In August 2024, the Tax Court in Varian Medical Systems Inc., v. Commissioner, 163 T.C. 76 (“Varian I”), held that Section 78 dividends do in fact qualify as a “dividend received” within the meaning of Section 245A and are therefore deductible by a U.S. shareholder under Section 245A(a). That opinion, however, determined that Section 245A(d)(1) disallows foreign tax credits (FTCs) for foreign taxes paid “with respect to” a dividend for which a deduction is allowed under Section 245A. The Tax Court adopted a formula to calculate the FTC disallowance that was proposed by the IRS during briefing in the litigation:
Disallowed FTC = Deemed paid FTC x (Section 78 gross up / (Net Section 965 inclusion + Section 78 gross up))
Then on April 8, 2026, the Tax Court issued a second opinion (“Varian II”) addressing the interplay of Section 246(c) and Section 245A, an issue that arose after the August 2024 opinion. Under Section 246(c), no deduction is allowed under Section 245A for dividends (including Section 78 dividends) on any share of stock that is “held by the taxpayer” for less than the prescribed holding period. The Tax Court in Varian II determined that “held by the taxpayer” requires direct ownership by the U.S. shareholder of controlled foreign corporation (CFC) stock; therefore, the holding period requirement of Section 246(c) cannot be met when a U.S. shareholder indirectly holds CFC stock. Thus, no Section 245A deduction is allowed for Section 78 dividends arising from lower-tier CFCs.
The FTC Disallowance Formula Does Not Apply
Section 245A(d)(1) disallows credits for foreign taxes paid or accrued (or treated as paid or accrued) for any dividend for which a deduction is allowed under that section. By holding that the Section 78 dividend qualifies as a dividend received, this limitation of the credit could apply. In Varian I, the Tax Court devotes only two paragraphs of reasoning in concluding that the FTCs must be reduced under Section 245(d)(1) in the context of Section 78 dividends. In a nutshell, the Tax Court determined that, because Section 78 dividends are attributable to foreign taxes paid by the CFC to the foreign taxing authority and the U.S. shareholder receives an FTC in that amount (because it is deemed to pay them via application of Section 901), those foreign taxes are paid “with respect to” the Section 78 dividend. As a result, the portion of FTCs that “relates to” the Section 78 dividend is disallowed.
However, there are no foreign taxes paid or accrued (and none should be treated as paid or accrued) on Section 78 dividends. Section 78 dividends result only after the application of the U.S. tax code—foreign countries do not recognize Section 78 dividends. In our view, to disallow FTCs under Section 245A(d)(1) for taxes paid “with respect to” a dividend, the taxes must have been paid to the foreign taxing authority because of the dividend and because of the dividend’s status as a dividend under foreign law. The Tax Court in Varian I took an overly broad view of the phrase “with respect to,” concluding that Section 245A(d)(1) limits FTCs when the deemed paid foreign taxes for which a taxpayer claims credits “relate to” the dividends for which a taxpayer claims a deduction (i.e., Section 78 dividends). In our view, a mere “relationship” between the Section 78 gross up and deemed paid foreign taxes should not be enough to consider foreign taxes as being “with respect to” Section 78 dividends.
The Varian I decision did not consider relevant Treasury Regulations prohibiting allocation of foreign taxes to foreign income that is not taxed under foreign law. Treasury Regulations Section 1.245A(d)-1 provides detailed rules to disallowing FTCs for foreign taxes “attributable to” dividends for which a Section 245A deduction is claimed. That regulation expressly incorporates the foreign tax allocation rules set forth in Treasury Regulations Section 1.861-20(f), which is captioned “Allocation and apportionment of foreign income taxes” and provides a clear rule prohibiting the attribution of foreign taxes to income that is not taxed in the foreign jurisdiction:
If foreign law, including by reason of an income tax convention, exempts certain types of income from tax, or if foreign taxable income is reduced to or below zero by foreign law deductions, then no foreign income tax is allocated and apportioned to that income.
Foreign tax is not imposed on Section 78 dividends; it is imposed on earnings that underlie a Section 78 dividend, which is not the same as saying foreign taxes are imposed on Section 78 dividends. We note that this regulation applies for tax years beginning after December 31, 2019, but regardless of the effective date, it supports the broader principle that foreign taxes cannot be attributable to income that doesn’t exist under foreign law. Moreover, all the examples in Treasury Regulations Section 1.245A(d)-1(d) involve foreign withholding tax, something which is imposed, of course, only when the foreign country itself recognizes a dividend.
Section 246(c) Does Not Require Direct Ownership of CFC Stock
Section 246(c)(1) provides that a deduction is disallowed for “any dividend on any share of stock” if that share of stock is “held by the taxpayer” for less than a specified period. Of course, Section 78 dividends are “dividends” for purposes of this rule. According to Varian II, shares of lower-tier CFC stock are not “held by the taxpayer” because they are held by a higher-tier CFC. The court reasoned that the term “held” as it is used in Section 246(c)(1) requires direct ownership; if Congress had intended for the term “held” to include indirect ownership, it could have said so, as it does in other provisions throughout the Code. Under the Tax Court’s view, a U.S. shareholder cannot satisfy the Section 246(c) holding period requirement without holding the stock in the first place, and thus there is no Section 245A deduction for Section 78 dividends attributable to such lower-tier CFCs.
However, the Subpart F regime, including GILTI (a/k/a NCTI) and Section 965, taxes non-U.S. income no matter where earned in the foreign chain as long as there is a U.S. shareholder with ownership in a CFC. In light of the construct of the Subpart F regime, the term “held by the taxpayer” should not be construed to require direct ownership.
Treasury’s own explanation of Treasury Regulations Section 1.78-1 and the language of the regulation itself both refer to CFCs and U.S. shareholders generally and do not differentiate between lower-tier and upper-tier CFCs. For example, the Treasury Decision finalizing Treasury Regulations Section 1.78-1 states “[n]otably, the amount of a dividend eligible for a dividends-received deduction under section 245A is determined based on the amount of a foreign corporation’s ‘undistributed foreign earnings.’” Additionally, Treasury Regulations Section 1.78-1(c) states
[t]he second sentence of paragraph (a) of this section also 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.
In neither instance does Treasury contemplate that a direct holding of CFC stock is a prerequisite for a deduction under Section 245A. Instead, the clear concern of the Treasury is that fiscal year U.S. shareholders could claim a Section 245A deduction for Section 78 dividends of a foreign corporation, regardless of where those Section 78 dividends originate.
Moreover, Section 901 itself has a holding requirement for FTCs, which necessarily applies to indirect holding when the credit comes from lower-tier CFCs. Section 901(k)(2) requires all CFCs in a chain to be held for at least 15 days to entitle the U.S. shareholder to an FTC. Section 958(a) does not apply to that section, so the “holding” must refer to the U.S. shareholder’s indirect holding, which could be affected by acquisitions by CFCs up the chain.
For taxpayers impacted by the FTC disallowance formula or the multitier controlled foreign corporation FTC issue, please contact Brian Harvel at +1 404 881 4491 or Sam Kaywood at +1 404 881 7481.
If you have any questions, or would like additional information, please contact one of the attorneys on our Federal & International Tax team.
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