Sec. 245A dividends-received deduction allowed for Sec. 78 dividend

The Tax Court held that a taxpayer was entitled to take the Sec. 245A foreign dividends-received deduction for its Sec. 78 dividend during a gap period (created by an effective date mismatch for new Sec. 245A and amendments to Sec. 78 in the Tax Cuts and Jobs Act (TCJA), P. L. 115-97), in which both Sec. 245A and Sec. 78 (prior to amendment by the TCJA) applied. However, the court further held that the taxpayer must reduce its foreign tax credits by the amount of the Sec. 78 dividend it properly treated as a deduction under Sec. 245A.

Sec. 245A and Sec. 78

In 2017, Congress enacted the TCJA, which, among other things, added Sec. 245A to the Code. This section allows a domestic corporation a deduction for certain dividends received from foreign subsidiaries. Sec. 245A applies to “distributions made after … December 31, 2017. ”

Because the deduction under Sec. 245A applies to dividends received by a domestic corporation from a foreign corporation, it had the potential to interact with existing Sec. 78. As in effect before the adoption of the TCJA, Sec. 78 provided that, for taxpayers who claimed foreign tax credits, a specified amount of the credits “shall be treated for purposes of this title (other than section 245) as a dividend received by such domestic corporation from the foreign corporation.”

Congress recognized that new Sec. 245A might otherwise allow a taxpayer who claims foreign tax credits to deduct a dividend that Sec. 78 would have deemed the taxpayer to receive on account of those foreign tax credits. So it amended Sec. 78 in the TCJA to prevent this result by providing that, for purposes of Sec. 245A, Sec. 78 dividends will not be treated as received by a domestic corporation from a foreign corporation.

However, Congress did not use the same effective date for the amendments to Sec. 78 as it used for new Sec. 245A. Instead, it made amended Sec. 78 effective for “taxable years of foreign corporations beginning after December 31, 2017, and … taxable years of United States shareholders in which or with which such taxable years of foreign corporations end” (TCJA, §14301(d)).

The practical result of the effective date mismatch was that, for some taxpayers, including those with foreign subsidiaries with fiscal years, a gap period was created during which Sec. 245A was in effect but the amendments to Sec. 78 were not. Thus, during this window, these taxpayers could take a Sec. 245A foreign dividends-received deduction for deemed Sec. 78 dividends.

Background of the case

Varian Medical Systems Inc. is the parent company of a consolidated group of medical device and software manufacturers. Varian operates through corporations in many countries, some of which are controlled foreign corporations (CFCs). Varian and its CFCs are fiscal-year taxpayers. Varian’s 2018 fiscal year and that of its CFCs started on Sept. 30, 2017, and ended on Sept. 28, 2018. Varian filed a consolidated federal income tax return for the year.

Varian elected to claim foreign tax credits for foreign taxes that it was deemed to have paid under Sec. 960. As required by Sec. 78, Varian increased its taxable income by reporting a dividend of approximately $159 million. Due to the effective date mismatch between new Sec. 245A and the amendments to Sec. 78 in the TCJA, the company also deducted under Sec. 245A approximately $60 million in connection with the Sec. 78 dividend it was treated as receiving from its CFCs.

The IRS selected Varian’s tax return for examination. As a result of the audit, the IRS issued Varian a notice of deficiency in which, among other things, it increased Varian’s Sec. 78 dividend by nearly $1.9 million and disallowed the foreign dividends-received deduction Varian claimed under Sec. 245A for the Sec. 78 deemed dividend. The IRS further determined in the notice, in the alternative, that if Varian was entitled to deduct its Sec. 78 deemed dividend under Sec. 245A, then Sec. 245A(d) would disallow any foreign tax credits attributable to that amount. Varian challenged the IRS’s determinations in Tax Court.

In Tax Court, the IRS moved for summary judgment, arguing that, despite the effect of the disparate effective dates for Sec. 245A and the Sec. 78 amendments, Sec. 245A permits a deduction only for dividends that are actually distributed (or treated as distributed) from earnings. According to the IRS, Sec. 78 dividends do not satisfy this requirement, so Varian could not claim a Sec. 245A foreign dividends-received deduction for its Sec. 78 dividend. It also argued that Regs. Sec. 1.78-1, as amended June 21, 2019, aligned the effective dates of Sec. 245A and Sec. 78, so there was no gap period in which a fiscal-year taxpayer such as Varian was permitted to take a Sec. 245A foreign dividends-received deduction for Sec. 78 dividends.

In addition, the IRS argued, as it had determined in the notice of deficiency, that if Varian could take a Sec. 245A foreign dividends-received deduction for its Sec. 78 dividend, it must reduce its foreign tax credits by the amount of its deemed paid foreign tax that was attributable to the foreign earnings reflected in its Sec. 78 dividend.

The Tax Court’s decision

The Tax Court held that Varian was entitled to a Sec. 245A dividends-received deduction for its Sec. 78 dividend treated as received in its 2018 tax year and that Regs. Sec. 1.78-1 did not alter this conclusion. However, it further held that, under Sec. 245A(d)(1), Varian’s foreign tax credits were disallowed to the extent they were attributable to amounts that the company properly treated as a dividend under Sec. 78 and deducted under Sec. 245A.

Statutory analysis of Secs. 78 and 245A: The parties disagreed on whether Varian’s Sec. 78 dividend qualified as a dividend for purposes of Sec. 245A. To answer this question, the Tax Court determined that, under Supreme Court precedent, it was required to enforce the plain statutory text of Secs. 245A and 78.

