Instead of agreeing to Schedule C concessions (see my blogpost “Stipulate, Don’t Capitulate”, 9/23/11) or failure to respond to a Rule 91 “facts deemed established” motion (see my blogpost “Stipulate, Don’t Capitulate – Part Deux”, 5/24/13), a Big Houston software outfit got hung up in a Section 482 transfer pricing settlement with IRS that winds up giving the hangee a $13 million deficiency.

Judge Kroupa, untangler of corporate tangles, gets this one: BMC Software Inc., 141 T. C. 5, filed 9/18/13.

BMC had a CFC, with which it developed software, and split up costs and sales territories. Then BMC killed the split and agreed to pay royalties to the CFC. Except IRS claimed the royalties weren’t arms’-length equivalents, and BMC capitulated, entering into a Section 7121 closing agreement, whereby BMC adjusted its gross income upwards to offset the claimed royalties to the extent not arms-length.

But that means the CFC’s income was less, so BMC had overpaid the CFC, and therefore BMC had to make secondary adjustments. BMC elected to treat the overpaid royalties as an account receivable from the CFC, rather than as a capital contribution to the CFC, per Rev. Proc. 99-32.

Judge Kroupa takes up the story: “To that end, petitioner and respondent entered into another closing agreement (accounts receivable closing agreement) that established for Federal income tax purposes interest-bearing accounts receivable from BSEH to petitioner. Respondent executed the accounts receivable closing agreement also…. The amounts of the accounts receivable corresponded to the amounts of the primary adjustments….

“The accounts receivable bore interest at the applicable Federal rate. The interest was deductible from [the CFC’s] taxable income and includible in petitioner’s taxable income.” 141 T. C. 5, at pp. 5-6.

The closing agreement provided that the CFC “will pay the account receivable, including interest thereon, by intercompany payment. Such payment will be free of the Federal income tax consequences of the secondary adjustments that would otherwise result from the primary adjustment; provided, the payment of the balance of the account, after taking into consideration any prepayment pursuant to section 4.02 of Rev. Proc. 99-32, is made within 90 days after execution of this closing agreement on behalf of the Commissioner.” 141 T. C. 5, at p. 6.

The CFC made the payment of the balance and interest on schedule.

Some years later, BMC had a mega-wad of cash offshore, parked in its CFC, so BMC wanted to take advantage of the Section 965 one-time tax-free dividend from a CFC. So BMC hauled back $721 million, and claimed it was all tax-free.

Except IRS claimed that the accounts receivable from the royalty settlement was related-party indebtedness, which reduces the tax-exempt part of the dividend from the CFC, thus the $13 million deficiency.

BMC claims Section 965(b)(3) doesn’t apply, as this deal isn’t an abusive transaction; in other words, that BMC didn’t fund the dividend from CFC. The royalty settlement took place years before, but within the timeframe when the accounts receivable would be considered related-party indebtedness.

But Judge Kroupa can’t find explicit language in Section 965(b)(3) limiting its scope to abusive deals. True, the statute gives Treasury power to enact regulations to prevent abuse, but that’s supplementary, not limiting.

Next, BMC claims the receivables weren’t debt. But IRS goes to Hank Black, law dictionarian. “Account receivable is defined as ‘[a]n account reflecting a balance owed by the debtor.’ Black’s Law Dictionary 18. Petitioner observed those requirements and included only the interest payments as income.” 141 T. C. 5, at p. 14. That’s debt.

Now for the magic language in the settlement agreement that the receivables deal “will be free of the Federal income tax consequences of the secondary adjustments that would otherwise result from the primary adjustment”.

Judge Kroupa: “Petitioner contends that the accounts receivable closing agreement precludes any further Federal income tax consequences resulting from the repayment. The accounts receivable therefore would be excluded when determining the amount of the dividend received deduction. Respondent contends that the accounts receivable closing agreement provision allows petitioner to substitute the tax consequences of the debt secondary adjustment for those of the deemed capital contribution secondary adjustments. Put another way, the accounts receivable would be established for all Federal income tax purposes with petitioner avoiding the consequences of the repayment for a deemed capital contribution. We agree with respondent.” 141 T. C. 5, at p. 16.

In other words, what BMC got was relief from capital contribution consequences and the chance to get its overpaid royalty money back tax-free, not a perpetual tax exemption. If BMC didn’t take the Rev. Proc. 99-32 route, it would have had to pay tax on the full amount it got back from the CFC when the royalty deal was blown up. It was the payback that was exempt from Federal tax consequences. And exempt because it was repayment of debt incurred during the period prohibited under Section 965(b)(3).

But it was still debt, and therefore not shielded by the tax-free one-time dividend.

Takeaway- The Law of Unintended Consequences applies to stipulations and settlements.