In Varian Medical Systems, Inc. v. Commissioner, 163 T.C. No 4 (August 26, 2024), the US Tax Court held that a non-calendar corporation (the taxpayer) may claim a dividends-received deduction (an IRC Section 245A DRD) for a portion of its mandatory repatriation tax inclusion under IRC Section 965 (i.e., the IRC Section 78 gross-up relating to that inclusion). Specifically, the Court found that a plain reading of the statutory text mandated different effective dates for IRC Section 245A and amended IRC Section 78, which allowed an IRC Section 245A DRD to be claimed during the "gap" period. In reaching this conclusion, the Court did not follow Treas. Reg. Section 1.78-1, which was amended in 2019 to modify the effective date of IRC Section 78.

The Court, however, also concluded that the taxpayer, under IRC Section 245A(d)(1), could not claim a foreign tax credit (FTC) for a portion of its deemed paid taxes to the extent attributable to the IRC Section 78 dividend.

Background

Before the enactment of the 2017 Tax Cuts and Jobs Act (TCJA), IRC Section 78 required a domestic corporation claiming an FTC to treat the taxes it was deemed to pay under then-IRC Section 902(a) or then-IRC Section 960(a)(1) as a dividend received from a foreign corporation for all purposes of the Code, other than IRC Section 245 (an IRC Section 78 dividend). The TCJA added new IRC Section 245A, which generally allows domestic corporations to deduct 100% of the foreign-source portion of any dividends received from a specified 10%-owned foreign corporation for distributions made after December 31, 2017.

In conjunction with the enactment of IRC Section 245A, the TCJA amended IRC Section 78 to, among other things, preclude a corporation from deducting the IRC Section 78 dividend under IRC Section 245A for "[tax] years of foreign corporations beginning after December 31, 2017, and … [tax] years of [US] shareholders in which or with which such [tax] years of the foreign corporations end." The TCJA also enacted IRC Section 965, which requires US shareholders to pay a one-time mandatory repatriation tax on the untaxed foreign earnings of certain specified foreign corporations, applicable to the last tax year of specified foreign corporations beginning before January 1, 2018.

The taxpayer and its CFCs were "fiscal-year" taxpayers, with the tax year relevant to the case ending on September 28, 2018 (the 2018 fiscal year). On its consolidated federal income tax return for the 2018 fiscal year, the taxpayer elected to claim an FTC for taxes that were deemed paid under IRC Section 960 with respect to its IRC Section 965 inclusion. As required by IRC Section 78, the taxpayer "grossed up" its taxable income in the amount of the deemed-paid taxes. The taxpayer claimed a deduction under IRC Section 245A for the IRC Section 78 from its CFCs.

Upon examination, the IRS disallowed the taxpayer's IRC Section 245A DRD for the IRC Section 78 dividend. The IRS alternatively determined that if the taxpayer could deduct the IRC Section 78 dividend, IRC Section 245A(d) would disallow any FTC attributed to that dividend. The taxpayer petitioned the Tax Court challenging the IRS's determination.

Court holdings

Claim for the IRC Section 245A DRD on the IRC Section 78 dividend

The Court determined that the IRC Section 78 dividend qualified as a "dividend received" within the meaning of IRC Section 245A. According to the Court, the statutory text of IRC Section 78 unambiguously treats the applicable amount as a dividend for all purposes of the Code (with the exception of IRC Section 245), and IRC Section 245A allows taxpayers to deduct the foreign-source portion of any dividend received from a specified 10%-owned foreign corporation. In making this determination, the Court agreed with the taxpayer that the different effective dates for IRC Section 245A and amended IRC Section 78 created a "gap" period (i.e., the period from January 1, 2018, through the last date in the taxpayer's 2018 fiscal year) during which the IRC Section 245A DRD was allowed for the IRC Section 78 dividend.

Importantly, the Court held that the IRS could not rely on its 2019 amendment to Treas. Reg. Section 1.78-1, which precludes an IRC Section 78 dividend received after December 31, 2017, from being treated as a dividend for purposes of IRC Section 245A. According to the Court, reliance on this rule would essentially give amended IRC Section 78 an effective date earlier than the one provided in the TCJA. In reaching this conclusion, the Court cited Loper Bright Enterprises v. Raimondo, 144 S. Ct. 2244 (2024), a recent Supreme Court ruling that requires courts to "exercise their independent judgment in deciding whether an agency has acted within its statutory authority." Applying the Loper Bright standard, the Court held that that Treasury, through Treas. Reg. Section 1.78-1 "impermissibly attempt[ed] to change an unambiguous provision of the statute [and] [a]s a result, the regulation f[ell] outside the boundaries of any authority that Congress may have delegated under [S]ection 245A or 7805."

For these reasons, the Court held that the taxpayer was eligible for the IRC Section 245A DRD for its IRC Section 78 dividend relating to the IRC Section 965 inclusion.

FTC limitation

IRC Section 245A(d)(1) denies an FTC under IRC Section 901 for any taxes paid or accrued "with respect to" any dividend for which a DRD is allowed. The Court noted that an IRC Section 78 dividend represented the share of a foreign corporation's earnings that were paid to a foreign country as taxes. By claiming FTCs for those taxes and including an IRC Section 78 dividend in income, the Court said, the taxpayer was treated as if it had received all the foreign earnings and directly paid the taxes. Thus, the Court found that foreign taxes that were treated as paid by the taxpayer were "with respect to" the IRC Section 78 dividend and were squarely within the IRC Section 245A(d) disallowance. Accordingly, the Court held that the taxpayer must reduce its FTC by the deemed paid foreign taxes attributed to the foreign earnings that were reflected in its IRC Section 78 dividend. In determining the disallowed portion of the FTC, the Court agreed with the IRS's calculation formula as expressed below:

Implications

The Court's ruling is significant for taxpayers with fiscal-year CFCs (including calendar-year taxpayers that have made a one-month deferral election under IRC Section 898(c)). Such taxpayers should consider filing protective or actual refund claims based on the IRC Section 245A DRD for the IRC Section 78 dividend (subject to the FTC disallowance). In light of the Court's application of the new Loper Bright standard to Treasury regulations, taxpayers may consider the ruling's impact on their tax controversy strategies.