-party-indebtedness rule in section 965 is that it is meant to ensure “that a dividend funded by a U.S. shareholder, directly or indirectly, and that does not create a net repatriation of funds, is ineligible for the benefits” of section 965. Of course, no taxpayer could fund a dividend by way of deemed accounts receivable created after the dividend was paid. Therefore, BMC concludes, the case does not implicate the underlying purpose of the related-party-indebtedness rule under section 965.

We will provide updates once oral arguments are scheduled.

BMC Software – Taxpayer’s reply brief

Commissioner’s Brief filed in BMC Software

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April 4, 2014

The Commissioner filed his brief in the BMC Software case last week. The brief hews closely to the Tax Court’s decision below. The brief primarily relies on the parties’ closing agreement and trumpets the finality of that agreement.

The Commissioner argues that BMC’s problem is of BMC’s own making—BMC chose to avail itself of the relief available under Rev. Proc. 99-32 and signed a closing agreement under which the accounts receivable were deemed established during the relevant testing period for the related-party indebtedness rule under section 965. And as if to suggest that BMC deserves the reduction in its section 965 deduction, the Commissioner repeatedly asserts that the underlying adjustments that precipitated BMC’s use of Rev. Proc. 99-32 resulted from BMC’s “aggressive” transfer-pricing strategies.

The Commissioner briefly addresses BMC’s primary argument on appeal, which is that the relevant definition of “indebtedness” for purposes of section 965 is the definition established in case law and not—as the Tax Court had found below—the Black’s Law definition. The Commissioner’s brief argues that most of the cases on which BMC relies for a definition of “debt” are inapplicable because they arise in the context of debt-equity disputes or other settlements where the Commissioner was challenging the taxpayer’s characterization of an amount as debt. According to the Commissioner’s brief, those cases address whether the underlying substance of an instrument or payment was truly debt but that “[f]actual inquiries to ascertain whether, and when, debt was created by the parties’ dealings are irrelevant here.”

The brief also addresses BMC’s arguments that the Tax Court misinterpreted the closing agreement. The Commissioner argues that parol evidence is irrelevant because the agreement is unambiguous and that in any event, the extrinsic evidence does not support BMC’s position.

BMC’s reply brief is due April 28.

BMC Software – Commissioner’s brief

Taxpayer’s Opening Brief Filed in BMC Software

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January 28, 2014

The taxpayer filed its opening brief in the Fifth Circuit appeal of BMC Software v. Commissioner.  As we described in our earlier coverage, the Tax Court relied on the legal fiction that accounts receivable created pursuant to Rev. Proc. 99-32 in a 2007 closing agreement were indebtedness for earlier years (2004-06) in order to deny some of the taxpayer’s section 965 deductions.  There are three main avenues of attack in the taxpayer’s brief.

First, the taxpayer argues that the Tax Court incorrectly treated those accounts receivable as “indebtedness” as that term is used in the exception to section 965 for related-party indebtedness created during the testing period.  The taxpayer contends that the Tax Court looked to the Black’s Law definition of “indebtedness” when it should have looked to the tax law definition.  And the taxpayer argues that the tax law definition—that “indebtedness” requires “an existing unconditional and legally enforceable obligation to pay”—does not include the fictional accounts receivable created under Rev. Proc. 99-32.  The taxpayer argues that those accounts did not exist and were not legally enforceable until 2007 (after the section 965 testing period) and therefore did not constitute related-party indebtedness during the testing period for purposes of section 965.

Second, the taxpayer argues that the Tax Court was wrong to interpret the 2007 closing agreement to constitute an implicit agreement that the accounts receivable were retroactive debt for purposes of section 965.  The taxpayer observes that closing agreements are strictly construed to bind the parties to only the expressly agreed terms.  And the taxpayer argues that the parties did not expressly agree to treat the accounts receivable as retroactive debt for section 965 purposes.  Moreover, the taxpayer argues that the Tax Court misinterpreted the express language in the agreement providing that the taxpayer’s payment of the accounts receivable “will be free of the Federal income tax consequences of the secondary adjustments that would otherwise result from the primary adjustments.”  The taxpayer then makes several other arguments based on the closing agreement.

