On March 13, 2015, the Fifth Circuit's decision in BMC Software Inc., 780 F.3d 669 (5th Cir. 2015), seemingly involved a narrow income repatriation issue. However, a deeper analysis of the decision sheds light on a much broader issue with significant importance to all tax practitioners: How much weight should a court give to IRS published guidance? IRS published guidance with meaningful explanation and analysis not contrary to the Internal Revenue Code may be given significant deference. IRS published guidance that lacks explanation and analysis is afforded no precedential weight.
During the tax year ended March 31, 2006, BMC Software Inc. (BMC) deducted $603 million under Sec. 965 through the repatriation of dividends paid to BMC by its wholly owned foreign subsidiary, BMC Software European Holding (BSEH). Congress enacted Sec. 965 to allow U.S. parent corporations to take a one-time 85% deduction on certain dividends paid to the U.S. parent by the U.S. parent's wholly owned foreign subsidiary. However, the Sec. 965 deduction is limited if there is related-party indebtedness between the U.S. parent and the foreign subsidiary.
Sec. 965(b)(3) prevents the U.S. parent from "round-tripping" by loaning cash to the foreign subsidiary to fund the repatriated Sec. 965 dividends back to the U.S. parent. As such, dividends paid by the foreign subsidiary that would otherwise be eligible for a deduction under Sec. 965 are reduced by any increase in related-party indebtedness during the Sec. 965(b)(3) testing period. The testing period begins on Oct. 3, 2004, the effective date of Sec. 965, and ends on the last day of the U.S. parent's tax year in which the dividend was paid. The testing date with regard to the dividends paid by BSEH to BMC ended March 31, 2006.
On Nov. 27, 2007, under Rev. Proc. 99-32, BMC and the IRS executed an unrelated transfer-pricing closing agreement that resulted in the creation of two accounts receivable in favor of BMC, payable by BSEH. The closing agreement provided that the accounts receivable had establishment dates of March 31, 2005, and March 31, 2006. The transfer-pricing closing agreement did not outline any impact the agreement had on Sec. 965(b)(3).
In 2011, the IRS issued BMC a notice of tax deficiency of approximately $13 million for the 2006 tax year on the grounds that the accounts receivable established under the transfer-pricing closing agreement between BMC and the IRS constituted related-party indebtedness that occurred during the Sec. 965(b)(3) testing period. As such, the IRS reduced BMC's Sec. 965 deduction in 2006 by the aggregate outstanding accounts receivable payable by BSEH.
BMC petitioned the Tax Court and challenged the IRS's position that the accounts receivable constituted related-party indebtedness; the Tax Court sustained the IRS's deficiency (BMC Software Inc., 141 T.C. 224 (2013)). BMC appealed the Tax Court's decision to the Fifth Circuit, which reversed and ruled in favor of BMC and primarily concluded that, though the accounts receivable were deemed to have been established during the Sec. 965(b)(3) testing period, they were not actually created until Nov. 27, 2007, after the testing period. The accounts receivable did not exist as of March 31, 2006, as required by the plain language of the statute. They were created and given March 31, 2005, and March 31, 2006, deemed establishment dates only to calculate accrued interest and correct the imbalance in BMC's cash account as a result of the adjustments made through the transfer-pricing closing agreement between BMC and the IRS.
The Hidden Meaning of BMC: IRS Authorities as Precedent
The IRS argued that the court should defer to Notice 2005-64, which supports the Service's position. Section 10.06 of Notice 2005-64 states "[a]ccounts payable established under Rev. Proc. 99-32 . . . in connection with section 482 adjustments are treated as indebtedness for purposes of section 965(b)(3)." Section 10.06 contains only this sentence, and the issue is not discussed in any other part of Notice 2005-64. The court rejected the IRS's position on the grounds that Notice 2005-64 is not afforded deference under either Chevron U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984), or Skidmore v. Swift, 323 U.S. 134 (1944).
Under Chevron, courts defer to an agency's construction of a statute the agency administers only if the issue is not addressed by Congress and the agency's construction is a permissible construction of the statute. The Supreme Court stated,
If Congress has explicitly left open a gap for the agency to fill, there is an express delegation of authority to the agency to elucidate a specific provision of the statute by regulation. Such legislative regulations are given controlling weight unless they are arbitrary, capricious, or manifestly contrary to the statute. [Chevron, 467 U.S. at 843]
The IRS conceded on brief and the Fifth Circuit agreed that Notice 2005-64 was not entitled to deference under Chevron. The court concluded that Section 10.06 of Notice 2005-64, which relates to the treatment of accounts receivable created in connection with Sec. 482 adjustments as related-party indebtedness, is directly contrary to the plain language of Sec. 965(b)(3). Because the statute is clear on its face, Congress spoke directly on the matter and left no gap for the IRS to fill by regulation or other guidance.
Under Skidmore, courts defer to an agency's construction of a statute only to the extent that the agency's construction is persuasive. The Supreme Court held that administrative interpretations,
while not controlling upon the courts by reason of their authority, do constitute a body of experience and informed judgment to which courts and litigants may properly resort for guidance. The weight of such a judgment in a particular case will depend upon the thoroughness evident in its consideration, the validity of its reasoning, its consistency with earlier and later pronouncements, and all those favors which give it power to persuade, if lacking power to control. [Skidmore, 323 U.S. at 140]
The Fifth Circuit in BMC Software held that the single sentence in Section 10.06 of Notice 2005-64 is not persuasive and is not afforded deference under Skidmore. Section 10.06 is entirely conclusory and contains no analysis or explanation for why accounts receivable created in connection with Sec. 482 adjustments are treated as related-party indebtedness for purposes of Sec. 965(b)(3). The lack of substance in Section 10.06 evidences a minimal thoroughness on the IRS's part in promulgating its interpretation of Sec. 965(b)(3) that, according to Skidmore, minimizes the usefulness of Section 10.06 to courts and litigants.
Finally, Skidmore refers to an agency interpretation's "power to persuade, if lacking power to control." Some IRS administrative guidance is binding on taxpayers and is not subject to Skidmore scrutiny, though it is mostly limited to temporary and final regulations. On the other hand, most IRS administrative guidance is only binding on the IRS, but not on taxpayers, including proposed regulations, notices, announcements, and various IRS Chief Counsel memoranda.This nonbinding guidance is useful to courts, litigants, and taxpayers to reach determinations on complicated tax issues, though such usefulness is limited to the guidance's level of explanation and analysis. Notwithstanding the guidance's persuasiveness, such guidance is never controlling.
In practice, IRS agents, revenue officers, and Appeals officers frequently cite authority that is not binding on taxpayers, including notices, the Internal Revenue Manual, and even actions on decisions. To the extent guidance is not supported by the Internal Revenue Code, Treasury regulations, or another legal basis, practitioners should scrutinize the IRS's position and arguments related to the issue at hand. Though the primary holding in BMC Software has limited relevance to the vast majority of taxpayers, it nonetheless stands as a firm reminder to practitioners of the weight that should be given to IRS guidance and how courts will treat it.
Mark Heroux is a principal with the Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.