BMC Software – The Complexity of the Code

One of the irritating aspects of the Internal Revenue Code is the complexity its tax law interactions and its various provisions. BMC Software Inc. v Comm., 141 TC No. 5 (2013) illustrates this point. BMC and its European Holding Company entered into a cost sharing arrangement (“CSA”) to develop computer software.

Later, in 2002, BMC took sole ownership of the software. The IRS audited the CSA and increased the income of BMC Software by $102 million. BMC and IRS entered into a closing agreement, agreeing to that figure. Here is where the interaction of the various provisions of the Code provides some complex interactions. The increased income was the result of the adjustment to the royalty payments by BMC to its European Holding Company for its interest in the software. BMC had to make an adjustment to its accounting records.

One-half of the accounting adjustment reflects the increase to its income. BMC could have elected to treat the other half of the accounting adjustment as a contribution to capital or as an account receivable. BMC chose the later alternative and entered into another closing agreement with IRS for its choice. During the period, BMC repatriated $721m of dividends at a time when the IRC §965 temporary dividends received deduction (“TDRD”) was applicable. This temporary provision permitted BMC to deduct from its income 85% of the dividends received in excess of average indebtedness. The term average indebtedness was defined to be the average of indebtedness from October 3, 2004 to the date of BMC’s election to utilize the TDRD under §965. The TDRD was designed to encourage the repatriation of funds from overseas operations to the United States. The public policy goal was that the repatriated funds would spur job growth and capital investment. The increase in the amount of indebtedness created by the receivable constituted indebtedness for purposes of §965. This increase in total indebtedness for the testing period made average indebtedness a higher figure.

This higher average meant a lesser amount would qualify for TDRD. BMC argued that the account receivable was created in 2007, a year after repatriation in 2006 and therefore should not increase average indebtedness in 2006. The court rejected that argument and held the creation of the account receivable was for the years in the test period. BMC also argued that the related party debt rules §965(b)(3) were meant to apply to abusive situations only. This argument was also rejected. The result was a reduction in the TDRD by $36.9m and a tax increase of $12.9m. Two points are worth noting. First, the interaction of the various tax law provisions is complex. Although the TDRD expired, we suspect others will find this case to be a reason not to repatriate funds. Second, our tax system encourages those companies with active businesses overseas to invest and reinvest through those foreign companies. Active income, in the most general terms, is not Subpart F income; therefore it is not subject to tax until repatriated. Looking at the economic opportunities around the world, it is easy to understand the tax reasons why funds are not repatriated.