Tax Court addresses disallowance of DRD and FTC

The Tax Court held that a portion of a taxpayer’s Sec. 245A dividends–received deduction (DRD) was disallowed, and the formula used to compute the taxpayer’s Sec. 245A(d)(1) foreign tax credit (FTC) disallowance must include the post–Sec. 965(c) amount.

Background

In Varian Medical Systems, Inc., 163 T.C. 76 (2024) (Varian I), the Tax Court addressed two issues of first impression, both related to provisions of the Tax Cuts and Jobs Act (TCJA), P.L. 115–97.

First, the Tax Court considered two effective–date provisions, one that established when new Sec. 245A, added by the TCJA, would take effect and another that established when changes made by the TCJA to preexisting Sec. 78 would take effect. The court held, as argued by Varian, that the two effective–date provisions created a mismatch, the terms of which had to be respected. As a result, the court held that, for certain taxpayers, new Sec. 245A operated in tandem with the pre–TCJA version of Sec. 78 for a time and that Varian was one of these taxpayers. Therefore, for Varian’s 2018 tax year, the court concluded that the company was entitled to a Sec. 245A DRD related to gross–up amounts it included in income as a dividend under the pre–TCJA version of Sec. 78.

Second, the court considered, in light of this holding, whether new Sec. 245A(d)(1) limited the amount of FTCs Varian would be entitled to claim. It held, as argued by the IRS, that Varian’s FTCs would be limited.

Based on the Tax Court’s opinion, Varian and the IRS worked to compute Varian’s Sec. 245A DRD and its disallowed FTCs under Sec. 245A(d)(1). Disputes arose in that process, and the parties made cross–motions for summary judgment addressing those disputes.

For its part, Varian maintained that Sec. 246 allowed its claimed Sec. 245A DRD in full. Varian further contended that, in determining the amount of its FTC disallowance under Sec. 245A(d)(1), its net Sec. 965 inclusion must be determined without regard to Sec. 965(c). The IRS argued that Varian was not entitled to the full DRD and that it must include the post–Sec. 965(c) amount in the computation of its FTC disallowance amount.

The Tax Court’s decision

The Tax Court granted the IRS’s motion for summary judgment. The court held that Sec. 246 disallowed a part of Varian’s Sec. 245A DRD and that the formula used to compute Varian’s FTC disallowance under Sec. 245A(d)(1) must include the post–Sec. 965(c) amount.

As the Tax Court explained, Sec. 245A authorizes a deduction for the “foreign–source portion” of dividends received from “specified 10–percent owned foreign corporation[s].” However, Sec. 246 sets out certain rules that limit the deduction.

Specifically, Sec. 246(c)(1) provides that no Sec. 245A DRD is allowed in respect of any dividend on any share of stock “which is held by the taxpayer” for fewer than a specified number of days within a defined window that straddles the “ex–dividend” date. For purposes of Sec. 245A DRDs, Sec. 246(c)(5) modifies the holding period, increasing its duration and establishing that ownership thresholds set by Sec. 245A must be maintained at all times during the period.

There was no dispute that the shares of Varian’s first–tier controlled foreign corporations (CFCs) were held by a member of Varian’s U.S. consolidated group for the time required by Sec. 246(c)(1) as modified by Sec. 246(c)(5). Thus, Varian and the IRS agreed that the holding period was satisfied for those CFCs.

With respect to Varian’s lower–tier CFCs, however, the IRS noted that the shares were held at all times by intermediate foreign corporations. Thus, in the IRS’s view, Varian or a member of its U.S. group (the taxpayer, for purposes of Sec. 246(c)) did not hold the shares at all. As a result, the IRS argued, the holding period was not satisfied, and Varian could not claim the deduction with respect to its lower–tier CFCs.

Application of holding period

To determine whether Varian was entitled to the DRD for the lower–tier CFCs, the Tax Court looked to the statute’s text. It first addressed which shares of stock were at issue and then to the requirement that the shares be “held by the taxpayer.”

On any share of stock: The Tax Court determined that, based on the text of the pre–TCJA version of Sec. 78, the Sec. 78 dividends in dispute were dividends “on” the shares of Varian’s lower–tier CFCs. Per Sec. 78, an amount equal to the taxes deemed paid by a foreign corporation under Sec. 902(a)(1) or Sec. 960(a)(1)(C) is treated as a dividend received by the domestic corporation from the foreign corporation. Thus, under the terms of Sec. 78, an amount equal to the taxes paid by each CFC is treated as a dividend received “from the foreign corporation” — i.e., the one that paid the tax.

Because a Sec. 78 dividend represents the taxes paid by a particular CFC, each Sec. 78 dividend is “on [the] share[s] of stock” of the CFC whose taxes it represents for purposes of Sec. 246(c)(1). Thus, for the Sec. 78 dividends attributable to the lower–tier CFCs to be deductible, the shares of those CFCs must have been “held by the taxpayer” (Varian or a member of its U.S. group) for purposes of Sec. 246(c)(1).

Held by the taxpayer: The phrase “held by the taxpayer” is not defined by Sec. 246(c) or related provisions, but “the taxpayer” is defined in Sec. 7701(a)(14) as “any person subject to any internal revenue tax.” Also, although the Code does not provide a general definition of the term “held,” it does offer principles for calculating holding periods for certain items of property. The Tax Court found that of particular relevance in Varian’s case was whether the term “held,” as it is used in Sec. 246(c)(1), requires direct ownership or whether it can be satisfied by indirect ownership through another entity.

