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US: Related-party indebtedness, section 965 repatriation rules

US: Related-party indebtedness, repatriation rules

The U.S. Court of Appeals for the Fifth Circuit in March 2015 issued a decision, reversing a U.S. Tax Court opinion and concluding that an account receivable established pursuant to Rev. Proc. 99-32 does not constitute related-party indebtedness for purposes of the related-party debt rule of section 965(b)(3). Consequently, the taxpayer was not required to reduce its dividends eligible for the section 965 dividends received deduction.


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The case is: BMC Software Inc. v. Commissioner, No. 13-60684 (5th Cir. March 13, 2015)

Dividends received deduction

Section 965—enacted as part of the American Jobs Creation Act of 2004 in October 2004—provided a limited window (generally from 2004 through 2006) during which U.S. companies could repatriate earnings from their foreign subsidiaries at a reduced tax rate. 

Section 965 generally provided that U.S. companies could elect, for one designated tax year, an 85% dividends received deduction (DRD) for eligible dividends from their foreign subsidiaries.  As a condition for obtaining this special DRD, electing U.S. taxpayers were required to invest the repatriated earnings in permitted expenditures that were documented with reasonable detail and specificity in a domestic reinvestment plan.  Expenses and foreign tax credits allocable to the exempt portion of the dividend were disallowed.

Section 965(b)(3) provided a limitation to the benefits of section 965 when controlled foreign corporation (CFC) dividends were funded by loans from its U.S. shareholder or a related U.S. person. 

Specifically, the amount of dividends qualifying for the temporary DRD was reduced to the extent of any increase in indebtedness to the U.S. parent from its CFCs. To determine this reduction, taxpayers compared their “opening" (generally as of 3 October 2004) and “closing” (as of the end of the tax year for which the taxpayer elected to apply section 965) amounts of such related-party indebtedness.  If the closing balance exceeded the opening balance, then there would be a dollar-for-dollar decrease in the amount of dividends for which the taxpayer could claim the section 965 DRD.


The taxpayer paid royalties to its wholly owned CFC for the use of certain computer software. 

The IRS audited the taxpayer’s fiscal years ending 31 March 2002 through 31 March 2006, and determined that royalty payments from the taxpayer to the CFC were not at arm’s length under section 482.

In 2007, the taxpayer and the IRS entered into two closing agreements. 

  • Under the first closing agreement, the taxpayer agreed to increase its income for the relevant years (the primary adjustment). 
  • The second closing agreement reflected secondary adjustments to conform accounts. The taxpayer elected to make these adjustments by establishing interest bearing accounts receivable for each year pursuant to Rev. Proc. 99-32, rather than through a capital contribution, which would give rise to other tax consequences.  

During its 2006 fiscal year, the taxpayer also paid a series of dividends that qualified for the DRD under section 965. 

At issue was whether the interest bearing accounts receivable established through the 2007 closing agreement were “indebtedness” that resulted in a retroactive reduction to the allowable section 965 DRD.  

The Tax Court in a 2013 opinion held that an accounts receivable established under Rev. Proc. 99-32 may constitute increased related-party indebtedness for the purposes of the related-party debt rule in section 965(b)(3). The Tax Court found that the accounts receivable were deemed established during the section 965 testing period and reduced the taxpayer’s dividends qualifying for the DRD.

The taxpayer appealed.

Fifth Circuit's decision

In a unanimous decision overturning the U.S. Tax Court decision, the circuit court of appeals held that neither the text of section 965 nor the provisions of the Rev. Proc. 99-32 closing agreement (the “Closing Agreement”) warranted treating the accounts receivable created pursuant to Rev. Proc. 99-32 as “indebtedness” under section 965.

In reaching its conclusion, the Fifth Circuit found that the plain meaning of section 965(b)(3) required that related-party debt be in existence at the end of the year in which the taxpayer makes the section 965 election.  As the accounts receivable were established on 27 November 2007, pursuant to a Closing Agreement, the Fifth Circuit held they did not exist as of the close of the tax year in which the taxpayer made the section 965 election—i.e., 31 March 2006. 