Finally, the taxpayer makes some policy-based arguments.  In one of these arguments, the taxpayer contends that the Tax Court’s decision is contrary to the purpose of section 965 and the related-party-indebtedness exception because the closing agreement postdated the testing period and therefore cannot be the sort of abuse that the related-party-indebtedness exception was meant to address.

BMC Software – Taxpayer’s Opening Brief

Fifth Circuit to Address Section 965 Deduction in BMC Software Appeal

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October 25, 2013

In BMC Software v. Commissioner, 141 T.C. No. 5, the Tax Court was faced with considering the effect that some legal fictions (created under a Revenue Procedure regarding transfer pricing adjustments) have on the temporary dividends-received deduction under section 965.  And while both the section 965 deduction and the legal fictions under the Revenue Procedure appear to have been designed to benefit taxpayers by facilitating tax-efficient repatriations, the Tax Court eliminated that benefit for some repatriated amounts.  The taxpayer has already appealed the decision (filed on September 18) to the Fifth Circuit (Case No. 13-60684), and success of that appeal may hinge in part on whether the Tax Court took the legal fictions in the Revenue Procedure too far.

First, some background on the section 965 deduction:  In 2004, Congress enacted the one-time deduction to encourage the repatriation of cash from controlled foreign corporations on the belief that the repatriation would benefit of the U.S. economy.  To ensure that taxpayers could not fund the repatriations from the United States (by lending funds from the U.S. to the CFC, immediately repatriating the funds as dividends, and then later treating would-be dividends as repayments of principal), Congress provided that the amount of the section 965 deduction would be reduced by any increase in related-party indebtedness during the “testing period.”  The testing period begins on the earliest date a taxpayer might have been aware of the availability of the one-time deduction—October 3, 2004—and ends at the close of the tax year for which the taxpayer elects to take the section 965 deduction.  Congress thus established a bright-line test that treated all increases in related-party debt during the testing period as presumptively abusive, regardless of whether the taxpayer had any intent to fund the repatriation from the United States.

BMC repatriated $721 million from a controlled foreign corporation (BSEH) and claimed the section 965 deduction for $709 million of that amount on its 2006 return.  On that return, BMC claimed that there was no increase in BSEH’s related party indebtedness between October 2004 and the close of BMC’s 2006 tax year in March 2006.  In the government’s view, however, this claim became untrue after the IRS reached a closing agreement with the IRS in 2007 with respect to BMC’s 2003-06 tax years.

That agreement made transfer pricing adjustments that increased BMC’s taxable income for the 2003-06 tax years.  The primary adjustments were premised on the IRS’s theory that the royalties BMC paid to its CFC were too high.  By making those primary adjustments and including additional amounts in income, BMC was deemed to have paid less to its CFC for tax purposes than it had actually paid.

The typical way of conforming BMC’s accounts in this circumstance is to treat the putative royalty payments (to the extent they exceeded the royalty agreed in the closing agreement) as deemed capital contributions to BSEH.  If BMC were to repatriate those amounts in future, they would be treated as taxable distributions (to the extent of earnings and profits).  But Rev. Proc. 99-32 permits taxpayers in this circumstance to elect to repatriate the funds tax-free by establishing accounts receivable and making intercompany payments to satisfy those accounts.  The accounts receivable created under Rev. Proc. 99-32 are, of course, legal fictions—the taxpayer did not actually loan the funds to its CFC.  BMC elected to use Rev. Proc. 99-32 and BSEH made the associated payments.

To give full effect to the legal fiction, Rev. Proc. 99-32 provides that each account receivable is “deemed to have been created as of the last day of the taxpayer’s taxable year for which the primary adjustment is made.”  So although BMC’s accounts receivable from BSEH were not actually established until the 2007 closing agreement, those accounts receivable were deemed to have been established at the close of each of the 2003-06 tax years.  Two of those years (those ending March 2005 and March 2006) fell into the testing period for BMC’s section 965 deduction.  The IRS treated the accounts receivable as related-party debt and reduced BMC’s section 965 deduction by the amounts of the accounts receivable for those two years, which was about $43 million.

BMC filed a petition in Tax Court, arguing (among other things) that the statutory rules apply only to abusive arrangements and that the accounts receivable were not related-party debt under section 965(b)(3).  The government conceded that BMC did not establish the accounts receivable to exploit the section 965 deduction, but argued that there is no carve-out for non-abusive transactions and the accounts receivable were indebtedness under the statute.

