Eaton Corporation and Subsidiaries v. Commissioner , 152 T.C. No. 2 ( 2019 )

152 T.C. No. 2
UNITED STATES TAX COURT
EATON CORPORATION AND SUBSIDIARIES, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 28040-14. Filed February 25, 2019.
This case is before us on cross-motions for partial summary
judgment. The issue is whether the earnings and profits (E&P) of the
upper tier controlled foreign corporation (CFC) partners of Eaton
Worldwide LLC (EW LLC), a domestic partnership, must be
increased as a result of the partnership’s I.R.C. sec. 951(a) income
inclusions.
P contends that EW LLC’s I.R.C. sec. 951(a) inclusions do not
affect the E&P of its upper tier CFC partners. Conversely, R
contends that the upper tier CFC partners increase their E&P to
reflect EW LLC’s I.R.C. sec. 951(a) inclusions.
Held: The E&P of upper tier CFC partners of a domestic
partnership, such as EW LLC, must be increased as a result of the
partnership’s I.R.C. sec. 951(a) income inclusions.
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Joel V. Williamson, Charles P. Hurley, John T. Hildy, Brian W. Kittle,
Geoffrey M. Collins, Christine S. Hooks, Rajiv Madan, Royce L. Tidwell,
Christopher P. Murphy, Nathan P. Wacker, Kevin R. Stults, and Christopher P.
Bowers, for petitioner.
John M. Altman, Ronald S. Collins, Jr., Eric P. Ingala, and Laurie A. Nasky,
for respondent.
OPINION
KERRIGAN, Judge: The Internal Revenue Service (respondent)
determined deficiencies in Federal income tax and penalties for the 2007-10
calendar taxable years (years in issue) of Eaton Corp. (Eaton or petitioner). This
case is before the Court on the parties’ cross-motions for partial summary
judgment. Unless otherwise indicated, all section references are to the Internal
Revenue Code (Code) in effect for the years in issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure.
Generally speaking, a controlled foreign corporation (CFC) that is a partner
in a domestic partnership must include in gross income its distributive share of
that partnership’s gross income, including income that the partnership included
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under section 951(a) with respect to any lower tier CFCs. According to
respondent the upper tier CFC partners must also increase their earnings and
profits (E&P) by such an amount. Adopting that approach, respondent contends
that the correct amounts to be included in petitioner’s gross income under sections
951 and 956 are $73,030,810 and $114,065,635 for tax years 2007 and 2008,
respectively.1
Petitioner, by contrast, contends that a domestic partnership’s section 951(a)
inclusions do not affect the E&P of its upper tier CFC partners. The primary issue
we must decide is whether the E&P of the upper tier CFC partners of Eaton
Worldwide LLC (EW LLC), a domestic partnership, must be increased as a result
of the partnership’s section 951(a) income inclusions.
Background
Some of the facts are stipulated and are so found. Eaton was a domestic
corporation with its principal place of business in Cleveland, Ohio, when it timely
filed its petition.
1
The parties have stipulated the amounts of the adjustments if the Court
upholds respondent’s position.
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I. Corporate Structure
During the years in issue Eaton was the parent of an affiliated group of
corporations (Eaton Group) that filed consolidated Federal income tax returns.
Members of the Eaton Group were 100% shareholders of foreign corporations that
were CFCs within the meaning of section 957. These CFCs collectively held
(directly or indirectly) 100% of the membership interests in EW LLC. The CFCs
that held membership interests in EW LLC during the years in issue were:
(1) Eaton Holding III S.a.r.l., (2) Eaton Finance N.V., and (3) Eaton B.V.
(collectively, upper tier CFC partners). Any adjustments to income under section
951(a) for the upper tier CFC partners would be made to the consolidated income
of the Eaton Group.
During the years in issue EW LLC owned equity interests in, and was the
sole U.S. shareholder of, several CFCs within the meaning of section 957(a)
(lower tier CFCs). EW LLC included in income under section 951(a) the
subpart F income earned by the lower tier CFCs and amounts calculated under
section 956 with respect to the lower tier CFCs. Because the upper tier CFC
partners were not U.S. persons under section 957(c), they were not U.S.
shareholders of the lower tier CFCs.