The IRS argued that in the Closing Agreement, the parties had agreed to backdate the creation of the accounts receivable which would place them in the relevant section 965(b)(3) testing period.  The Fifth Circuit rejected this argument stating that:


…text of section 965(b)(3) requires that, to reduce the allocable deduction, there must have been indebtedness as of the close of the applicable tax year.  Because the accounts receivable were not created until 2007, [the taxpayer’s] § 965 deduction cannot be reduced under § 965(b)(3).


Notably, the circuit court of appeals also refused to grant weight to Notice 2005-64—one of three IRS notices that provide guidance on the application of section 965. Section 10.06 of Notice 2005-64 states, without support or analysis, that accounts receivable created under Rev. Proc. 99-32 “are to be treated as indebtedness for purposes of section 965(b)(3).”  The Fifth Circuit reasoned that the statement in Notice 2005-64 was conclusory, with no analysis on which the court could base reliance, particularly when the language was counter to what the court viewed as the plain language of the statute.   

The Fifth Circuit also noted that the Commissioner has since changed the IRS position in regards to Rev. Proc. 99-32 closing agreements in that it now explicitly outlines the section 965 tax consequences within such agreements.  The Closing Agreement that the taxpayer entered into did not reference section 965, and the appeals court concluded that the taxpayer thus did not contractually agree in the Closing Agreement to treat the accounts receivable as indebtedness for purposes of its section 965 deduction. The Commissioner’s argument in this regard was premised upon an introductory clause in the Closing Agreement which stated, “now it is hereby determined and agreed for federal income tax purposes" for the proposition that the parties agreed to back date the accounts receivable for all tax purposes.

The Fifth Circuit rejected “the Commissioner’s expansive interpretation of the boilerplate provision” noting that the Closing Agreement already enumerated the exclusive tax consequences of entering into the Closing Agreement and that the Commissioner’s interpretation adding additional consequences would be inconsistent with the taxpayer’s intent in entering into the agreement.  

KPMG observation

The BMC Software decision interprets a statutory provision that is not currently effective, and thus has limited direct application. The broader import of the decision is likely to be in the area of transfer pricing and the interplay between section 956 inclusions under Subpart F of the Code and the election by taxpayers to establish an account receivable under Rev. Proc. 99-32. 

Reg section 1.482-1(g)(3) requires a conforming adjustment—sometimes also called a secondary adjustment—whenever there is a primary transfer pricing adjustment under section 482.  Depending on the circumstance, the conforming adjustment is either a deemed dividend or a deemed capital contribution. Because these deemed transactions can result in unwanted tax consequences (e.g., withholding tax), taxpayers sometimes prefer to avoid this deemed transaction.  The regulations state that the deemed transaction can be avoided if the taxpayer repays the amount of the primary adjustment pursuant to an applicable revenue procedure (i.e., Rev. Proc. 99-32). 

As discussed above, the mechanism by which Rev. Proc. 99-32 functions is to deem the creation of an account receivable between the related parties involved in the controlled transaction that has been adjusted.  This account receivable is deemed to be created as of the last day of the year in which the transfer pricing adjustment falls, and is deemed outstanding until it is paid.  In circumstances when the account receivable is held by a controlled foreign corporation (CFC) of a U.S. taxpayer, the question arises whether this account receivable is an investment of earnings in U.S. property under section 956, and thus required to be currently included in income of the U.S. taxpayer under section 951(a)(1)(B). 

The Fifth Circuit determination that an account receivable created under Rev. Proc. 99-32 is not indebtedness for purposes of section 965, is at least supportive of the position that it is also not indebtedness for purposes of section 956.  Tax professionals have observed that this finding is helpful because taxpayers have generally taken a position consistent with the Fifth Circuit’s holding. As such, the decision is being seen as a welcomed development.


For more information, contact a KPMG tax professional in the United States:


Sean Foley | (202) 533-5588 |


Caren Shein | (202) 533-4210 |

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