The court held that the statutory exclusion of related-party indebtedness from the section 965 deduction is a straightforward arithmetic formula devoid of any intent requirement or express reference to abusive transactions.  The court also held that the accounts receivable fall under the plain meaning of the term “indebtedness” and therefore reduce BMC’s section 965 deduction under section 965(b)(3).  So even though both the section 965 deduction and Rev. Proc. 99-32 were meant to permit taxpayers to repatriate funds with little or no U.S. tax impact, the mechanical application of section 965(b)(3) and Rev. Proc. 99-32 eliminated that benefit for $43 million that BMC repatriated as a dividend.

This does not seem like the right result.  And here it seems the culprit may be the legal fiction that the accounts receivable were established during the testing period.  The statute may not expressly address abusive intent, but that is because Congress chose to use the testing period in the related-party-debt rule as a blunt instrument to stamp out all potential abuses of the section 965 deduction.  This anti-abuse intent is baked into the formula for determining excluded related-party debt because the opening date of the testing period coincides with the earliest that a taxpayer might have tried to create an intercompany debt to exploit the section 965 deduction.  BMC did not create an intercompany debt during the testing period; the accounts receivable were not actually established until after the close of the testing period.  Perhaps the court took the legal fiction that the accounts receivable were established in 2005 and 2006 one step too far.  And perhaps the Fifth Circuit will address this legal fiction on appeal.

BMC Software – Tax Court Opinion

Eleventh Circuit Affirms Tax Court in Peco Foods

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July 7, 2013

In an unpublished opinion, the Eleventh Circuit affirmed the Tax Court’s decision in Peco Foods.  As we described in our earlier coverage here, the Tax Court held that the taxpayer could not subdivide broader classes of assets acquired in two transactions into discernible subcomponents for depreciation purposes because the taxpayer had agreed to an express allocation (in both agreements at issue) to the broader classes “for all purposes (including financial accounting and tax purposes).”  The Tax Court decided that because of that express allocation, the Danielson rule and language in section 1060 prevented the taxpayer from subdividing the asset classes (and thereby getting accelerated depreciation for some of those subclasses).

The taxpayer challenged the Tax Court’s application of the Danielson rule on appeal (among other things).  The taxpayer argued that under the Eleventh Circuit’s decision in Fort, the Danielson rule applies only where a taxpayer challenges the form of a transaction.  And since the subdivision of assets for depreciation purposes is not a challenge to form, the taxpayer argued that the Danielson rule did not apply.

The Eleventh Circuit made no mention of its decision in Fort, nor did it explain whether Peco’s attempt to subdivide the acquired asset classes for depreciation purposes was a challenge to the form of the transactions.  Instead, the Eleventh Circuit summarily affirmed the Tax Court’s holding that the express allocation in the agreements was unambiguous and binding under section 1060 and the Danielson rule.  So unfortunately for taxpayers—for whom the Danielson rule is a one-way street in the IRS’s favor—the Eleventh Circuit did nothing to explain how its decision in Fort limits the breadth of the Danielson rule.

Peco Foods – Eleventh Circuit Unpublished Opinion

When Characterizing Golfer’s Endorsement Income, Image Matters

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May 7, 2013

As a follow-up to our posts on the Goosen case regarding sourcing of a golfer’s income from sponsors (see here), we provide this update on the case involving golfer Sergio Garcia.  While they were not technically related cases, the significant overlap in issues and facts—not to mention witness testimony—meant that the outcome in Goosen partially determined the outcome in Garcia.

Both cases involved the character of the golfers’ endorsement income.  Coincidentally, the golfers each had an endorsement contract with the same brand—TaylorMade.  The golfers both argued that the lion’s share of the endorsement income was royalty income (i.e., paid for the use of the golfer’s name and likeness) and not personal services income (which is typically subject to a higher tax rate than royalties because of tax treaties).

Garcia had sold the rights to his image to a Swiss corporation (of which Garcia owned 99.5%) that in turn assigned the rights to a Delaware LLC (of which Garcia owned 99.8%).  Garcia’s amended endorsement agreement assigned 85% of the contract payments to the LLC as payments for the use of his image rights.  So Garcia argued that at least 85% of the endorsement payments were royalty income by virtue of the terms of the endorsement agreement.  The Service originally argued that none of endorsement payments were royalty income and that all of the payments were for personal services.  But the Service later tempered its position and argued that the “vast majority” of payments were for personal services.

