Refund Opportunity for Fiscal-Year Taxpayers With International Footprint

19 Dec 2024 Refund Opportunity for Fiscal-Year Taxpayers With International Footprint

Authored by RSM US LLP, December 19, 2024

Refund opportunity

The Tax Court’s recent Varian decision may present a significant refund opportunity for taxpayers with the following characteristics:

i) a tax year that does not end Dec. 31;

ii) a section 965 mandatory repatriation tax or other Subpart F inclusion for the last taxable year which began before Jan. 1, 2018; and

iii) A section 965 deemed repatriation tax Subpart F income inclusion with respect to the income of a deferred foreign income corporation and with which there is a section 960 foreign tax credit attributable to the foreign taxes paid upon such income of the foreign corporation.

Pre-TCJA background

Prior to the Tax Cuts and Jobs Act of 2017 (TCJA), the income of foreign subsidiaries of US parent companies was subject to US tax – under our previous worldwide tax system — but US tax was generally deferred until dividended back to the US. There was an exception to this general rule of deferral in that certain types of passive or highly mobile income did not enjoy deferral from taxation, but rather was immediately taxed under the Subpart F rules.

Since 1918, the US has generally granted US taxpayers a tax credit for foreign income taxes paid. To the extent there are foreign taxes paid on income subject to immediate taxation under the Subpart F rules, there would generally also be a foreign tax credit on that as well, under section 960.

When a US parent corporation claims a foreign tax credit for the taxes paid by its foreign subsidiary, it must deem itself to be paid a dividend under section 78, generally equal to the amount of the foreign tax credit being claimed.

Illustration:

• US Parent (USP) owns 100% of Foreign Sub (ForSub).
• ForSub has $100 of income.
• ForSub pays $7 of tax to a foreign government for this $100 of income.
• USP has a $93 income inclusion under Subpart F.
• USP elects to claim a $7 foreign tax credit under section 960.
• USP must also include a deemed dividend amount of $7 as USP’s taxable income.

TCJA reform

One of the major goals of the Tax Cuts & Jobs Act of 2017 (TCJA) was to reform the international tax rules of the Internal Revenue Code (Code). In particular, there was a desire to move the US towards a territorial type of tax system, whereby the income of foreign subsidiaries of US parent companies would generally be exempt from US income tax.

Moving away from the old worldwide system and towards a new territorial system (AKA a participation exemption system) was accomplished by enactment of the section 245A DRD. That is, dividends received by a US corporation from a “specified 10-percent owned foreign corporation” would be eligible for a 100% DRD. The point of this was to not have a disincentive for US parent corporations to bring home the earnings and profits (E&P) of certain foreign corporations. (Another point of this was to not encourage new international businesses from having their parent corporation outside of the US via inversion or otherwise.)

However, Congress intended the new section 245A DRD to be the rule on a go-forward basis, for income of foreign subsidiaries earned after TCJA enactment. Congress did not want US parent companies of foreign subsidiaries to have a windfall whereby the accumulated E&P (earned prior to enactment of TCJA, but on which no US tax had been paid) would forever escape US taxation. Given that such taxpayers had anticipated eventually paying US tax on such amounts – there was deferral, after all, not permanent exclusion – to allow such accumulated E&P to be dividended back and receive a DRD would have been an inappropriate benefit to taxpayers so situated.

So, Congress enacted, as part of TCJA, the new section 965 deemed repatriation tax (AKA DRT, mandatory repatriation tax, MRT, and participation exemption transition tax) whereby a percentage of such accumulated E&P would be included in US parent’s taxable income, even though the cash might remain at the foreign subsidiary. This accomplished the goal of taxing these accumulated E&P.

Given that the section 965 tax was a type of subpart F inclusion, any foreign taxes paid on the accumulated E&P would be potentially eligible to have a section 960 foreign tax credit (FTC) claimed at the time of the section 965 inclusion. Furthermore, if credit were claimed, there would be section 78 deemed dividend to the US taxpayer, equal to the amount of foreign taxes deemed paid under section 960.

Policy insight: don’t DRD away Subpart F inclusions

Although the US in TCJA generally moved to a territorial tax system, it did not do so completely. Congress retained Subpart F as it existed prior to TCJA, and even expanded it to include a new category of income – Global Intangible low-taxed income (GILTI) income. And, as already explained, Subpart F was also expanded by enacting the section 965 tax. Congress made a specific decision to move to territorial taxation overall – hence the new section 245A DRD.

At the same time, Congress decided for certain limited categories of income to move more towards a pure worldwide tax system via these expansions of Subpart F. Thus, it would have been anomalous to allow a section 245A DRD for these various Subpart F inclusions. The whole point of an item of income giving rise to a Subpart F inclusion is to make the US tax system more “pure worldwide”-like than it otherwise would be; and the entire point of allowing a section 245A DRD is to make the system more territorial (i.e., less worldwide). There would be no point in creating immediate taxable income only to have it immediately deducted away.

And TCJA did not in fact result in Subpart F inclusions being immediately deducted away.

Subpart F inclusions are NOT dividends (although sometimes thought of as “deemed dividends”). That’s why the section 245A DIVIDENDS-received deduction may not be claimed upon a subpart F inclusion – including a section 965 inclusion. The inclusion is not a dividend and thus of course cannot generate a DIVIDENDS-received deduction.¹ Thus, the aforementioned anomaly of having a section 245A DRD subtract away Subpart F inclusions is completely avoided.

