Fifth Circuit to Address Section 965 Deduction in BMC Software Appeal

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

Government Submits Supplemental Authority in Loving

We recently reported on the oral argument before the D.C. Circuit in Loving, in which the court considered the validity of the recently promulgated Treasury regulations addressing registration of tax return preparers.  Subsequent to that argument, former IRS Commissioner Lawrence Gibbs published an article defending the IRS’s authority to promulgate those regulations and discussing their importance to tax administration.  The government has now filed a FRAP Rule 28(j) letter bringing the article to the attention of the court and highlighting some points made in the article.  The plaintiffs have responded to that letter, arguing that the article is not the kind of supplemental authority that is covered by Rule 28(j) and briefly addressing some of the points made in the article.  Copies of the letters are attached below (the article itself is appended to the government’s letter).

[Note:  Lawrence Gibbs is a member of Miller & Chevalier.]

Loving – Government’s Rule 28(j) Letter

Loving – Plaintiffs’ Response to Rule 28(j) Letter

 

Oral Argument Scheduled in Bergmann

We have previously reported on the Ninth Circuit’s consideration of the qualified amended return regulation in the Bergmann case.  Several months after the close of the briefing, the court has now scheduled the case for oral argument on December 3 in San Francisco.  The identity of the three-judge panel will be announced at a future date.

Supreme Court Struggles to Unravel TEFRA Jurisdiction in Woods Oral Argument

The Supreme Court held oral argument in United States v. Woods on October 9.  As we have previously reported, the case presents two distinct questions:  (1) a TEFRA jurisdictional question concerning whether the court could determine the applicability of the valuation overstatement penalty in a partnership-level proceeding; and (2) the merits question whether the 40% penalty applied when the partnership was found not to have economic substance and therefore the basis claimed by the taxpayers in the partnership was not recognized.

Most of the argument time for both advocates was spent on the jurisdictional issue, as the Justices often seemed genuinely confused about how TEFRA is generally supposed to work and about the respective positions of the parties on how the statutory provisions should be interpreted in the circumstances of this case.  [For example, Justice Sotomayor:  “what is this case a fight about?” “Could you give me a concrete example, because I’m not quite sure about what you’re talking about.”  Justice Breyer:  “I am genuinely confused.  I have read this several times.”]  Thus, a higher percentage of the Justices’ questions than usual appeared designed simply to elicit information or alleviate confusion, rather than to test the strength of the advocate’s position.

Justice Sotomayor began the questioning by suggesting to government counsel, Deputy Solicitor General Malcolm Stewart, that there was an “incongruity” in its position in that it was acknowledging that there were partner-level issues that precluded a final determination of penalty liability until the partner-level proceeding, yet it was insisting that the penalty could be imposed without a notice of deficiency prior to the partner-level proceedings.  Mr. Stewart responded that a taxpayer would have an opportunity before the penalty is imposed to make the kinds of broad objections that are at issue in this case.  He would have to file a partner-level refund suit only if he had undeniably partner-specific issues like a good faith reasonable cause defense, and Congress contemplated that there would not be a prepayment forum for those kinds of issues.

Justice Kagan suggested that the government’s position essentially was “what you do at the partnership level is anything that doesn’t require looking at an individual’s tax return”; Mr. Stewart agreed, but he said that he preferred to state the position as “any question that will necessarily have the same answer for all partners should presumptively be resolved at the partnership level.”

Chief Justice Roberts asked Mr. Stewart about the D.C. Circuit’s reasoning in Petaluma that the penalty issue related to outside basis and therefore could not be resolved at the partnership level even if the answer was obvious.  Mr. Stewart began his response by agreeing (as the government has throughout the litigation) with the proposition that “outside basis, in and of itself, is not a partnership item,” but this observation triggered some questions looking for clarification.  Justice Scalia asked why outside basis would vary from partner to partner, and Justice Kennedy suggested that the government was arguing that “outside basis in this case is necessarily related to inside basis” – a formulation that Mr. Stewart rejected.  The result was that the last few minutes of Mr. Stewart’s argument on the jurisdictional point were diverted into explaining that the government was not making certain arguments being suggested by the Court.

When Gregory Garre began his argument for the taxpayers, Justice Kagan zeroed in on the statutory text and asked if the case didn’t just boil down to whether the “related to a partnership item” language in the statute required that the relationship be direct [taxpayers’ view] or could be satisfied if the relationship were indirect [government’s view].  Mr. Garre responded by arguing that the government’s position was more at variance with the statutory text than she had suggested because the statute gives a partnership-level proceeding jurisdiction over “partnership items” and outside basis concededly was not a partnership item.  Justice Scalia, and later Justice Kagan, pushed back against that answer by noting that the statute establishes jurisdiction over more than partnership items.  Justice Kennedy chimed in to note that penalties are always paid by the partners, not the partnership itself, yet TEFRA contemplates that some penalties are determined at the partnership level.

