Last month, the Tax Court issued a second opinion in Varian Medical Systems, Inc. v. Commissioner, addressing collateral issues left unresolved by the court's earlier decision that the plain language of the effective date provisions of the Tax Cuts and Jobs Act (TCJA) entitled a fiscal year (FY) taxpayer to a section 245A dividends received deduction (DRD) for section 78 dividends the taxpayer was deemed to receive during a one-time "gap period." The court resolved both secondary issues in favor of the Internal Revenue Service (IRS), concluding that (1) a section 78 dividend deemed from a lower-tier foreign corporation cannot satisfy the holding period required for a section 245A DRD and (2) adopting the IRS approach to computing the amount of foreign tax credits (FTCs) disallowed under section 245A(d). See our coverage of the prior briefing here. 

In cross-motions for summary judgment, the IRS and the taxpayer disputed whether holding period rules in section 246 applied to disallow a section 245A DRD for section 78 dividends from lower-tier controlled foreign corporations (CFCs). As a threshold matter, the court "exercise[d] [its] discretion to overlook any potential forfeiture of the Commissioner's section 246 argument" in the earlier motion practice. On the merits, section 246(c) disallows a deduction for "any dividend on any share of stock," if that share of stock is "held by the taxpayer" for less than a specified period. The court interpreted "held by the taxpayer" to require the U.S. shareholder to directly own the relevant shares, and concluded that the U.S. shareholder did not directly hold the lower-tier CFC shares on which the section 78 dividend was paid. As a result, the taxpayer was permitted a section 245A DRD only for section 78 dividends attributable to foreign taxes paid by first-tier CFCs whose shares were directly held by the taxpayer for the requisite period. 

The court's conclusion on the meaning of "held" is challenging to reconcile with its conclusion that the U.S. shareholder received a dividend "on any share of stock," which is a precondition for the holding period rules applying in the first place. The court stated that section 78 treats the U.S. shareholder "as receiving the section 78 dividends directly from each CFC, and not indirectly through the chain of ownership," and therefore, the U.S. shareholder must have received dividends "on" shares of the lower-tier CFCs. The court further observed that a "defining characteristic of a dividend" is that "it is paid to a shareholder based on the shareholder's stock ownership." In essence, the court respected a fiction of direct ownership for purposes of concluding that the U.S. shareholder received a "dividend on any share of stock." However, the court then abandoned this fiction and adopted a literalist approach to conclude that the U.S. shareholder never "held" the shares on which it received the section 78 dividends. 

On the second issue, the IRS and Varian disputed the proper computation of FTCs disallowed under section 245A(d). In its prior opinion, the Tax Court held that section 245A(d) required a reduction in Varian's FTC for foreign taxes paid or accrued "with respect to" the section 78 dividend for which a DRD was allowed, and adopted a disallowance formula offered by the IRS on brief. In applying that formula, the IRS and the taxpayer disagreed over the meaning of "net section 965 inclusion." The court held that the "net section 965 inclusion" must reflect the section 965(a) inclusion amount reduced by the section 965(c) deduction, because all other elements of the formula reflect "post-section 965(c) amounts," and "[u]sing the post-reduction amounts for some parts of the formula but not others destroys the proportionate relationship between the amounts and results in a disproportionate (and much reduced) disallowance" of FTCs. Under the Tax Court's approach to FTC disallowance, the formula disallows a percentage of FTCs equal to the foreign effective tax rate on the underlying CFC earnings. 

This decision constrains the practical benefits of the first Varian holding, at least in the Tax Court. The court has directed the parties in a similar case, Sysco v. Commissioner, to address the impact of the second Varian decision on pending cross-motions for summary judgment on the same legal issues. Taxpayers litigating or auditing similar claims should reassess their exposure in light of the court's analysis and monitor whether these holdings are appealed or addressed in related cases.

For more information, please contact:

Layla J. Asali, lasali@milchev.com, 202-626-5866

Jeffrey M. Tebbs, jtebbs@milchev.com, 202-626-1480

Katherine Chace, kchace@milchev.com, 202-626-5894

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