On March 13, 2015, the United States Court of Appeals for the Fifth Circuit (the “Appeals Court”) reversed a decision of the United States Tax Court regarding the rules relating to the repatriation of earnings under Code §965.
Code §965 was a temporary statute permitting an 85% dividends received deduction in connection with the repatriation of earnings from a foreign subsidiary as long as the proper tests were satisfied. One test related to intercompany loans to foreign subsidiaries allowing them to pay the low-tax dividends. Even though the statute is not currently in effect, the reasoning of the Appeals Court suggests that substance will at times prevail, even if it works against the I.R.S.
BMC Software, Inc. (“BMC”) was a software developer that generated income from licensing operations. It had in effect a qualified joint cost-sharing agreement with a subsidiary. In 2002, the agreement was terminated and BMC began to pay royalties to the subsidiary in return for the transfer of rights back to BMC. In an I.R.S. examination, the arm’s length nature of the royalty amount was challenged and ultimately was resolved through two closing agreements entered into in 2007. The first determined that the amount of an arm’s length royalty was less than the amount paid. The second permitted BMC to treat the excess payment as a loan to the foreign subsidiary. This treatment, which has a long history in practice, was permitted under Rev. Proc. 99-32. As a result, the cash flow between BMC and its subsidiary was not changed but made to conform to the agreed amount of an arm’s length royalty, and the return of the cash would be tax-free but for some deemed interest.