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The lower tier CFCs did not make any distributions of property to EW LLC
during 2007 and 2008. On March 16, 2007, EW LLC purchased all the issued and
outstanding common stock of AT Holdings Corp. (AT Holdings) from a third
party for $387,743,528. AT Holdings was a Delaware corporation, and its sole
asset was the stock of Argo-Tech Corp., also a Delaware corporation. EW LLC
thereafter owned 100% of the issued and outstanding common stock of
AT Holdings or its successor, Eaton Industrial Corp. For the purposes of applying
sections 951(a)(1)(B) and 956, EW LLC’s interest in AT Holdings constituted
U.S. property, which was treated as held by the upper tier CFC partners. Each
upper tier CFC partner was thus treated as holding an interest in U.S. property by
virtue of EW LLC’s ownership of AT Holdings.2
II. Tax and Financial Reporting
During the years in issue EW LLC, as the sole U.S. shareholder of the lower
tier CFCs, was required under section 951(a) to include in gross income its pro
rata share of the subpart F income generated by the lower tier CFCs and section
956 amounts with respect to the lower tier CFCs. The lower tier CFCs treated the
2
The parties do not dispute that, to the extent the upper tier CFC partners
have applicable earnings, the U.S. shareholders of the upper tier CFC partners
must include in income sec. 956 amounts based on the upper tier CFC partners’
holdings of AT Holdings stock.
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amounts thus included by EW LLC as previously taxed E&P under section 959(c).
EW LLC timely filed Forms 1065, U.S. Return of Partnership Income, for the
years in issue on which it reported income inclusions under section 951(a) with
respect to the lower tier CFCs.
During the years in issue EW LLC issued Schedules K-1, Partner’s Share of
Income, Deductions, Credits, etc., to the upper tier CFC partners reflecting their
distributive shares of its income inclusions under section 951(a). These
distributive shares have since been adjusted slightly following an analysis of EW
LLC’s capital accounts. The upper tier CFC partners excluded these amounts
from gross income and from the calculation of their subpart F income.
None of the upper tier CFC partners made any adjustments to their E&P
corresponding to their distributive shares of EW LLC’s income inclusions under
section 951(a). For all other items of income, gain, loss, deduction, or credit
reflected on the Schedules K-1, the upper tier CFC partners did make adjustments
to their respective E&P. The upper tier CFC partners likewise made no
adjustments to their respective bases in their partnership interests in EW LLC
corresponding to their distributive shares of EW LLC’s income inclusions under
section 951(a). For all other items of income, gain, loss, deduction, or credit
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reflected on the Schedules K-1, the upper tier CFC partners did make adjustments
to their respective bases in their partnership interests.
The consolidated financial position of Eaton Group and the consolidated
results of its operations and cashflows were reported in conformity with U.S.
generally accepted accounting principles (GAAP) for the years in issue. For
financial reporting purposes (but not for Federal income tax purposes) Eaton’s
consolidated financial statements included the results and cashflows of the upper
tier CFC partners, EW LLC, and the lower tier CFCs. Each of the upper tier CFC
partners prepared its unconsolidated financial statements and accounting records
in conformity with U.S. GAAP.
Discussion
I. Summary Judgment Standard
Summary judgment may be granted where the pleadings and other materials
show that there is no genuine dispute as to any material fact and that a decision
may be rendered as a matter of law. Rule 121(b); Sundstrand Corp. v.
Commissioner, 98 T.C. 518, 520 (1992), aff’d, 17 F.3d 965 (7th Cir. 1994). The
burden is on the moving party to demonstrate that there is no genuine dispute as to
any material fact and that he or she is entitled to judgment as a matter of law.
FPL Grp., Inc. & Subs. v. Commissioner, 116 T.C. 73, 74-75 (2001). Both parties
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have moved for partial summary judgment, and they agree that there exist no
genuine disputes of material fact regarding the question they have asked us to
decide. After reviewing the pleadings and the stipulation of facts and attached
exhibits, we conclude that a decision may be rendered as a matter of law.
