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In Varian Medical Systems, Inc. and Subsidiaries v. Commissioner, 163 T.C. No. 4 (August 2024), the Tax Court had to determine whether the Petitioner-corporation was entitled to the 100% dividends received deduction (DRD) under Section 245A for dividends received from foreign subsidiaries including the amount treated as a gross-up for foreign tax credits in accordance with Section 78. The Tax Court held it was so entitled to treat the Section 78 amount as eligible for the Section 245A DRD and further held that Section 245A(d)(1) disallows foreign tax credits (FTCs) to prevent a "double benefit" from being realized by the taxpayer. In rendering its decision on the parties' cross motions for partial summary judgment, the Court explains the proper scope of Section 245A, the participation exemption enacted by Congress in the Tax Cuts and Jobs Act of 2017. The case also involved a detailed reconciliation of the transition tax rules and computations under Section 965. The case is further noteworthy since it was the first case to consider the validity of a Treasury Regulation after the Supreme Court's decision in Loper Bright which repealed the Chevron doctrine. See August, "Supreme Court Reels-In the Chevron Doctrine and Then Feasts at the Corner Post Cafe Courtesy of Messrs. Marbury-Madison, " Corporate Taxation (Sept/Oct 2024) (WESTLAW). In Varian Medical Systems, the Tax Court invalidated a long-standing regulation under Section 78 which the government argued precluded the taxpayer from benefitting from 100% dividends received deduction under Section 78 for a "gross-up" of foreign taxes paid with respect to Section 245A. While the proximate cause for the confusion in this area was the result of a statutory mismatch of the effective dates between Section 245A and amendment to Section 78, on a go-forward basis the confusion will be left to the computations and sourcing of income inclusions, distributions and basis adjustments. Yes indeed, TCJA 2017 in the cross-border context provides the tax advisor with a great deal of moving pieces to consider in order to assess predictable outcomes as well as issues in need of further guidance from the IRS in advising clients in this area.

Sections 245A and 965: The Benefit and Cost to Changing to a Hybrid Territorial System of Income Taxation

Section 245A, otherwise referred to as the "participation exemption", was enacted into law under the Tax Cuts and Jobs Act of 2017 (TCJA 2017). The benefits under Section 245A are limited to a domestic corporation owning 10% or more of the voting stock of a foreign corporation with respect to actual or deemed dividends received from the foreign corporation or subsidiary. Prior to TCJA 2017, the dividend from a foreign corporation was fully taxable unless the US shareholder was previously taxed on the associated income under subpart F in which case the dividend may be a non-taxable recovery of basis PTEP distribution under Section 959. But the enactment of the participation exemption in TCJA 2017 came at a substantial tax cost, Section 965.

Section 965 (as amended in the TCJA 2017) mandates certain foreign corporations make a one-time increase to their subpart F income equal to the greater of the post-1986 accumulated deferred foreign income as of November 2, 2017, or their post-1986 accumulated deferred foreign income (DFIC) as of December 31, 2017, each referred to as the “E&P measurement date.” All U.S. shareholders, as defined in Section 961(b), of foreign corporations must include their pro rata share of the deferred foreign income in gross in- come under subpart F income for the applicable “inclusion year”, i.e., its last taxable year beginning before 2018. A portion of each U.S. shareholder’s pro rata share of deferred foreign income is deductible; the amount deductible varies de- pending upon whether the deferred foreign income is held in the form of liquid or illiquid assets. The deduction results in a reduced rate of tax of 14% on DFIC held in liquid form and 7% for the balance of the DFIC amount. A corresponding portion of the credit for foreign taxes is disallowed, thus limiting the foreign tax credit to the taxable portion of the included income. The Section 965 inclusion amount needs to be separately tracked and accounted for in sourcing previously taxed earnings distributions along with other income inclusions for subpart F income, global intangible low-taxed income (GILTI) and Section 1248 inclusions. There's much more to this PTEP account tracking. See August, "Tracking the PTEP Account Footprints of the Controlled Foreign Corporation Monster: The Serice Issues PTEP Proposed Regulations", ___ Corporate Taxation ___ (March/April 2025 to be published shortly). As mentioned, Section 245A, allows U.S. corporations owning 10% or more of a foreign subsidiary’s stock to receive a 100% dividends deduction (Section 245A DRD) for foreign income sourced dividends from the foreign corporation other than dividends received from a passive foreign income company (PFIC) per Section 1297. While the income inclusion rule in Section 965 applied to all U.S. shareholders, the participation exemption benefit is limited to 10% U.S. shareholders which are domestic corporations. From an ordering standpoint, PTEP distributions are first sourced under subpart F and GILTI PTEP accounts.

