Under section 7121(a) of the Internal Revenue Code, the IRS is authorized to enter into a closing agreement with a taxpayer. Once a closing agreement is executed, it is “final and conclusive” and will be binding on both the taxpayer and the government in the absence of “fraud or malfeasance, or misrepresentation of a material fact.” I.R.C. § 7121(b). There are two types of closing agreements:
- Closing agreements that conclusively determine tax liability for a particular year or series of years; these are recorded on Form 866. Most closing agreements fit this model.
- There are also narrower closing agreements that resolve one or more specific issues; these are recorded on Form 906.
On November 22nd, the Tax Court issued an interesting decision dealing with the scope of a Form 906 closing agreement that offers some cautionary lessons for taxpayers and their representatives. Analog Devices, Inc. v. Comm’r, 147 T.C. No. 15, 2016 U.S. Tax Ct. LEXIS 32 (Nov. 22, 2016).
The taxpayer, Analog Devices, had a subsidiary that was a controlled foreign corporation. The subsidiary was organized in the Netherlands and based in Ireland; it was known as Analog Devices B.V. Analog Devices, 2016 U.S. Tax Ct. LEXIS 32 at *3. The subsidiary paid intercompany royalties to the taxpayer; those royalties were periodically reviewed and adjusted by the IRS under section 482 of the Code, which governs transfer pricing for related party transactions. Id. at *3-*4. An examination of the taxpayer’s returns for the 2001-2003 tax years resulted in a proposed increase in the royalty that the taxpayer accepted. Id. at *4-*5. The taxpayer filed an amended 2004 tax return to reflect the increased royalty rate, and the increase was also reflected in its 2005 return. The subsidiary paid the taxpayer the additional royalties in a series of payments in 2006. Id. at *5.
When the IRS makes a transfer pricing adjustment, secondary adjustments are generally necessary to conform the taxpayer’s accounts to reflect the adjustment. See Treas. Reg. § 1.482-1(g)(3)(i). These adjustments between the parties can be treated as either a dividend or a capital contribution. Id. Alternatively, the taxpayer may be able to treat the adjustments as an interest-bearing account receivable under Rev. Proc. 99-32, 1999-2 C.B. 296 (Aug. 23, 1999). Analog Devices did not elect this treatment for the adjustments for the 2004 and 2005 tax years. 2016 U.S. Tax Ct. LEXIS 32 at *5-*6.
In 2005, the taxpayer elected to repatriate cash from the subsidiary in part due to the availability of an advantageous dividends received deduction of 85% of the amount repatriated under section 965 of the Code. Id. at *6. To claim this benefit, the taxpayer filed a Form 8895 with its 2005 tax return; the form required the taxpayer to disclose the extent of its related party debt, because an increase in related party debt would limit the availability of the deduction. Id. at *6-*7. The taxpayer reported that it had no related party debt at the beginning and end of the relevant testing period, which ran from October 3, 2004 to October 29, 2005. Id. at *7.
Subsequently, the IRS commenced audits of tax years 2004 and 2005, which were later expanded to include 2006 and 2007. Id. During the examination, the IRS proposed a resolution that would have resulted in treating the additional royalty payments from the subsidiary as a constructive dividend. Id. at *8. In response, the taxpayer requested relief under Rev. Proc. 99-32, so that the additional royalty payments could be treated as interest-bearing receivables instead. Id. The IRS then issued a notice of proposed adjustment indicating that the taxpayer’s dividends received deduction should be reduced because the election under Rev. Proc. 99-32 increased related party debt; under section 965(b)(3) of the Code, an increase between October 3, 2004 and the close of the tax year for which the election under section 965 was made would reduce the available deduction. See I.R.C. § 965(b)(3). For Analog Devices, the relevant testing period ended as of October 29, 2005. 2016 U.S. Tax Ct. LEXIS 32 at *7.
The parties then entered into a closing agreement in May 2009. Id. at *9. The agreement contained a mixture of recitals, some of which were stock language from a pattern agreement, while others were negotiated by the parties. Id. at *10. The recitals were followed by a stock clause indicating that the parties agreed to be bound by the following provisions of the agreement for “all Federal income tax purposes.” That clause was then followed by specific determined clauses reciting the terms of the parties’ agreement. Id. at *10-*11. The determined clauses included both standard provisions and negotiated clauses; one of the negotiated clauses established a series of accounts receivable due to the taxpayer from its subsidiary for the additional royalty amounts. Id. at *11. Although the accounts receivable were not established until the agreement was signed, the agreement provided that each of the accounts receivable was deemed to be established as of the end of the particular tax year to which it applied. Id.
Almost three years later, the IRS issued a notice of deficiency indicating that a portion of the accounts receivable established under the closing agreement was related party indebtedness that triggered a reduction in the taxpayer’s dividends received deduction under section 965(b)(3) of the Code. Id. at *12-*13.