II. Background Law
Subpart F was enacted in response to perceived abuses by U.S. taxpayers
through the use of CFCs. See Dougherty v. Commissioner, 60 T.C. 917, 928
(1973) (“In subpart F, Congress has singled out a particular class of taxpayers,
U.S. shareholders, whose degree of control over their foreign corporation allows
them to treat the corporation’s undistributed earnings as they see fit.” (Fn. ref.
omitted.)). The goal of subpart F is to tax currently specified earnings of CFCs
that are, in the aggregate, controlled by U.S. shareholders. Textron, Inc. v.
Commissioner, 117 T.C. 67, 73-74 (2001).
In the ordinary course foreign source income earned by a CFC is not subject
to U.S. taxation until it is repatriated in the form of a dividend or other distribution
to the CFC’s U.S. shareholders. Secs. 881 and 882; Dave Fischbein Mfg. Co. v.
Commissioner, 59 T.C. 338, 353 (1972); see also S. Rept. No. 87-1881, at 78
(1962), 1962-3 C.B. 703, 784. However, under section 951(a), a U.S. shareholder
must include in gross income for the current taxable year its pro rata share of
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certain items attributable to the CFC, regardless of whether any distribution was
made.
Sections 951(a)(1)(B) and 956 were intended “to prevent the repatriation of
income to the United States in a manner which does not subject it to U.S.
taxation.” H.R. Rept. No. 87-1447, at 58 (1962), 1962-3 C.B. 405, 462. The
Senate Finance Committee report noted that “[g]enerally, earnings brought back to
the United States are taxed to the shareholders on the grounds that this is
substantially the equivalent of a dividend being paid to them.” S. Rept. No. 87-
1881, supra at 88, 1962-3 C.B. at 794.
A CFC is a foreign corporation whose stock is more than 50% (in terms of
voting power or value) owned (directly, indirectly, or constructively) by U.S.
shareholders on any day during the corporation’s taxable year. Sec. 957(a). A
U.S. shareholder is a U.S. person who owns (directly, indirectly, or constructively)
10% or more of the total combined voting power of the foreign corporation’s
stock. Sec. 951(b). All of petitioner’s foreign subsidiaries are CFCs, and
petitioner is a U.S. shareholder under section 951(b).
Section 951(a) requires that a U.S. shareholder owning CFC stock on the
last day of the CFC’s taxable year include in gross income for the current taxable
year its pro rata share of certain items attributable to the CFC, regardless of
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whether any distribution was actually made. Generally, this includes both its
“subpart F income” and “the amount determined under section 956”. See sec.
951(a)(1). The amount determined under section 956
is the U.S. shareholder’s pro rata share of the lesser of two amounts:
(1) the excess of (a) the average amounts of the CFC’s investments in
U.S. property as of the end of each quarter of the taxable year over
(b) the CFC’s earnings and profits representing previous sec. 956
inclusions; or (2) the amount of the CFC’s “applicable earnings”, as
defined in sec. 956(b)(1), representing essentially the CFC’s current
and accumulated earnings and profits that have not already been
included in its U.S. shareholders’ gross incomes.
Rodriguez v. Commissioner, 137 T.C. 174, 176 n.3 (2011) (citing Boris I. Bittker
& Lawrence Lokken, Federal Taxation of Income, Estates and Gifts, para. 69.11.1,
at 69-72 through 69-74 (rev. 3d ed. 2005)), aff’d, 722 F.3d 306 (5th Cir. 2013).
U.S. property includes, among other things, stock and debt of U.S. corporations.
See sec. 956(c)(1)(B) and (C). Generally, the amount taken into account with
respect to any property that is U.S. property under section 956(a) is its adjusted
basis, reduced by any liability to which the property is subject.
When the CFC eventually distributes the amounts previously included in the
U.S. shareholder’s gross income pursuant to section 951, the distribution then
reduces the CFC’s E&P. See sec. 959(d). To avoid double taxation to the
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shareholder, the actual distribution is excluded from the shareholder’s gross
income. See sec. 959(a).