Citing a number of dictionary definitions, the Tax Court found the term “hold” is defined as “to have possession or ownership of” or “to possess by a lawful title” and stated that the Supreme Court has long recognized this meaning for “hold.” The court also found that “[a]n equally longstanding principle treats parent corporations and their subsidiaries as separate taxable entities,” noting that the Supreme Court has stated:

An individual shareholder, by virtue of his ownership of shares, does not own the corporation’s assets and, as a result, does not own subsidiary corporations in which the corporation holds an interest. A corporate parent which owns the shares of a subsidiary does not, for that reason alone, own or have legal title to the assets of the subsidiary; and, it follows with even greater force, the parent does not own or have legal title to the subsidiaries of the subsidiary. [Dole Food Co. v. Patrickson, 538 U.S. 468, 474–75 (2003) (citations omitted)]

Absent a specific statutory rule to the contrary, the Tax Court stated, these principles apply with the same force in the tax context. The court found that there was no contrary rule in Sec. 246(c); rather, in the court’s view, “the statutory clues we have are aligned with the Supreme Court’s holding.”

The Tax Court concluded that for the “reasons given by the Supreme Court,” the shares held by Varian’s foreign subsidiaries during the relevant period could not be treated as Varian’s assets and were not held by Varian or members of its U.S. group within the meaning of Sec. 246(c)(1). According to the court, if Congress had intended for the term “held” to include indirect ownership, it could have said so, as it did in at least 22 other instances in the Code and as it did in Sec. 246(c)(5)(B). It could have provided an aggregation or indirect-ownership rule or set out detailed ownership attribution rules. However, as the court pointed out, it did neither, simply requiring that the taxpayer must hold the shares. “In these circumstances,” the court stated, “indirect ownership through a foreign corporation does not suffice.”

FTC disallowance computation — Sec. 245A(d)

Sec. 245A(d)(1) provides in relevant part that “[n]o credit shall be allowed under section 901 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.” In Varian I, because Varian was allowed a deduction under Sec. 245A with respect to its Sec. 78 dividend, the Tax Court found that Sec. 245A(d)(1) required a corresponding reduction to its FTC. The amount of the reduction, the court had concluded, would be the amount of Varian’s deemed paid FTC that was attributable to the foreign earnings reflected in its deductible Sec. 78 dividend. The court expressed the amount of the reduction in an equation:

Disallowed FTC = Deemed paid FTC × [Sec. 78 gross–up ÷ (Net Sec. 965 inclusion + Sec. 78 gross–up)]

Varian and the IRS disputed the meaning of “net section 965 inclusion” in the equation’s denominator. Varian argued that the proper amount is the amount established in Sec. 965(a) (the “accumulated post–1986 deferred foreign income” of its CFCs), reduced by the amount established in Sec. 965(b) (the “aggregate foreign E&P [earnings and profits] deficit”) with respect to its CFCs. The IRS agreed with this computation as a starting point but argued that the resulting amount must be further reduced by the transition tax deduction under Sec. 965(c) (part of the mandatory repatriation tax regime) to arrive at Varian’s net Sec. 965 inclusion.

The Tax Court determined that the IRS was correct. It observed that in Varian’s proposed formula, all the numbers were the same as the numbers used in the IRS’s formula (the post–Sec. 965(c) numbers), except that the net Sec. 965 inclusion in the denominator was the full amount of the first–tier CFC’s Sec. 965(a) income inclusion, unreduced by Sec. 965(c). The Tax Court further observed that the Sec. 965(c) deduction is significant, constituting more than half of Varian’s Sec. 965(a) inclusion amount. Thus, its omission from the net Sec. 965 inclusion in the denominator drastically reduced the percentage of Varian’s disallowed FTCs, cutting them almost in half.

The Tax Court stated that it was “hard pressed to see any rationale for Varian’s approach, beyond achieving a more favorable result.” As the court noted, all the other amounts in the formula, as Varian and the IRS agreed, were the post–Sec. 965(c) amounts. The court found, “Using the post–section 965(c) amount for the net section 965 inclusion compares apples to apples and preserves a meaningful ratio; namely, that approach identifies the percentage of the already–reduced foreign taxes attributable to the already–reduced section 78 dividend.” Thus, the court concluded that using the pre–Sec. 965(c) amount for the net Sec. 965 inclusion created an inflated denominator and a meaningless ratio.

More specifically, according to the Tax Court, because of Sec. 965(c), the amounts relevant to the formula (the earnings of Varian’s first–tier CFCs and the related foreign taxes and Sec. 78 dividends) were each reduced by more than half. Thus, using the post–reduction amounts for some parts of the formula but not others destroyed the proportionate relationship between the amounts and resulted in a disproportionate (and much reduced) disallowance.

Reflections

Both Varian and the IRS claimed that the other had forfeited an argument because the arguments came too late. Varian claimed the IRS had forfeited its argument concerning Sec. 246, and the IRS claimed that Varian had forfeited its argument concerning Sec. 245(d)(1). The Tax Court, however, rejected both these claims and allowed the arguments to be made with respect to their cross–motions for summary judgment.

Varian Medical Systems, Inc., 166 T.C. No. 8 (2026)

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.