Section 78, enacted in the Revenue Act of 1962, P.L. No. 87-834, provides that where a domestic corporation receives dividends from certain foreign corporations and such domestic corporation elects to claim foreign tax credits for any taxable year (see former Section 902(a)(1) or Section 960(a)(1)(C)), the domestic shareholder is treated as having also received a dividend equal to the taxes deemed paid by such foreign corporation. This increase for the foreign tax credit amount is referred to as the "gross-up" amount.

A Brief Summary of the Facts in Varian Medical Systems, Inc.

VMS is the domestic parent corporation of a consolidated group of medical device and software manufacturing companies headquartered in Palo Alto, CA. It is the world's leading manufacturer of medical devices and software for treating cancer and other medical conditions and employs over 11,000 people worldwide. Varian operates a number of controlled foreign corporations (CFCs) as part of its worldwide operations. For US corporate income tax purposes, VMS filed a consolidated income tax return for the year in issue, f/y/e September 30, 2018. The CFCs use the same fiscal year. VMS elected to claim FTCs it was deemed to pay under amended Section 960 by application of Section 960(b)(1). The dividend income under Section 78, including the "gross up" for the Section 960 amount, was reported at $159 million. VMS claimed a deduction of approximately $60 million under Section 245A based on the dividends it received from its "first tier" CFCs. The IRS issued a statutory notice of deficiency disallowing the claimed 100% DRD for the first tier CFC's deemed dividends and further increased VMS' Section 78 dividend by close to $2 million which last item was uncontested at trial. The Commissioner determined an income tax deficiency for the 2018 consolidated return tax year in the amount of $16.88 million under Section 965 (the transition tax). In particular, the IRS disallowed a deduction under Section 245A for $60.2 million under Section 78 and also increased the taxpayer's "foreign cash position" in computing an increased rate of tax (14% instead of 7%) under Section 965 which the taxpayer did not dispute. As an aside VMS is now an indirect, wholly owned subsidiary of Siemens Healthineers AG, a German company. In contrast in its Tax Court petition VMS claimed that it understated its deduction under Section 245A and that as a result of certain NOL carrybacks and carryforwards it had overpaid its US consolidated income tax liability by $22.7 million.

Issues Before the Tax Court in Varian Medical Systems, Inc. (VMS)

Two issues were before the Court: (i) the interaction of Section 78, a long-standing provision of the Code, with respect to dividends received from a foreign corporation and Section 245A DRD rule; and (ii) how does Section 245A apply? The Court answered both questions in its opinion. Since Section 245A applies to dividends received by a domestic corporation from a foreign corporation Section 78 would tie-in and the two provisions would be applied in tandem. In addition VMS was required to include as part of the dividend received the Section 78 foreign tax accrued or paid with respect to the dividend. While there was an FTC gross up, Section 245A, if applicable, would deny the taking of the credit since the dividend is 100% deductible, including the Section 78 gross-up amount. But there was a glitch in effective dates. The reform to Section 78 specially incorporating Section 245A did not commence until the succeeding taxable year of the Petitioner. Stated simply, the effective date "window" open to review by the Court was when Section 245A was already in effect but the amendments to Section 78 were not. During this "open window" period VMS received the dividends from the foreign corporations.