Thanks to some testimony by the TaylorMade CEO that undermined the allocation in the agreement, the Tax Court declined to follow the 85/15 allocation in the amended endorsement agreement.  But the Tax Court also rejected the Service’s argument that the “vast majority” of payments were for personal services.  And the Tax Court determined that a 50/50 split was unwarranted.

In rejecting the 50/50 split, the Court tied the outcome in Garcia directly to the outcome in Goosen.  As we wrote before, the Court opted for a 50/50 split between royalties and personal services for Goosen’s endorsement income.  But expert testimony in Goosen contrasted Goosen’s endorsement income with Garcia’s.  The expert in Goosen (Jim Baugh, formerly of Wilson Sporting Goods) had testified that, while Goosen had better on-course results than Garcia, Garcia had a bigger endorsement deal because of Garcia’s “flash, looks and maverick personality.”  Consequently, the Court found that Garcia’s endorsement agreement “was more heavily weighted toward image rights than Mr. Goosen’s” and decided on a royalty/personal services split of 65/35.

The Tax Court also rejected the Service’s argument that Garcia’s royalty income was taxable in the U.S. under the U.S.-Swiss treaty.  Perhaps the IRS will appeal that legal issue.  Will Garcia appeal?  The Tax Court’s decision is a victory for Garcia relative to the outcome in Goosen.  On the other hand, if Garcia’s brand hinges on his “maverick personality,” then perhaps the “maverick” thing to do is to roll the dice with an appeal.  Decision has not yet been entered under Rule 155, so we will wait to see whether there is an appeal.

Garcia – Tax Court Opinion

Eleventh Circuit to Address Scope of Danielson Rule

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April 1, 2013

With oral argument scheduled for April 18 in Peco Foods v. Commissioner, No. 12-12169, the Eleventh Circuit will soon decide a case that involves the scope of the Danielson rule.  That rule, established in Danielson v. Commissioner, 378 F.2d 771, 775 (3d Cir. 1967), provides that “a party can challenge the tax consequences of his agreement as construed by the Commissioner only by adducing proof which in an action between the parties to the agreement would be admissible to alter that construction or to show its unenforceability because of mistake, undue influence, fraud, duress, etc.”  The Eleventh Circuit has expressly adopted the Danielson rule.

In Peco Foods, the Commissioner used that rule (along with the allocation rules under section 1060) to prevent the taxpayer from subdividing broader classes of purchased assets (to which the purchase agreement had expressly allocated a portion of the purchase price) into discernible subcomponents for depreciation purposes.  The taxpayer is a poultry processor that purchased the assets at two poultry processing plants in the mid- to late-1990s.  In each of the purchase transactions, Peco and the seller agreed to allocate the purchase price among listed assets “for all purposes (including financial accounting and tax purposes).”  The first agreement allocated purchase price among 26 listed assets; the second allocated purchase price among three broad classes of assets.

Prompted by the Tax Court’s decision in Hospital Corporation of America v. Commissioner, 109 T.C. 21 (1997), Peco commissioned a cost segregation study that subdivided the listed assets into subcomponents.  Some of these subcomponents fell into asset classes that are subject to accelerated depreciation methods.  For instance, Peco subdivided the class of assets listed as “Real Property: Improvements” on the original allocation schedule into subcomponents that were tangible personal property subject to a 7- or 15-year depreciation period under section 1245.  If they were classified as structural components of nonresidential real property, the assets would have been subject to a 39-year depreciation period under section 1250.

With the segregation study in hand, Peco applied to change its accounting method for those subcomponents with its 1998 return and claimed higher depreciation deductions on subsequent returns.  The IRS disallowed these deductions and issued a notice of deficiency; the taxpayer filed a petition in Tax Court.

