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Closing Agreement Doesn't Preclude Reduction of Taxpayer's Dividends-Received Deduction (Parker Tax Publishing: October 4, 2013)

A corporation's dividends-received deduction was reduced as a result of increased related-party indebtedness between the corporation and its controlled foreign corporation. BMC Software Inc. v. Comm'r, 141 T.C. No. 5 (9/18/13).

BMC Software, Inc. is a U.S. corporation that develops and licenses computer software. It is the common parent of a group of subsidiaries that file consolidated federal income tax returns. It is also the parent of nonconsolidated foreign affiliates. BMC's wholly owned BMC Software European Holding (BSEH) was a controlled foreign corporation (CFC) under Code Sec. 956 for its tax year ending March 31, 2006.

After auditing BMC, the IRS determined that royalty payments from BMC to BSEH were not arm's length under Code Sec. 482. The IRS and BMC then entered into a closing agreement under Code Sec. 7121 making primary adjustments regarding the royalty payments. The primary adjustments increased BMC's income and required it to conform its accounts with secondary adjustments. BMC accomplished the secondary adjustments by electing to establish accounts receivable under Rev. Proc. 99-32 rather than treat the secondary adjustments as deemed capital contributions. BMC had previously repatriated funds from its BSEH in transactions unrelated to the royalty payments or adjustments. BMC claimed a corresponding one-time dividends-received deduction under Code Sec. 965. The deduction was subject to certain limitations, including a reduction for an increased related-party indebtedness between BMC and its CFC. BMC claimed the deduction before agreeing to the primary adjustments or establishing the accounts receivable. The IRS determined that the accounts receivable that were deemed established during the testing period constituted an increase in related-party indebtedness and disallowed a corresponding amount of the deduction. The IRS issued a deficiency notice and BMC filed a petition for redetermination with the Tax Court.

According to BMC, the reduction for related-party indebtedness applies only to transactions intended to finance dividends. BMC also asserted that the parties agreed in a closing agreement that BMC avoids any federal income tax consequences from establishing the accounts receivable. BMC also argued that the accounts receivable did not constitute related-party indebtedness.

The Tax Court sided with the IRS, holding that the related-party debt rule under Code Sec. 965(b)(3) does not apply only to increased indebtedness resulting from intentionally abusive transactions. Further, the court stated, the election under Rev. Proc. 99-32 allowed BMC to avoid the federal income tax consequences of a deemed capital contribution. The repayment is treated as a return of principal and interest for all federal income tax purposes. Finally, the court concluded that the accounts receivable are deemed established during the testing period and qualify as increased related-party indebtedness.

For a discussion of the Code Sec. 482 rules for allocating income and deductions among related corporations, see Parker Tax ¶241,597.

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