The court found, under this approach, that before Sec. 78 was amended by the TCJA, it provided that Varian must treat the amount to which Sec. 78 applied as a dividend received from its foreign subsidiaries for all relevant purposes of the Code, and Sec 245A(a) provided a deduction for the foreign-source portion of any dividend received from such subsidiaries. Reading the statutes together, the court found that the “obvious conclusion” was that for 2018, Varian could deduct its Sec. 78 dividend. The court agreed with Varian that the amendments to Sec. 78 made by the TCJA, which otherwise would have prevented this result, did not apply to Varian’s 2018 tax year because the different effective dates for the new Sec. 245A and the amendments to Sec. 78 resulted in a gap period in which the Sec. 78 dividend could be deducted under Sec. 245A.

Regs. Sec. 1.78-1: As amended in 2019, the second sentence of Regs. Sec. 1. 78-1(a) states, “A section 78 dividend is treated as a dividend for all purposes of the Code, except that it is not treated as a dividend for purposes of section 245 or 245A, and does not increase the earnings and profits of the domestic corporation or decrease the earnings and profits of the foreign corporation.” Regs. Sec. 1. 78-1(c) provides that this sentence applies “to section 78 dividends that are received after December 31, 2017, by reason of taxes deemed paid under section 960(a) with respect to a taxable year of a foreign corporation beginning before January 1, 2018.”

This rule, the Tax Court reasoned, essentially gives the Sec. 78 amendments made by the TCJA an earlier effective date than was provided for in the TCJA and therefore would prevent Varian from deducting its Sec. 78 dividend under Sec. 245A. However, the Tax Court noted that the plain text of Sec. 78 clearly provided for the deduction, and as the Supreme Court has stated, “self-serving regulations ‘never justify departing from the statute’s clear text’” (Niz-Chavez v. Garland, 141 S. Ct. 1474, 1485 (2021)).

Applying the Supreme Court’s recent holding in Loper Bright Enterprises v. Raimondo, 144 S. Ct. 2244 follow an executive agency’s guidance (whether in a regulation or elsewhere) if it contradicted the statutory text, and that it was only allowed to follow the best interpretation of the statute, not merely a permissible interpretation of it. In this case, the court found that the IRS’s interpretation contradicted the statutory text and that not only the best, but also the unambiguous, reading of the provisions at issue permitted Varian’s deduction of the Sec. 78 dividend under Sec. 245A due to the effective date mismatch.

Sec. 245A(d) limits on foreign tax credits: Sec. 245A(d)(1) provides that a foreign tax credit is allowed “for any taxes paid or accrued (or treated as paid or accrued) with respect to any dividend for which a deduction is allowed under this section.” Accordingly, the IRS argued that if the Tax Court allowed Varian to deduct its Sec. 78 dividend under Sec. 245A, the company was required by Sec. 245A(d)(1) to reduce its foreign tax credits by the amount of its deemed paid foreign tax that was attributable to the foreign earnings reflected in its Sec. 78 dividend.

In response, Varian argued that Sec. 245A(d)(1) should be read as limiting foreign tax credits only for “taxes paid or accrued (or treated as paid or accrued) on any dividend.” Thus, Sec. 245A(d) was irrelevant to the company’s Sec. 78 dividend.

The Tax Court agreed with the IRS, concluding that Varian had misconstrued the meaning of the phrase “with respect to” in Sec. 245A(d)(1). The court found that the ordinary meaning of the phrase “with respect to” is “concerning” or “relating to.” Applying this meaning to “with respect to” in Sec. 245A(d)(1), the court determined, limits foreign tax credits so far as the deemed paid foreign taxes for which a taxpayer claims credits relate to the dividends for which a taxpayer claims a deduction.

The court found that Varian’s deemed paid foreign taxes “undoubtedly” related to its Sec. 78 dividend. A Sec.78 dividend, the court explained, is the share of a foreign corporation’s earnings that were paid out to a foreign country as tax and therefore never repatriated (or attributed) to the domestic corporation. By claiming foreign tax credits for those taxes and including a Sec. 78 dividend in income, a domestic corporation such as Varian is considered to have received all the foreign corporation’s foreign earnings and directly paid the tax on those earnings.

Therefore, for purposes of Sec. 245A(d)(1), the court held that the foreign taxes Varian was treated as paying were “with respect to” its Sec. 78 dividend. Consequently, the company was required to reduce the foreign tax credits it claimed in 2018 to the extent that they were attributable to deemed paid foreign taxes from foreign earnings reflected in the amounts it properly treated as a dividend under Sec. 78 and deducted under Sec. 245A.

Reflections

That Congress did not intend the result created by the effective date mismatch between the amendments to Sec. 78 and new Sec. 245A is evidenced by the fact that in January 2019, Rep. Kevin Brady, R-Texas, the chairman of the House Ways and Means Committee, released a discussion draft addressing various “technical and clerical corrections” related to the TCJA, which included a proposed fix for the effective date mismatch. However, Congress never acted on the proposal, and, citing the Supreme Court in Alexander v. Sandoval, 532 U.S. 275, 292–93 (2001), the Tax Court did not draw an inference from the congressional inaction.

Varian Medical Systems Inc., 163 T.C. No. 4 (2024)

Contributor

James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser’s tax technical content manager. For more information about this column, contact thetaxadviser@aicpa.org.