In a Tax Court Memorandum opinion by Judge Laro, T.C. Memo 2012-18, the Tax Court upheld the Commissioner’s deficiencies.  The Tax Court’s decision was based on both the Danielson rule and section 1060(a), the latter of which provides that if the parties in an applicable asset acquisition “agree in writing as to the allocation of any consideration,” the agreement “shall be binding on both the transferee and transferor unless the Secretary determines that such allocation . . . is not appropriate.”  The taxpayer argued that section 1060 serves only to allocate purchase price among assets under the residual method of section 338(b)(5) and that section 1060 does not bar further subdivision of the allocation for purposes of determining useful lives for depreciation.  The Tax Court held that the directive in section 1060 that an allocation by the parties “shall be binding” trumps the application of the residual method of section 338(b)(5).

The Tax Court also rejected the taxpayer’s argument that Danielson was inapposite.  The taxpayer had relied on United States v. Fort, 638 F.3d 1334 (11th Cir. 2011), in which the Eleventh Circuit held that “the Danielson rule applies if a taxpayer ‘challenge[s] the form of a transaction.’”  (citation omitted)  Since the taxpayer in Fort had challenged the specific tax consequences of the form of the transaction but not the form itself, the Eleventh Circuit found that Fort fell outside the scope of the Danielson rule.  The Tax Court held that while the taxpayer in Fort had not challenged the form of the transaction, the taxpayer in Peco—by “seeking to reallocate the purchase price among assets not listed in the original allocation schedules”—sought to challenge the form of the transaction.  Therefore, reasoned the Tax Court, because there was no ambiguity to the allocations in the purchase agreements under the applicable contract laws of the states in which the agreements were entered, Danielson applies to prevent the taxpayer from subdividing the listed into distinct components for depreciation purposes.

On appeal, the taxpayer contests the Tax Court’s holdings with respect to both section 1060 and Danielson.  In its brief, the taxpayer argues that whether an asset is tangible personal property or a structural component of a building is a matter of facts and circumstances and that the words used to describe the asset “are of no utility in connection with its categorization as a structural component.”  The taxpayer also argues that classifying assets for depreciation purposes is not a challenge to the form of the transaction (unlike, for example, treating the transaction as a merger or lease rather than an asset acquisition, which would have been a challenge to form) and therefore, under the holding in Fort, the Danielson rule does not apply.

In his opposition brief, the Commissioner echoes the Tax Court’s holding that the taxpayer’s subdivision of listed assets for depreciation purposes is an attempt to “restructure the form of the transaction” and therefore falls within the purview of the Danielson rule (and is not excluded by the rule articulated in Fort).  The Commissioner then goes a step further, arguing that the taxpayer was not merely “changing the classification of assets” but also “added assets.”  Moreover, the Commissioner insists that what the taxpayer did with respect to depreciation “goes considerably deeper than merely a change to the classification for depreciation purposes.”

Peco Foods – Tax Court Memorandum Opinion

Peco Foods – Taxpayer’s 11th Circuit Brief

Peco Foods – Commissioner’s 11th Circuit Opposition Brief

 

Goosen Appeal Dismissed; Garcia Decision Looms

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June 21, 2012

While this post is significantly belated, it’s still worth noting that the IRS (the original appellant) and Goosen (who had cross appealed) stipulated to dismiss the appeal to the D.C. Circuit back in February.

This doesn’t mark the end of the IRS’s fight with pro golfers over the character and source of income (especially royalty income).  Sergio Garcia disputed deficiencies on similar issues; his case was tried in the Tax Court back in March.  (Case No. 013649-10).  We’ll update you when the decision is issued in that case.

Service Appeals Goosen Tax Court Decision to D.C. Circuit

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January 4, 2012

We posted in November 2011 about the Tax Court’s decision on the character and source of golfer Retief Goosen’s endorsement income.  The Service appealed that decision to the D.C. Circuit in December.  The D.C. Circuit case number is 11-1478.  We’ll post updates as the appeal progresses.

Court of Federal Claims Construes “Same Taxpayer” Requirement for Interest Netting

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December 9, 2011

In Magma Power v. United States, Case No. 09-419T, the Court of Federal Claims tackled the arcane topic of interest netting.  The issue in Magma Power was a narrow question of statutory interpretation, but the broader topic of interest netting warrants a word of explanation. 