Mr. Garre then emphasized that this penalty could not be determined at the partnership level because “outside basis isn’t reported anywhere at all on the partnership” return.  Justices Scalia and Breyer both blurted out “so what” in response.  There followed a long colloquy in which Mr. Garre argued to Justice Breyer that the difference between overstatements of outside basis and inside basis was of jurisdictional significance.  Justice Breyer appeared unconvinced, suggesting instead that the partnership itself is a partnership item, and therefore the penalty based on shamming the partnership should also be regarded as a partnership item.  Mr. Garre replied that the penalty was for overstating outside basis, which concededly is not a partnership item.

Justice Ginsburg showed great interest in the recently enacted economic substance penalty, asking about it on three different occasions.  Although that new penalty is not applicable to the tax years at issue in this case, the taxpayers had argued that its enactment showed that Congress did not agree with the government’s position – namely, that the valuation overstatement penalty already on the books would apply when partnerships are found to lack economic substance.  With respect to jurisdiction, Mr. Garre confirmed that the new penalty could be imposed at the partnership level because it is based on shamming the transaction, a partnership-level determination.  With respect to the merits, the advocates unsurprisingly responded differently to Justice Ginsburg’s questions.  Mr. Stewart stated that, although there was some overlap between the new penalty and the overstatement penalty at issue in this case, the overlap was not total, and it is not anomalous to have some degree of overlap.  Therefore, enactment of the new penalty was not inconsistent with the government’s position.  Mr. Garre, by contrast, asserted that the new penalty “that Congress passed to cover this situation here solves all the problems,” and thus it would be wrong for the Court “to fit a square peg into a round hole” by applying the valuation overstatement penalty to this situation.  Chief Justice Roberts later asked about how the new penalty operates as well.

Mr. Garre then emphasized the “practical consequences” of resolving the penalty issue at the partnership level – specifically, that it would allow the government to impose the penalty without making a prepayment forum available for the taxpayer to contest it.  Justice Sotomayor had begun the argument by asking Mr. Stewart about this point, and now she switched sides and asked Mr. Garre why that was inappropriate when it was “obvious” that the partner was going to claim a nonzero basis.  Mr. Garre responded that, obvious or not, the court could not create jurisdiction by “assuming a fact necessary to the penalty.”

Justice Scalia had asked Mr. Stewart whether pushing the penalty determination to the partner level would open the door to inconsistent outcomes on the same legal issue.  That was a friendly question, and Mr. Stewart happily agreed.  When Justice Scalia asked Mr. Garre the same question, it led to a more extended discussion with several Justices.  Mr. Garre initially responded that there was no danger of inconsistent outcomes on the merits issue because the Supreme Court’s resolution of that issue would be binding on everyone.  Although different outcomes could occur because different partners have different outside basis, that is what Congress intended and is the reason why TEFRA provides for partner-level proceedings.  Justice Scalia then asked about the possibility of different results on whether the partnership was a sham, but Mr. Garre pointed out that this determination was properly made at the partnership level and would apply equally to all partners.  Chief Justice Roberts, however, questioned whether the asserted need for a partner-level determination of outside basis was mostly theoretical, asking:  “does your case hinge on the perhaps unusual situations where you have one of these partners having a fit of conscience and decides to put down the real number or has some other adjustment to it?”  Mr. Garre responded “largely, yes,” but added that the statute did not allow these determinations to be made at the partnership level even if they are obvious, and that where individual transactions are shammed (instead of the entire partnership), it will not be obvious that the basis is overstated.  Justice Sotomayor remarked that she was confused by the individual transaction point, but she did not press Mr. Garre on the point after he explained it a second time.

The jurisdictional discussions left so little time for the advocates to address the merits that the argument did not shed much light on the Justices’ views on the applicability of the valuation overstatement penalty.  During the government’s argument, Justice Ginsburg finally moved the discussion to the merits by asking the question about the new economic substance penalty discussed above.  One other question followed from Chief Justice Roberts in which he asked Mr. Stewart to respond to one of the taxpayers’ main arguments – namely, that there is not an overvaluation of an amount here but instead a determination wiping out the entire transaction.  Mr. Stewart responded that it was appropriate to apply the valuation overstatement penalty because “the whole point of the avoidance scheme was to create an artificially inflated basis.”

Mr. Garre also moved to the merits issue late in his argument.  He began by emphasizing that Congress clearly aimed this penalty at the fundamentally different situation where the taxpayer misstated the amount of the value.  Justice Kagan interjected to say that he was describing “the prototypical case,” but that didn’t have to be the only case, and the statute was drafted more broadly.  Mr. Garre responded that “context, punctuation, pre-enactment history, post-enactment history and structure” supported the taxpayers’ position, but Justice Kagan rejoined skeptically that “you’re saying they have text, and you have a bunch of other things.”  Mr. Garre then expanded on his answer, stating that the reference to “basis” in the statute “comes in a parenthetical, subordinate way” and thus must be related to an overvaluation, not to a situation where “the thing doesn’t exist at all.”  He then ended his argument by noting that tax penalties are to be strictly construed in favor of the taxpayer and by inviting the Court to review the amicus brief filed by Prof. David Shakow for examples of other situations that would be mistakenly swept into the valuation overstatement penalty if the government were to prevail.

