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August 2024
The US Tax Court released its opinion in Varian Medical Systems Inc. and Subsidiaries v. Commissioner, 163 T.C. No. 4, on August 26, addressing Section 78 (the Section 78 Gross Up) and Section 245A. The Court held that (1) the taxpayer was allowed a dividends received deduction (DRD) under Section 245A with respect to an amount treated as a dividend under Section 78 for its final tax year beginning before December 31, 2017, based on the plain language of the effective date provisions in the 2017 tax reform act (the Act), and (2) a proportionate amount of deemed paid credits attributable to the Section 78 Gross Up was disallowed as a foreign tax credit (FTC) under Section 245A(d). Thus, each party’s motion for summary judgment in the case was upheld in part. Judge Toro authored the unanimous (13-0) reviewed opinion.
The decision in Varian is the latest case in which a court has held that statutory language enacted by Congress is clear and unambiguous and therefore cannot be overridden by a Treasury regulation, even when that regulation carries out Treasury’s interpretation of overarching policy concerns. Further, this decision is the first challenge to a Treasury regulation to apply Loper Bright Enterprises v. Raimondo, the recent Supreme Court decision that overturned the Chevron doctrine’s deference to agency regulations and may provide a framework for other ongoing challenges to tax regulations.
Taxpayers that owned foreign corporations with a fiscal year ending after December 31, 2017, may consider amending their transition tax year returns or seeking adjustments for open tax years to reflect the decision in Varian. In addition, when evaluating the potential impact, taxpayers should consider state taxes.
Varian, a domestic corporation with its principal place of business in California, owned various foreign corporations that constituted controlled foreign corporations within the meaning of Section 957(a) (CFCs). Varian and its CFCs were fiscal year taxpayers. For its tax year ended September 28, 2018, Varian claimed a ‘deemed paid’ FTC under Section 960 of approximately $159 million. In connection with claiming the deemed paid credit, Varian was required to include a ‘gross up’ amount under Section 78 in its taxable income. Under Section 78 this amount was treated as a dividend received by Varian from the CFCs. Varian then claimed a Section 245A DRD of approximately $60 million with respect to the Section 78 Gross Up.
The IRS disallowed the Section 245A DRD with respect to the Section 78 Gross Up and also argued that, if a Section 245A DRD were to be allowed, then a portion of the deemed paid FTCs associated with the Section 78 Gross Up would be disallowed under Section 245A(d).
Varian petitioned the Tax Court for a redetermination of the IRS’s adjustment and, ultimately, filed a motion for summary judgment. As part of its motion for summary judgment, Varian included not only the amount of the Section 78 Gross Up with respect to its first-tier CFC, but also the Section 78 Gross Up with respect to lower-tier CFCs. The IRS also filed a motion for summary judgment in support of its positions. As discussed below, the Court upheld each motion, in part, granting the Section 245 DRD with respect to the Section 78 Gross Up and disallowing a proportionate amount of the FTCs under Section 245A(d).
The taxpayer’s primary argument was based on the effective dates of the provisions enacted by the Act. Section 245A provides for a DRD with respect to the foreign-source portion of a dividend received from a foreign corporation after December 31, 2017.
Section 78, as it existed prior to the Act, provided that, where a taxpayer claims an FTC under Section 960, it must include the amount of such credit as a dividend for purposes of the Code, with certain exceptions. As part of the Act, Section 78 was amended such that the Section 78 Gross Up is not treated as a dividend for purposes of applying the Section 245A DRD. This amendment was effective for tax years of foreign corporations beginning after December 31, 2017.
On June 21, 2019, Treasury and the IRS amended Reg. 1.78-1(a), which provides that a Section 78 Gross Up is not treated as a dividend for purposes of applying the Section 245A DRD, effective for Section 78 Gross Ups received after December 31, 2017, with respect to fiscal-year foreign corporations.
Based on the Act’s enactment dates, Varian argued that the amendment to Section 78 was not yet effective and thus not applicable for Varian’s foreign subsidiaries for its tax year beginning on September 30, 2017, and ending September 28, 2018, meaning any Section 78 Gross Up amount included in Varian’s income with respect to such CFCs still would be treated as a dividend for purposes of Section 245A. In taking this position, Varian argued that Reg. 1.78-1(a) was invalid with respect to its foreign subsidiaries for the tax year ended September 28, 2018.
