Background
As part of the Tax Cuts and Jobs Act (TCJA), Congress added section 245A, which provides a deduction for the foreign-source portion of any dividend received by a US shareholder from the shareholder’s specified 10-percent owned foreign corporation. Before amendment by the TCJA, section 78 (“Old Section 78”) provided that if a domestic corporation claimed foreign tax credits for any taxable year under section 902 and section 960(a)(1), an amount equal to the taxes deemed paid by such corporation for such taxable year “shall be treated” for purposes of the Code (except section 245) as a dividend received by such domestic corporation from the foreign corporation. After amendment by the TCJA, section 78 (“New Section 78”) provides that an amount equal to the foreign taxes paid under section 960(a) shall be treated for purposes of the Code (except section 245 and section 245A) as dividends received by the domestic corporation from the foreign corporation whose taxes are deemed paid. Section 245A applied to distributions made after December 31, 2017. New Section 78 applied to “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."
The taxpayer in this case, Varian Medical Systems, and its controlled foreign corporations (CFCs) were fiscal-year taxpayers. For the taxable year at issue, Varian's taxable year started on September 30, 2017, and ended on September 28, 2018 (“FY18”). During this taxable year, Varian elected to claim FTCs for foreign taxes that it was deemed to pay under section 960 and was therefore required to treat an amount equal to the foreign taxes paid as a dividend under section 78. During Varian’s FY18 taxable year, section 245A applied at the same time as Old Section 78. Accordingly, based on the unambiguous statutory effective dates and the overlapping application of section 245A and Old Section 78, Varian claimed a deduction under section 245A for the section 78 dividends from its specified foreign corporations.
To override the TCJA’s unambiguous statutory effective dates, Treasury and the IRS issued Treas. Reg. § 1.78-1(a), which provides, in pertinent part, that “[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”. Treas. Reg. § 1.78-1(c) states that this provision “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.” Thus, the regulatory effective date in the second sentence of Treas. Reg. § 1.78-1(c) contradicts the TCJA’s unambiguous statutory effective dates (described above).
The IRS audited Varian’s tax return and issued a Notice of Deficiency. The IRS disallowed Varian's claimed deduction under section 245A for its section 78 dividend. In the alternative, the IRS determined that if Varian was in fact entitled to deduct its section 78 dividend under section 245A, then section 245A(d) would partially disallow foreign tax credits attributable to that amount.
Analysis
The central issue in this case involved the attempt by Treasury and the IRS to override the unambiguous statutory effective dates in the TCJA. Applying Loper Bright, the Court determined that the best reading of the operative statutes meant that Varian could claim a dividends-received deduction under section 245A for the section 78 dividend that arose in connection with Varian’s section 965 transition tax. The Court also concluded that section 245A(d) applies to disallow a portion of the deemed paid taxes as an FTC.
Implications
Fiscal-year taxpayers who claimed foreign tax credits in connection with their section 965 transition tax should consider the potential to file a refund claim based on the application of the Tax Court’s opinion in Varian to their facts.