On rebuttal, Justice Breyer quickly interrupted to ask about his theory that the jurisdictional issue must be resolved in the government’s favor because the existence of the partnership is a “partnership item,” noting his concern that this approach might be too “simple” given that three courts had gone the other way and that he did not “want to say that you are right for the wrong reasons.”  Before Mr. Stewart could respond, however, Chief Justice Roberts asked if he could “pose perhaps a less friendly question.”  He then asked Mr. Stewart to comment on an analogy drawn by Mr. Garre to a taxpayer who claims a deduction for donating a $1 million painting when in fact he never donated a painting at all.  That situation would involve a misstatement, but not a valuation misstatement, and Mr. Garre argued that in both situations the valuation misstatement penalty would be inapplicable.  Mr. Stewart, however, sought to distinguish the painting example from this case because the IRS did not determine that the underlying currency transactions did not occur, just that the partnerships were shams.  Chief Justice Roberts appeared unpersuaded by this distinction, commenting that calling the partnerships shams was “like saying that there were no partnerships,” so it seemed that the situations were “pretty closely parallel.”

Given the nature of the questioning, it is harder than usual to draw any conclusions from the oral argument, except perhaps that the Court (or at least the Justice who is assigned to write the opinion) is regretting its decision to add the jurisdictional question to the case.  Justice Scalia appeared solidly on the side of the government on the jurisdictional question.  Justice Breyer appeared to be leaning that way as well, but on a theory not espoused in the briefs that he himself seemed to recognize might not withstand more rigorous analysis.  Conversely, Chief Justice Roberts referred several times to the D.C. Circuit’s Petaluma decision, perhaps indicating that he finds its reasoning persuasive.  In the end, most of the Justices seem still to be figuring the case out, and we will have to wait to see where they come out.

NPR Court Asks Parties for Additional Information on Jurisdictional Questions

It has been almost two years since the Fifth Circuit heard oral argument in the NPR Investments case, which involves a “son-of-BOSS” tax shelter and associated questions regarding penalties and jurisdiction under TEFRA.  See our previous reports on the oral argument and describing the issues.  Last week, the court issued an order directing the parties to file short “letter briefs,” answering some specific questions involving TEFRA jurisdiction over penalties.  In particular, the court asked the parties to address how NPR compares to the Petaluma (D.C. Cir.) and Jade Trading (Fed. Cir.) cases in which the courts found a lack of jurisdiction in partnership-level proceedings to impose a valuation misstatement penalty where a basis-inflating transaction was found to lack economic substance.  As we have reported, the Supreme Court is preparing to hear argument in U.S. v. Woods, which involves the validity of such a penalty and the same jurisdictional issue addressed in Petaluma and Jade Trading.

It is not clear whether the Fifth Circuit panel considering NPR was aware that the Supreme Court is poised to decide these questions in Woods (though Woods is a case that comes from the Fifth Circuit), but it certainly is aware of it now.  The government’s response to the court’s order points the court to the government’s brief in Woods and explicitly states that “the issue whether Petaluma and Jade Trading were correctly decided is at the heart of the jurisdictional issue before the Supreme Court in Woods, scheduled for argument on October 9.”  Given that a Supreme Court decision will be coming down in the next several months that, at a minimum, will bear closely on the issues in NPR Investments and quite possibly resolve them definitively, it is hard to see why the Fifth Circuit would press ahead to decide the NPR case.  Most likely, it will continue to sit on the case until Woods is decided.  But that is not certain.  The responses to the court’s request for supplemental briefs demonstrated some level of agreement between the government and the taxpayer.  If the Fifth Circuit has an opinion almost ready to go, but for a couple of areas of uncertainty that have now been cleared up by the supplemental briefs, it might go ahead and issue its opinion.  If it does, however, the ultimate result in the case likely will still remain in play until the Supreme Court speaks in Woods.

NPR Investments – Court Request for Supplemental Briefs

NPR Investments – Government’s Supplemental Brief

NPR Investments – Taxpayer’s Supplemental Brief

Supreme Court Grants Certiorari in Quality Stores

The Supreme Court, not surprisingly, granted cert this morning in the Quality Stores case.  As we have previously reported (see our prior coverage here), the Court is now poised to resolve a conflict between the Sixth Circuit and the Federal Circuit regarding whether severance payments paid to employees pursuant to an involuntary reduction in force are “wages” subject to FICA taxation.  Notably, Justice Kagan did not participate in the order granting the petition, perhaps because she had some involvement in the case during her tenure as Solicitor General.  Her recusal creates the theoretical possibility that the Court could ultimately divide 4-4 on the case and thus be unable to resolve the conflict.

The government’s opening brief is due November 15.  Oral argument will likely be scheduled for January 2014.