The Tax Court agreed with Varian that the Section 78 Gross Up was considered a dividend for purposes of applying the Section 245A DRD for the tax year at issue. The Court believed it was clear that Congress had spoken to the issue with its enactment of specific effective dates and that the lack of a specific treatment of such amount as a dividend for applying the Section 245A DRD was not determinative. As discussed below, the Court also ruled that the amendment to Reg. 1.78-1 in 2019 did not alter its conclusion.
Observation: In response to the IRS’s policy concern of allowing a Section 245A DRD with respect to the Section 78 Gross Up, the Tax Court concluded any such policy consideration is not for the courts or an administrative agency to address, but for the legislature to remedy. Given that Congress directly spoke on the effective dates in this case, the Tax Court stated, “appeals to policy and Congress’s overarching purpose cannot overcome these choices, no matter how much the Commissioner may dislike them.” This position may inform challenges to other regulations promulgated by Treasury following the enactment of the Act where Treasury cited broad policy purposes, such as the denial of the Section 245A DRD in the context of extraordinary disposition and extraordinary reduction transactions. Further, the decision may renew Congressional interest in technical corrections (including technical corrections to effective dates).
On June 28, 2024, the Supreme Court overruled Chevron and provided a new standard for administrative agency rulemaking in Loper Bright. As the Court put it: “[i]n the business of statutory interpretation, if it is not the best [reading], it is not permissible.” Applying principles of statutory construction and this new standard set forth in Loper Bright, the Tax Court determined that Treasury’s regulation impermissibly attempted to change the clear and unambiguous effective dates of the Act. In other words, the Tax Court did not find the regulation to alter its conclusion based on the plain meaning of the legislative language.
Observation: This is the Tax Court’s first opinion applying the standard set forth in Loper Bright clearly indicating that it is the Court’s role to analyze what is the best interpretation of a statute, rather than deferring to what may be a permissible reading in a regulation. Moreover, the Tax Court did not view the grant of regulatory authority in Section 245A(g) as sufficient to overrule the plain meaning of the statutory text. This decision, therefore, could be significant with respect to ongoing validity litigation in which the IRS is claiming regulatory authority based on a grant of authority to issue “regulations or other guidance as may be necessary or appropriate to carry out the provisions of this section” or similar language.
Observation: Fundamentally, the issues in Varian arose from a clear mismatch in the effective dates with respect to Sections 78 and 245A. The mismatch presented in Varian is not unique. There are a number of provisions of the Act where the plain language of the statute may yield a result contrary to Treasury’s interpretation of the intended policy of the provisions. Many of these cases were identified in a proposed technical corrections bill that was not enacted. The Varian decision is not surprising considering the unambiguous statutes at issue and could suggest that the government could timely pursue technical corrections in lieu of regulations to address statutory issues.
Section 245A(d) provides that a taxpayer is disallowed an FTC for any taxes paid or accrued with respect to any dividend for which a Section 245A DRD is allowed. The IRS argued that if Varian were to be allowed a Section 245A DRD, then a related portion of the deemed paid taxes under Section 960 should be disallowed under Section 245A(d).
The Tax Court agreed with the IRS that Section 245A(d) applies to disallow a portion of the deemed paid taxes as an FTC. The Court indicated that the deemed paid foreign taxes under Section 960 undoubtedly relate to the Section 78 Gross Up and, accordingly, such foreign taxes are paid ‘with respect to’ the Section 78 Gross Up.
In determining the amount of the FTCs disallowed, the Tax Court ruled that the foreign taxes deemed paid under Section 960 are disallowed in the same proportion as the Section 78 Gross Up compares to the total shareholder income inclusion (i.e., the sum of the Section 965 inclusion and the Section 78 Gross Up).
Observation: The Tax Court appears to have granted the Section 245A DRD to a Section 78 Gross Up from lower-tier CFCs. Thus, the Tax Court may not view a Section 78 Gross Up with respect to a lower-tier CFC any differently from a first-tier CFC.