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The US Tax Court, in a unanimous panel decision, has held that a fiscal-year domestic corporation with an IRC Section 965 inclusion from fiscal-year controlled foreign corporations may claim an IRC Section 245A dividends received deduction (DRD) on the IRC Section 78 gross up on that inclusion. The court also held, however, that the taxpayer was required to reduce its US foreign tax credits for the taxes attributable to the gross up under IRC Section 245A(d)(1).

In Varian Medical Systems, Inc. v. Commissioner, 163 T.C. No 4 (August 26, 2024), the court found that a plain reading of the statutory text amending IRC Sections 245A and 78 authorized such a deduction for the relevant period and the IRS could not rely upon 2019 amendments to Reg. Section 1.78-1 to apply amended IRC Section 78 to a period before the statutory effective date.

IRC Section 245A(d) provides that no credit is allowed under IRC Section 901 for any taxes paid or accrued with respect to any dividend for which a DRD is allowed. The court sided with the IRS on requiring the taxpayer to reduce its foreign tax credit, finding that an IRC Section 78 dividend represents the share of a foreign corporation's earnings that were paid out to a foreign country as tax and have been effectively repatriated to the domestic corporation. By claiming foreign tax credits for those taxes, and including an IRC Section 78 dividend in income, the taxpayer is treated as if it received all of the foreign earnings and directly paid the taxes. The court found that because the taxpayer claimed a deduction under IRC Section 245A for its IRC Section 78 dividend, it must reduce its foreign tax credit by the amount that its deemed paid foreign taxes are attributed to the foreign earnings reflected in its IRC Section 78 dividend.

A Tax Alert is forthcoming.