Tax Court Addresses Mismatched Effective Dates of Two TCJA Foreign Provisions

(Parker Tax Publishing September 2024)

The Tax Court resolved two issues of first impression involving the tax treatment of two related foreign dividend provisions where there was a mismatch in the effective dates of those provisions. The court (1) granted partial summary judgment to a corporate taxpayer and held that the taxpayer could claim a deduction under Code Sec. 245A for its Code Sec. 78 dividend income, and (2) agreed with the IRS that Code Sec. 245A(d)(1) limited the amount of related foreign tax credits that the taxpayer could claim with respect to those dividends. Varian Medical Systems, Inc. v. Comm'r, 163 T.C. No. 4 (2024).

Facts

Varian Medical Systems, Inc. (Varian) is the parent company of a consolidated group of medical device and software manufacturers. Varian operates through corporations in many different countries, at least some of which are controlled foreign corporation (CFCs). Varian and its CFCs are fiscal year taxpayers.

In 2017, the Tax Cuts and Jobs Act (TCJA) enacted Code Sec. 245A, which provides a dividends-received deduction (DRD) for certain dividends received by a U.S. corporation from certain foreign corporations. Given its formulation, the DRD had the potential to interact with then-existing Code Sec. 78, as in effect before the TCJA. Code Sec. 78 provided that, for taxpayers who claimed foreign tax credits, a specified amount (other than Code Sec. 245 amounts) was to be treated as a dividend received by such domestic corporation from the foreign corporation. TCJA also amended Code Sec. 78 to provide that amounts treated as dividends under Code Sec. 78 do not qualify for the DRD in Code Sec. 245A.

Under the TCJA, Code Sec. 245A applies to distributions made after December 31, 2017. However, instead of using the same effective date as Code Sec. 245A, the TCJA amended Code Sec. 78 for tax years of foreign corporations beginning after December 31, 2017, and tax years of U.S. shareholders in which, or with which, such tax years of foreign corporations end. Thus, for some taxpayers, this effective date mismatch created a window during which Code Sec. 245A was in effect, but the amendments to Code Sec. 78 were not.

Varian filed a consolidated federal income tax return for its fiscal year ending September 28, 2018 (2018 Year). On that return, Varian elected to claim foreign tax credits for foreign taxes that it was deemed to pay under Code Sec. 960 and was therefore required to "gross up" its taxable income under Code Sec. 78 by reporting a dividend of approximately $159 million. Varian also claimed a deduction of approximately $60 million under Code Sec. 245A in connection with the dividend it was treated as receiving under Code Sec. 78 from its first tier CFCs. Thus, relying on the effective date mismatch, for its 2018 year, Varian claimed the DRD under Code Sec. 245A for an amount it was required to treat as a dividend income under Code Sec. 78.

After examining Varian's tax return, the IRS issued a notice of deficiency in which, among other things, it disallowed Varian's Code Sec. 245A deduction and increased Varian's Code Sec. 78 dividend by nearly $1.9 million. The IRS further determined, in the alternative, that if Varian was entitled to a deduct its Code Sec. 78 dividend under Code Sec. 245A, then Code Sec. 245A(d) disallowed any foreign tax credits attributable to that amount.

Varian petitioned the Tax Court for a redetermination, alleging that the IRS's disallowance of its Code Sec. 245A deduction was erroneous. The Tax Court was asked to address two questions of first impression: (1) how do the two effective date provisions enacted by TCJA, and an existing provision (i.e., Code Sec. 78), interact; and (2) how does Code Sec. 245A actually apply?

The IRS argued that allowing Varian a deduction for its Code Sec. 78 dividend would produce an absurd result and an inappropriate windfall for a subset of taxpayers and would permit effectively both a deduction and a credit for foreign taxes. The IRS contended that, despite the disparate effective dates, Varian could not claim a deduction for its Code Sec. 78 dividend income because Code Sec. 245A permits a deduction only for dividends that are actually distributed (or treated as distributed) from earnings, and, in the IRS's view, Code Sec. 78 dividends do not satisfy this requirement. Alternatively, the IRS argued that Reg. Sec. 1.78-1, as amended June 21, 2019, disallowed the deduction.

Varian disagreed, arguing that the operative text of Code Sec. 245A permitted the deduction for its Code Sec. 78 dividend and that no other provision prohibited it. Varian also argued that Reg. Sec. 1.78-1 is invalid because it purports to apply amended Code Sec. 78 to a period starting before the effective date provided in the TCJA.

Analysis

The Tax Court granted both parties' motions in part. The court held that Varian was entitled under Code Sec. 245A to a deduction for amounts properly treated as dividends under Code Sec. 78 for its 2018 tax year, and Reg. Sec. 1.78-1 did not alter this conclusion because it could not contravene the clear statutory text. On the other hand, the Tax Court also sided with the IRS and held that Code Sec. 245A(d)(1) disallows foreign tax credits to the extent they are attributable to amounts Varian properly treated as dividends under Code Sec. 78 and deducted under Code Sec. 245A.

In the court's view, Congress appeared to have understood that, without some intervention, Code Sec. 78 dividends would be deductible under Code Sec. 245A and that is why it amended Code Sec. 78 to preclude the deduction. But, the court observed, Congress chose a later effective date for this amendment, allowing fiscal year taxpayers like Varian to deduct their Code Sec. 78 dividends for a limited time. This choice, the court said, stood in contrast to another express exclusion from Code Sec. 245A, which Congress crafted to take effect at the same time as the deduction. In other words, the court concluded that Congress knew how to draft a contemporaneous exclusion if it so desired. The court did agree, however, with the IRS's argument that if Varian was entitled to the deduction, Code Sec. 245A(d)(1) limited the amount of foreign tax credits Varian may claim.

With respect to the IRS's argument that allowing the deduction would produce an absurd result and an inappropriate windfall for a subset of taxpayers (i.e., taxpayers like Varian), the court said that an interpretation is absurd only if the result would be so gross as to shock one's general moral or common sense. The court found that the fact that its interpretation of Code Sec. 245A would reduce the amount of income tax owed by certain taxpayers did not mean that result was absurd. For example, the court observed that the Code is full of provisions that treat taxpayers differently, but that does not mean those provisions are absurd. The court concluded that general policy concerns (i.e., those that fall short of an absurd result) and speculation about congressional intent cannot override clear statutory language.

For a discussion of the taxation of U.S. shareholders of certain foreign corporations, see Parker Tax ¶201,500.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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