III. Analysis
To determine whether the upper tier CFC partners are required to increase
their E&P to reflect their distributive shares of EW LLC’s section 951(a)
inclusions, we need to analyze the interaction between sections 312 and 964.
Section 312, a provision of subchapter C, is captioned “Effect on Earnings and
Profits.” That section and the regulations interpreting it provide elaborate,
technical rules governing the calculation of E&P. See sec. 1.312-6, Income Tax
Regs. Section 964(a), a provision of subpart F captioned “Earnings and Profits”,
concerns the calculation of “the earnings and profits of any foreign corporation”.
Section 964(a) provides that, “[e]xcept as provided in section 312(k)(4),
* * * the earnings and profits of any foreign corporation * * * shall be determined
according to rules substantially similar to those applicable to domestic
corporations, under regulations prescribed by the Secretary.” The “rules
* * * applicable to domestic corporations” are set forth in section 312 and the
regulations interpreting it. Section 312(k)(4), captioned “Certain Foreign
Corporations”, provides that special depreciation rules apply to computation of a
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foreign corporation’s E&P if “less than 20 percent of * * * [its] gross income * * *
is derived from sources within the United States.”
We must first decide the universe of regulations to which the phrase “under
regulations prescribed by the Secretary”, as used in section 964(a), refers. That
phrase, as enacted in 1969, is naturally read to refer to any regulations that the
Secretary might later promulgate under section 964(a). But given the statutory
text, we believe that this phrase also refers to regulations that the Secretary had
previously promulgated, or might in the future promulgate, under section 312.3
The phrase “under regulations prescribed by the Secretary” immediately
follows the phrase “rules substantially similar to those applicable to domestic
corporations”. Section 964(a) provides that the same general rules apply to E&P
computations for domestic and foreign corporations. Since those rules are set
forth both in section 312 and in the regulations interpreting it, the reference to
“regulations” in section 964(a) is reasonably read to include regulations
promulgated under section 312 as well as under section 964(a). There is nothing
3
The Secretary promulgated the initial regulations under sec. 312 in
December 1955. See T.D. 6152, 1955-2 C.B. 61, 99-117.
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in the text of section 964(a) that limits the scope of “regulations” to regulations
that might later be promulgated under that specific provision.4
The Code “does not comprehensively define ‘earnings and profits,’” but
“[p]rovisions of the Code and regulations relating to earnings and profits
ordinarily take taxable income as the point of departure.” Boris I. Bittker &
Lawrence Lokken, Federal Taxation of Income, Estates and Gifts, para. 92.1.3, at
*4-*5 (Westlaw 2018). Among the items entering into the computation of E&P
are “all items includible in gross income under section 61 or corresponding
provisions of prior revenue acts.” Sec. 1.312-6(b), Income Tax Regs. Thus, a
corporation’s E&P are calculated by making certain adjustments to its taxable
income. See DiLeo v. Commissioner, 96 T.C. 858, 888 (1991), aff’d, 959 F.2d 16
(2d Cir. 1992); Henry C. Beck Co. v. Commissioner, 52 T.C. 1, 6 (1969) (defining
E&P as a measure “to approximate a corporation’s power to make distributions
which are more than just a return of investment” (quoting Arthur R. Albrecht,
“‘Dividends’ and ‘Earnings or Profits’”, 7 Tax L. Rev. 157, 183 (1952))), aff’d per
curiam, 433 F.2d 309 (5th Cir. 1970).
4
Cf., e.g., sec. 964(d)(3) (“The Secretary shall prescribe such regulations as
may be necessary or appropriate to carry out the purposes of this subsection.”
(Emphasis added.)).
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Section 312 and its accompanying regulations specify how the E&P
computation is affected by various corporate transactions and events.
Transactions and events that may require adjustments in computing E&P include
distributions of property, distributions of appreciated property, distributions of
property subject to indebtedness, distributions of stock and securities, tax-free
distributions, redemptions, corporate separations and reorganizations, discharge of
indebtedness income, depreciation, installment sales, and last-in, first-out (LIFO)
inventory adjustments. See sec. 312.