The Tax Court had previously dealt with the very same question, upholding the IRS’s position that a retroactive increase in related party debt under a closing agreement triggered section 965(b)(3). The Fifth Circuit, however, reversed, reasoning that the accounts receivable did not exist until the relevant closing agreement was signed and were consequently irrelevant. BMC Software, Inc. v. Comm’r, 780 F.2d 669, 674-76 (5th Cir. 2015), rev’g 141 T.C. 224 (2013). Accordingly, the Tax Court commenced its analysis with BMC Software.
Although the Fifth Circuit’s holding in BMC Software was not binding because the taxpayer’s appeal from an adverse determination would be to the First Circuit, the court acknowledged that it needed to reconsider its prior position. 2016 U.S. Tax Ct. LEXIS 32 at *23. After concluding that principles of stare decisis did not require that it follow its prior ruling, the Tax Court turned to the substantive merits.
The Tax Court commenced its analysis of the relevant closing agreement by reciting basic principles governing their construction. Initially, the court observed that a closing agreement is strictly construed to cover only the specific issues covered in the agreement and that recitals are not binding. Id. at *28 (citing Zanetz v. Comm’r, 90 T.C.753, 762, 766 (1988)). The court acknowledged, however, that recitals supplied relevant context that could be useful in determining the intent of the parties. Id. (citations omitted). The court commented that the parties’ intent was to be determined “from the four corners of the agreement where the contract is unambiguous; extrinsic evidence may be used to discern intent where the contract has ambiguities.” Id. at *29 (citing Rink v. Comm’r, 100 T.C. 319, 325 (1993), aff’d, 47 F.3d 168 (6th Cir. 1995)). The Tax Court also stressed the importance of context in construing a closing agreement. Id. (citations omitted).
Against that background, the court commenced its analysis of the parties’ agreement. While acknowledging that it had previously treated the introductory language indicating that the parties established accounts receivable “for all Federal income tax purposes” as creating related party debt relevant under section 965(b)(3), the Tax Court commented that it “did not consider the context in which the parties used [that language], which the rules of Federal common law contract interpretation require us to do.” Id. at *30. In assessing the context, the Tax Court first noted that the parties were drafting the agreement “against the backdrop of longstanding caselaw holding that ‘a court may not include as part of the agreement matters other than the matters specifically agreed upon and mentioned in the closing agreement.’” Id. (citing Zanetz v. Comm’r, 90 T.C. at 766). The court also observed that the parties had agreed to a specific recital that expressed their intent to limit the agreement to “certain issues identified below.” Id. at *31.
Turning to the specific phrase “for all Federal income tax purposes,” the court noted that was simply an introductory phrase and not part of the determined clauses; the court also emphasized that the language was not something the parties specifically agreed to adopt. Id. at *31-*32. In light of that background, the Tax Court concluded that “our giving the phrase ‘for all Federal income tax purposes’ a literal application would be to ignore our mandate to interpret a contract in context and would broaden the scope of the closing agreement beyond what the parties intended.” Id. at *33 (footnote and citations omitted).
The court also considered the implications of the actual determined clauses; here the court noted that the parties’ specific agreement dealt with the accounts receivable, the method for the subsidiary to pay them, and various tax implications. Id. at *34. The court also observed that the agreement did not discuss any tax consequences of establishing the accounts receivable and made no mention of section 965, a point that the Fifth Circuit had emphasized in BMC Software. Id. (citing BMC Software, 780 F.3d at 676-77).
The court ended its contractual analysis by concluding that the parties had manifested an intent to deal with the issues related to the section 482 transfer pricing adjustments and did not manifest an intent to address section 965(b)(3); the Tax Court reasoned that the specific clauses that the parties agreed upon “must be interpreted to limit the phrase ‘for all Federal income tax purposes.’” Id. at *34-*35.
After rebutting certain contentions of the dissent, the court turned to the question of extrinsic evidence. Here, the court flatly rejected the government’s efforts to demonstrate that the treatment of the accounts receivable as related party debt under section 965(b)(3) was covered by the agreement because the taxpayer was aware of the government’s position. In the court’s view, the extrinsic evidence confirmed that both parties were aware that section 965(b)(3) was an issue and elected not to address it. Id. at *41.
Finally, the court considered the effect of section 965(b)(3) in light of the parties’ agreement. Here, the Tax Court endorsed the Fifth Circuit’s position that indebtedness had to be in existence at the end of the tax year in which the section 965 election was made. Id. at *43 (citing BMC Software, 780 F.3d at 674-76). Consequently, the Tax Court concluded that the closing agreement had no impact on the taxpayer’s related party debt for purposes of section 965(b)(3), and the taxpayer prevailed.
The taxpayer in Analog Devices could not have anticipated the complications that lay ahead when it negotiated its closing agreement in 2009, as the initial decision in BMC Software was not issued until 2013. Looking forward, however, there are two lessons that the case provides for taxpayers and their representatives.
First, they should recognize that an issue-specific closing agreement may have implications for other issues that should be considered carefully in drafting the agreement. If issues are discussed with the government but are not resolved, a recital to that effect might prove helpful. Alternatively, a clause in the agreement indicating that the parties do not intend it to effect certain designated issues would promote clarity.
More generally, the case serves as a reminder that attorneys need to apply the same careful scrutiny to “boilerplate” terms in an agreement that they apply to the negotiated terms.