The IRS argued, in its motion for partial summary judgment under TC Rule 121(a), that despite different effective dates, Varian was precluded from claiming Section 245A deduction for the Section 78 dividend since Section 245A permits a deduction only for dividends actually distributed (or treated as distributed) under Section 245A and that Section 78 dividends do not meet this requirement or such outcome of disallowing the DRD is otherwise required under the pre-TCJA 2017 regulations to Section 78. Reg. §1.78-1. The Service further argued that if Section 245A overrode Section 78 that no FTCs would be allowable despite the gross-up for FTCs. Therefore, $6.4 million in FTCs claimed by Varian would be disallowed. The regulations to Section 78, adopted in 1965 (T.D. 6805) provided that "[a] section 78 dividend shall be treated as a dividend for all purposes of the Code, except that it shall not be treated as a dividend under section 245, relating to dividends received from certain foreign corporations, or increase the earnings and profits of the domestic corporation". The regulation also explained that Section 78 dividends are treated as received in the same taxable year in which the U.S. corporation (1) received the dividend of foreign earnings upon which it was deemed to pay foreign taxes or (2) included in its subpart F income amounts for which it had deemed paid foreign taxes under section 960. See Treas. Reg. § 1.78-1(d) (1965). VMS argued that the operative statute is Section 245A and permitted the 100% DRD without being adversely affected by Section 78 which was revised in TCJA 2017 to support VMS' position but with a mismatched effective date. VMS further argued that the regulation cited by the Respondent was invalid having been overridden by Congress in the plain meaning of the statute.

Tax Court's Holdings in Favor of Petitioner in Part and for the Commissioner, In Part.

VMS filed its petition in the Tax Court for a redetermination of the claims asserted in the statutory notice of deficiency. It further argued, for the first time, that the Section 78 dividend amount, including gross-up, qualified for the 100% DRD under Section 245A, was understated by approximately $100 million. The parties would then file cross-motions for partial summary judgment. The Tax Court announced to the litigants that it also wanted to be briefed on the impact of the U.S. Supreme Court's recent decision in Loper Bright Enterprises v. Raimondo, 144 S. Ct. 2244, 2273 (2024), overruling Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984)

The Tax Court did not struggle in arriving at its conclusions. First, VMS was entitled to its 100% participation exemption deduction for amount properly treated as dividends under Section 78 for its 2018 tax year. Second, the government's argument that such position would violate Reg. §1.78-1 was flawed and could not be construed in a manner which was in direct contravention with Section 245A as enacted into law by Congress. Third, the Court sided with the Commissioner that Section 245A(d)(1) disallows FTCs to the extent they are attributable to amounts the Petitioner treated as dividends under Section 78 and takes a 100% DRD.

The Court went through a detailed analysis of Section 245A and intersecting provisions including "coordinated statutory amendments" to other Code sections, such as Section 1248(j) which provides that "any amount received by the domestic corporation which is treated as a dividend by reason of this section shall [also] be treated as a dividend for purposes of applying Section 245A.” Also Section 964(e) provides that gain recognized by a CFC on the sale or exchange of stock in a foreign corporation may be recharacterized in part as dividend received by the CFC and that the deduction allowable under Section 245A shall be allowable to the ultimate US shareholder for the resulting subpart F income in the same manner as if such subpart F income were a dividend received by the shareholder from the CFC selling the CFC stock. The government also made arguments under Section 274(a)(4) and Section 261 to disallow the application of Section 245A, but such additional arguments were summarily rejected by the Court.

As to Loper Bright, supa, and the repeal of the Chevron doctrine, the Court rejected the government's view that the regulations under Section 78 precluded application of Section 245A. Under Skidmore v. Swift & Co, 323 US 134 (1944) analysis, the Court viewed the regulation was not the best view on the proper statutory interpretation to be given to Section 245A read in conjunction with Section 78 for the year in issue. The Court found that the government was attempting to change an unambiguous provision of the statute and there is no need for "gap-filling" by the IRS in arguing that a long-standing regulation should be granted deference let alone should be considered "the best" interpretation. The Court had an easy canvass to write out its disagreement with the Commissioner's position in light of Loper Bright. I think the "twist" here on why the Court spent time in this area was to alert the government that "old regulations" do not override the unambiguous statutory language of a later statute. Point made! There was no ambiguity as to the statutory language to the effective date of Section 245A and that the regulation under Section 78 cited by the Commissioner was essentially "out of time". There was no delegation of authority to the US Treasury to override the effective date stated for Section 245A.

THIS POST IS FOR INFORMATIONAL PURPOSES ONLY AND IS NOT INTENDED TO BE OR MAY OTHERWISE BE RELIED UPON AS LEGAL ADVICE.

August Tax Law, P.C.