The rules applicable to domestic corporations, as set forth in section 312
and its accompanying regulations, assume that the corporation will have
determined its taxable income using U.S. tax accounting principles. Because that
assumption will often be invalid for a foreign corporation, the regulations under
section 964 require that preliminary adjustments be made to the profit and loss
(P&L) statement of a foreign corporation to enable the rules of section 312 to be
applied correctly.
Section 1.964-1(a)(1), Income Tax Regs., provides as follows:
[E]xcept as otherwise provided in the Code and regulations, the
earnings and profits * * * of a foreign corporation for its taxable year
shall be computed for all federal income tax purposes substantially as
if such corporation were a domestic corporation by--
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(i) Preparing a profit and loss statement with respect to such
year from the books of account regularly maintained by the
corporation for the purpose of accounting to its shareholders;
(ii) Making the adjustments necessary to conform such
statement to the accounting principles described in paragraph (b) of
this section; and
(iii) Making the further adjustments necessary to conform such
statement to the tax accounting standards described in paragraph (c)
of this section.
Paragraph (b) of the regulation, captioned “Accounting adjustments”, states
that “[t]he accounting principles to be applied in making the adjustments required
by paragraph (a)(1)(ii) * * * shall be those accounting principles generally
accepted in the United States for purposes of reflecting in the financial statements
of a domestic corporation the operations of its foreign affiliates”. Id. para. (b)(1).
These principles include (for example) “clear reflection * * * of income” and rules
governing “translation of foreign currency amounts into United States dollars.”
Id. subdivs. (i), (v). Paragraph (c) of the regulation, captioned “Tax adjustments”,
specifies various “tax accounting standards to be applied in making the
adjustments required by paragraph (a)(1)(iii)”. These include (for example)
adjustments to inventories to conform to “the provisions of sections 471 and 472”
and adjustments required by U.S. rules governing changes in accounting method.
See id. para. (c)(1)(i) and (ii); see also id. para. (a)(2) (providing that a foreign
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corporation’s P&L must be adjusted to reflect the nondeductibility of “bribe[s]”
and “kickback[s]” under section 162(c)).
The regulations issued under section 964, described above, do not provide
comprehensive guidance for calculating the E&P of a foreign corporation. Rather,
they specify a preliminary process by which a foreign corporation’s P&L
statement is conformed to, or made to resemble, that of a domestic corporation by
making a series of tax accounting adjustments. Section 964(a) then incorporates
the rules of section 312--other than the depreciation rule of section 312(k)(4)--by
requiring that the foreign corporation’s E&P shall be computed “according to rules
substantially similar to those applicable to domestic corporations”. See sec.
1.964-1(a)(1), Income Tax Regs. (providing that the E&P of a foreign corporation
“shall be computed * * * substantially as if such corporation were a domestic
corporation”). In other words the foreign corporation’s E&P are “determined
according to rules substantially similar to those applicable to domestic
corporations” in that its P&L statements, as adjusted through the “regulations
prescribed by the Secretary”, are then further adjusted through most of the rules
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under section 312 that would apply to a similarly situated domestic corporation’s
computation of its E&P. See sec. 964(a); sec. 1.964-1(a)(1), Income Tax Regs.5
This Court and the Commissioner have consistently applied the principles
of section 312 to compute a foreign corporation’s E&P. See H.H. Robertson Co.
v. Commissioner, 59 T.C. 53, 70-74 (1972) (concluding section 312(a)(3) applies
to determine the effect of an earlier distribution), aff’d without published opinion,
500 F.2d 1399 (3d Cir. 1974); Juha v. Commissioner, T.C. Memo. 2012-68, slip
op. at 12-15 (discussing the application of section 312 and its regulations in
determining a foreign corporation’s E&P). In Rev. Rul. 86-131, 1986-2 C.B. 135,
the Commissioner analyzed the effect of a distribution of property on the E&P of a
foreign corporation. For a domestic corporation, section 312(a) sets forth the
general rule governing that subject. The Commissioner concluded that “[t]he rules
of section 312(a) apply to distributions by a foreign corporation as well as a
domestic corporation.” Rev. Rul. 86-131, 1986-2 C.B. at 136 (citing H.H.