The government charges interest on tax underpayments at a higher rate (under section 6601) than it pays on tax overpayments.  Because it often takes several years or more to determine whether a taxpayer has an overpayment or underpayment for a particular tax year and the amount of that overpayment or underpayment, there are sometimes post-return periods during which a taxpayer has overlapping overpayments and underpayments.  When this occurs, the taxpayer should owe no interest on the overlapping amount.  If the overlapping amounts are not netted, however, the rate disparity results in net interest in the government’s favor.  To correct this inequity, Congress enacted section 6621(d), which provides that “to the extent that, for any period, interest is payable . . . and allowable . . . on equivalent underpayments and overpayments for the same taxpayer, . . . the net rate of interest on such amounts shall be zero.” 

The narrow statutory-interpretation issue in Magma Power is the meaning of the term “same taxpayer” under section 6621(d).  The IRS had denied section 6621(d) relief to Magma Power on the theory that Magma Power was no longer the “same taxpayer” after becoming a member of a consolidated group. 

Magma Power filed a return for its 1993 tax year sometime in 1994.  In February 1995, CalEnergy Company acquired Magma Power and subsequently included Magma Power on its consolidated tax returns.  The IRS later determined a deficiency for Magma Power’s 1993 tax year, and Magma Power paid that deficiency and over $9 million in associated underpayment interest in 2000 and 2002.  The CalEnergy consolidated group overpaid its taxes in four consecutive tax years from 1995 through 1998.  Despite some disagreement between the parties, the court found that some portion of these overpayments were attributable to Magma Power’s activities.  In 2004 and 2005, the IRS refunded those overpayments plus the associated overpayment interest to the consolidated group agent (which by then was MidAmerican Energy Holdings Company).  There were overlapping underpayments and overpayments for the period that began with the filing of the 1995-98 returns and ended with the satisfaction of Magma Power’s 1993 underpayment.  Magma Power claimed interest-netting refunds for that period.  The IRS denied the refund on the theory that the consolidated group could not net its overpayments with Magma Power’s underpayments because of the “same taxpayer” requirement of section 6621(d). 

The court’s plain-language analysis of section 6621(d) is straightforward and decisively rebuts what appears to be a flimsy position taken by the IRS.  The essence of the court’s conclusion is that becoming a member of a consolidated group does not fundamentally alter a taxpayer’s identity.  The court rests this decision on the uncontroversial premise that the taxpayer identification number (or EIN, for corporations like Magma Power) is the sine qua non of taxpayer identity.  And because Magma Power retained the same EIN (and therefore same identity) after its inclusion in the consolidated group, the court held that Magma Power was the same taxpayer for section 6621(d) purposes for the 1993 underpayment and its allocable portion of the 1995-98 overpayments. 

Although the court addresses several arguments made by the government, the only notable bump in the court’s road to its conclusion was some language in another Court of Federal Claims decision, Energy East v. United States, 92 Fed. Cl. 29 (2010), aff’d 645 F.3d 1358 (Fed. Cir. 2011).  Interpreting the meaning of “same taxpayer” for interest-netting purposes in Energy East, the lower court cited the dictionary definition of “same” and decided that section 6621(d) requires that the taxpayer must be “identical” and “without addition, change, or discontinuance.”  (The issue on appeal was narrower and the Federal Circuit did not reject or adopt this aspect of the lower court’s opinion.)

The court in Magma Power had little difficulty distinguishing Energy East:  Energy East was trying to net the overpayment years of acquired companies against its own underpayment years.  The hitch was that both the underpayment years and overpayment years came before Energy East acquired those companies.  In Magma Power, the court held that the Energy East situation was “radically different” than Magma Power’s attempt to net its own 1993 underpayment against its own later overpayments (albeit encompassed within the Cal Energy consolidated group).

The government may well appeal Magma Power based on the broad language in the lower court’s decision in Energy East.  If they do, we’ll keep you posted. 

Magma Power opinion 10.28.2011

Tax Court Addresses Character and Sourcing Issues for Golfer’s Endorsement Income

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November 1, 2011

In what appears may be the first in a series of cases on the endorsement income of non-resident aliens, the Tax Court was tasked with characterizing and sourcing the endorsement income for golfer Retief Goosen.  The court’s decision may impact how other athletes and entertainers structure their endorsement deals and indicates how taxpayers should expect the IRS to source royalty income in similar cases. 

Goosen, a native South African who is a U.K. resident, is subject to U.S. tax because playing professional golf in the U.S. amounts to engaging in a U.S. trade or business.  He had endorsement agreements with Acushnet (which makes Titleist golf balls), TaylorMade, and Izod to use or wear their products while playing golf (these are the “on-course” endorsements).  He also had endorsement agreements with Rolex, Upper Deck, and Electronic Arts (the “off-course” endorsements). 