But DRD away section 78 dividends?

The section 965 inclusion is based on the E&P of the foreign subsidiary.² That E&P will generally be reduced by the amount of foreign taxes paid on such E&P.³ That E&P will generally be reduced by the amount of foreign taxes paid on such E&P. ⁴

So, given that there often will be a section 960 FTC affiliated with a Subpart F inclusion (including the section 965 inclusion), the US parent corporation would be at an advantage over another US corporation that operates by means of a foreign branch – unless section 78 deems there to be a dividend to the US parent equal to the amount of the section 960 FTC.

However, were a section 245A DRD allowed as to this section 78 dividend, then effectively section 78 would do nothing. That is, if the section 78 dividend were $X, and the section 245A on that amount were also $X, then it would be the same as if there were no section 78 dividend upon which one would have to pay tax.

This point is similar to the point above – it would have been anomalous to allow a section 245A DRD to wipe out Subpart F inclusions. However, section 245A does not do that as to Subpart F inclusions because Subpart F inclusions are not dividends.

Section 78 dividends are, however, dividends, and thus would have been eligible for the section 245A DIVIDENDS-received deduction.

Thus, Congress considered it necessary to disallow a section 245A DRD for section 78 dividends. Congress did this by amending section 78 to provide that the section 78 amount would be considered a dividend for all purposes of the Code – except for purposes of calculating the section 245A DRD.

So, what’s the issue?

There’s an effective date mismatch. The mismatch is between when the DRD is allowed and when the section 78 amount is considered a dividend This mismatch allows the DRD of section 78 amounts during the TCJA transitional period.

The TCJA made new section 245A effective for “distributions made after . . . Dec. 31, 2017.”⁵

But for taxable years beginning after Dec. 31, 2017, a section 78 dividend is not treated as a dividend for purposes of the section 245A DRD. But for years beginning prior to Jan. 1, 2018, a section 78 dividend is treated as a dividend for purposes of the section 245A DRD dividends-received deduction.

The effective dates line up for calendar-year companies. However, for any company that had a year beginning prior to Jan. 1, 2018, but ending after Dec. 31, 2017, the new section 245A DRD would have taken effect, but the amendment to section 78 – excluding a section 78 dividend from being a dividend eligible for a section 245A DRD – would not yet have taken effect.

That is, under the plain language of the relevant provisions of TCJA, fiscal-year (i.e., that did not have a taxable year ended Dec. 31, 2017) taxpayers get the unusual benefit of being able to DRD away their section 78 amount that one year. This was the position of Varian in the Tax Court, and this position triumphed – notwithstanding the Commissioner’s regulations, appeals to policy, and warnings of an absurd result.

Although the section 960 FTC can be limited under section 245A(d)(1), this decision often represents a significant opportunity for fiscal-year taxpayers with an international footprint.

Too late?

No, taxpayers are not too late to take advantage of the Varian decision.

The section 965 year of inclusion was “the last taxable year of a deferred foreign income corporation which begins before Jan. 1, 2018.”⁶

For some taxpayers, that year will already be closed by statute of limitation.⁷ However, many large corporate taxpayers will still have that year open because they agreed with the IRS to leave the year open.⁸

Furthermore, even if the year has closed, there still may be an opportunity for tax benefit. Most taxpayers with a section 965 liability made an election to pay that liability over the course of eight years.⁹ Such an election to pay the section 965 net tax liability over eight years seemingly includes paying the liability stemming from the section 78 dividend over eight years as well.¹⁰ A claim for credit or refund of an overpayment of tax must be paid within three years from the time the return was filed or two years from the time the tax was paid, whichever is later.¹¹

For taxpayers that made the election to pay over eight years, this will mean that a number of years are still open, or still have not even been filed yet.Furthermore, given that the eight-year payment plan backloaded most of the payments into the later years, a majority of the tax liability stemming from section 78 gross-up affiliated with the section 965 tax, means there is likely still opportunity to claim a significant benefit from the Varian decision.

[1] Varian Medical Systems, Inc. v. Commissioner (Tax Court, Aug. 26, 2024):As a general matter, subpart F income is not a dividend; rather it is simply an inclusion in gross income. See Rodriguez v. Commissioner, 137 T.C. 174, 177-78 (2011), aff’d, 722 F.3d 306 (5th Cir. 2013). Therefore, subpart F income does not qualify for a deduction under the terms of section 245A.

[2] Section 965(d)(2).

[3] Kevin W. Kaiser, Earnings and Profits Computation Case Study, The Tax Adviser n. 19 (Oct. 1, 2013) (“Note that foreign tax paid generally should be taken into account as a reduction to E&P whether or not the corporation claimed the foreign taxes as a credit under section 901 or 902.”)

[4] Section 275(a)(4).

[5] TCJA section 14101(f), 131 Stat. at 2192.

[6] Section 965(a).

[7] Section 6511(a) (“Claim for credit or refund of an overpayment of any tax … shall be filed by the taxpayer within 3 years from the time the return was filed …”).

[8] Sections 6511(c), 6501(c)(4).

[9] Section 965(h).

[10] Section 965(h)(6).

[11] Section 6511(a).

This article was written by Tony Coughlan, Mike Zima, Rob Schmidt and originally appeared on 2024-12-19. Reprinted with permission from RSM US LLP.
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