Fifth Circuit Reverses Tax Court in BMC Software

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

Tax Court Reversed on Historic Rehabilitation Credits in Historic Boardwalk

[Note:  Miller & Chevalier filed a brief in this case on behalf of National Trust for Historic Preservation]

In a detailed 85-page opinion, the Third Circuit has reversed the Tax Court’s opinion that upheld a claim for historic rehabilitation tax credits by the private partner in a public/private partnership that rehabilitated a historic property on the Atlantic City boardwalk.  See our earlier report here.  The government had argued both that the transaction lacked economic substance and that the private partner, Pitney Bowes, was not a bona fide partner in the enterprise.  The Third Circuit agreed with the government’s second argument and therefore found it unnecessary to decide whether there was economic substance.  Given that approach, the court stated that it would “not opine on the parties’ dispute” on whether the Ninth Circuit was correct in Sacks v. Commissioner, 69 F.3d 982 (9th Cir. 1995), in stating that the policy of providing a rehabilitation credit as a tax incentive is relevant “in evaluating whether a transaction has economic substance.”  Slip op. 54 n.50.  The court did make some general observations on economic substance, however, noting its agreement with amicus that the government’s position had inappropriately blurred the line between economic substance and the substance-over-form doctrine, which are “distinct” doctrines.  Slip op. 52 n.50.  Citing Southgate Master Fund, L.L.C. v. United States, 659 F.3d 466, 484 (5th Cir. 2011), the court added that “even if a transaction has economic substance, the tax treatment of those engaged in the transaction is still subject to a substance-over-form inquiry to determine whether a party was a bona fide partner in the business engaged in the transaction.”  Slip op. 53 n.50.

Turning to the issue that it found dispositive, the court concluded that Pitney Bowes was not a bona fide partner because it “lacked a meaningful stake in either the success or failure of [the partnership].”  Slip op. 85.  In reaching that conclusion, the court relied heavily on two recent court of appeals’ decisions, the Second Circuit’s analysis of bona fide equity partnership participation in TIFD III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006) (“Castle Harbour”) and the Fourth Circuit’s analysis of “disguised sales” in Virginia Historic Tax Credit Fund 2001 LP v. Commissioner, 639 F.3d 129 (4th Cir. 2011).  Although the taxpayer had objected that the latter case was irrelevant because no disguised sale issue was present, the court agreed with the government’s argument in its reply brief that “the disguised-sale analysis in that case ‘touches on the same risk-reward analysis that lies at the heart of the bona fide-partner determination.’”  Slip op. 67 n.54 (quoting U.S. Reply Br. 9).  See our previous report here.  The court elaborated on this point as follows:  “Although we are not suggesting that a disguised-sale determination and a bona fide-partner inquiry are interchangeable, the analysis pertinent to each look to whether the putative partner is subject to meaningful risks of partnership operations before that partner receives the benefits which may flow from that enterprise.”  Id. at 69 n.54.

The taxpayer had relied heavily on the Tax Court’s findings regarding the essentially factbound question of bona fide partnership, but the Third Circuit found that the deferential standard of review of factual findings was not an obstacle to reversal.  The court first stated that “the record belies” the Tax Court’s conclusion that Pitney Bowes faced a risk that the rehabilitation would not be completed.  Id. at 73.  To deal with the standard of review, the court of appeals drew a hair-splitting distinction between the factual issue of “the existence of a risk” and what the court believed to be a “purely . . . legal question of how the parties agreed to divide that risk,” which “depends on the . . . documents and hence is a question of law.”  Id. at 73 n.57.  The court of appeals directly rejected other Tax Court findings regarding risk as “clearly erroneous.”  Id. at 76.

The court did not dwell on the policy implications of its decision.  It stated that it was “mindful of Congress’s goal of encouraging rehabilitation of historic buildings” and had not ignored the concerns expressed by the amici that a ruling for the government could “jeopardize the viability of future historic rehabilitation projects.”  Id. at 84.  But the court brushed aside those concerns, taking comfort in the response of the government’s reply brief that “[i]t is the prohibited sale of tax credits, not the tax credit provision itself, that the IRS has challenged.”  Id. at 85.  Be that as it may, decisions like this are likely to diminish the practical effectiveness of the credit as an incentive and thus to frustrate to some extent Congress’s desire to encourage historic rehabilitation projects.

A petition for rehearing would be due on October 11.

Historic Boardwalk – Third Circuit Opinion

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The Tax Appellate Blog is a new blog dedicated to covering important tax cases pending before the various federal  courts of appeals that are of interest to practitioners and others who follow the development of federal tax law. We will try to post regularly as developments warrant, and we welcome commentary from the broader tax law community. We also plan to provide links to the pleadings and other pertinent documents in those cases.  So, welcome aboard.