There were three main issues before the Tax Court:

(1)  Was Goosen’s on-course endorsement income personal services income or royalty income or some combination of the two?  (The parties agreed that all of the off-course endorsement income was royalty income.)   The personal services income of nonresident aliens is subject to regular U.S. tax rates; they typically owe less U.S. tax on royalty income under tax treaties. 

(2)  What portion of Goosen’s royalty income was U.S.-source income?  Under section 872, the gross income of nonresidents includes U.S.-source income. 

(3)  What portion, if any, of that U.S.-source royalty income was effectively connected to a U.S. trade or business?  While U.S.-source royalties are generally subject to a flat 30% withholding tax, if  royalties are effectively connected to a U.S. trade or business, they are subject to the graduated rates that apply to U.S. residents. 

On the first issue, Goosen argued that the on-course endorsements were paid for the use of his name and likeness, which is classic royalty income.  The IRS argued that because the on-course endorsement agreements required Goosen to make personal appearances and to play in a minimum number of golf tournaments (all while using Titleist balls and TaylorMade clubs and wearing Izod), the on-course endorsements were paid for personal services.  The court split the difference, deciding that the sponsors paid for both the use of Goosen’s image and likeness and for personal services. 

On the one hand, the court found that the sponsors were paying for more than just Goosen’s golfing—that the sponsors wanted to be associated with Goosen’s image.  The court cited the morals clause in a couple of Goosen’s endorsement agreements as evidence that the sponsorship was about more than just golfing.  (This morals-clause discussion enabled the court—and, conveniently, this blog entry—to meet the requirement that anything written about golf must mention Tiger Woods.) 

The court also cited expert testimony from Jim Baugh (formerly of Wilson Sporting Goods) for the proposition that image is sometimes more important than performance.  Baugh testified that while Goosen has won more and consistently been ranked higher than golfer Sergio Garcia, the two have effectively identical endorsement agreements with TaylorMade.  Baugh attributed this to Garcia’s “flash, looks and maverick personality.”  This is notable testimony because Garcia has his own Tax Court case pending, which is set for trial in Miami in March 2012. By detailing this testimony, the court gifts Garcia with a tailor-made argument that, relative to Goosen, a greater portion of Garcia’s TaylorMade endorsement income is royalty income. 

On the other hand, the court held that the endorsement income could not be solely attributable to Goosen’s image.  After all, the on-course endorsements required Goosen to make personal appearances and to play in a specified number of tournaments, all while wearing or using the sponsors’ products.  Acknowledging that precision in allocating between royalty and personal service income was unattainable, the court settled on a straightforward 50-50 split. 

As for the second issue, the court was left to decide what portion of Goosen’s royalty income was U.S.-source income.  Generally, the source of royalty income from an intangible is where the property (in this case, Goosen’s image) is used.  With respect to the Upper Deck and EA endorsements, the court looked to the relative U.S.-to-worldwide sales percentages of Upper Deck’s golf cards (92% in the U.S.) and EA’s video games (70% in the U.S.) and then sourced Goosen’s royalty income accordingly.  For the three on-course endorsements and the Rolex endorsement, the court determined that while Goosen was marketed worldwide, the U.S. constitutes about half of that worldwide golf market.  The court therefore treated half of the income from those four endorsements as U.S.-source income. 

Finally, the court had to decide whether any of that U.S.-source income was effectively connected to a U.S. trade or business.  The court held that only the on-course endorsement royalty income was effectively connected to a U.S. trade or business.  The court found that since the off-course endorsements didn’t require Goosen to play golf tournaments or to be physically present in the U.S., that royalty income was not effectively connected to the U.S. 

The aspect of the decision that seems to have scared some practitioners (other than the existence of a worldwide market for collectible golf cards, which maybe scares only this practitioner) was how the court sourced royalty income according to the U.S.-to-worldwide sales percentages.  The fear is that the IRS will simply apply those percentages in every case, and taxpayers will have no room to negotiate a more favorable allocation. 

We’ll keep an eye on where this case heads and will post updates on the Sergio Garcia case. 

 Goosen Tax Court opinion