Robertson Co. v. Commissioner, 59 T.C. 70-75).6
5
The Secretary issued Notice 2009-7, 2009-3 I.R.B. 312, and Notice 2010-
41, 2010-22 I.R.B. 715, which address transactions similar to the transaction at
issue. However, neither notice addresses the calculation of the E&P of a foreign
corporation.
6
We are not bound by revenue rulings, and the weight we afford them
(continued...)
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For these reasons and looking at the plain meaning of the relevant
provisions, we conclude that the rules set forth in section 312 and its regulations
must be applied in determining the E&P of the upper tier CFC partners of EW
LLC. See Huntsberry v. Commissioner, 83 T.C. 742, 747-748 (1984). The next
step is to determine what should be included in their E&P. There is no explicit
rule in section 312, section 964, or their accompanying regulations specifying how
a CFC’s distributive share of partnership income generally--or its distributive
share of a partnership’s income inclusion under section 951(a) specifically--should
be treated for purposes of computing its E&P. We accordingly consult the general
rules set forth in subpart F and section 312.
Subpart F requires that the upper tier CFC partners compute their gross
income as if they were domestic corporations. See sec. 1.952-2(a)(1), (c)(1),
Income Tax Regs. The upper tier CFC partners are partners of a domestic
partnership. Section 701 provides that a partnership is not liable for Federal
income tax; instead, its partners are liable in their individual capacities for the
income tax arising from the partnership’s operations. In determining its income
6
(...continued)
depends upon their persuasiveness and the consistency of the Commissioner’s
position over time. See Skidmore v. Swift & Co., 323 U.S. 134, 140 (1944);
PSB Holdings, Inc. v. Commissioner, 129 T.C. 131, 142 (2007).
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tax, a partner must take into account its “distributive share” of each item of
partnership income, gain, loss, deduction, and credit. Sec. 702. Each partner is
taxed on its distributive share of partnership income without regard to whether the
income is actually distributed. Sec. 1.702-1(a), Income Tax Regs.
Under these rules the upper tier CFC partners must include in their gross
income their distributive shares of EW LLC’s income. Under section 951(a) EW
LLC’s income includes subpart F income and section 956(a) inclusions from the
lower tier CFCs, regardless of whether the lower tier CFCs made actual
distributions. The gross income of the upper tier CFC partners thus includes their
distributive share of EW LLC’s gross income, whether or not distributed, pursuant
to sections 61(a)(13) and 702(c). The fact that the upper tier partners are CFCs
makes no difference. For the purposes of computing gross and taxable income
under subpart F, a foreign corporation is treated as a domestic corporation and the
principles of sections 61 and 63 apply. Sec. 1.952-2(a) and (b), Income Tax Regs.
Since there are no Code provisions or regulations that have special rules for
E&P with respect to distributive shares of partnership income pursuant to section
951(a), the general rules of section 312 apply. Section 1.312-6(b), Income Tax
Regs., explicitly states that E&P shall be determined by taking into account “all
items includible in gross income under section 61”. Because the upper tier CFC
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partners’ distributive shares of EW LLC’s section 951(a) inclusions are
“includible in [their] gross income”, their E&P must be increased by those
amounts.
Therefore, each upper tier CFC partner is required to include in gross
income, and make a correlative increase to its E&P to reflect, its distributive share
of EW LLC’s partnership income, including EW LLC’s section 951(a) inclusions
with respect to the lower tier CFCs. If the upper tier CFC partners did not increase
their E&P on this account, there is no other mechanism to ensure that their E&P
would ever be increased. That would produce an irrational result because (as
noted supra pp. 5-6) the lower tier CFCs treated the amounts included by EW LLC
as “previously taxed E&P” under section 959(c).
The fact that the upper tier CFC partners did not reflect their distributive
shares of EW LLC’s section 951(a) inclusions on their unconsolidated financial
statements has no bearing on the requirement that such amounts be included in
their E&P. The P&L statement to which the regulations refer is not produced by
copying local financial records but by preparing from such records a financial
statement conforming to U.S. tax standards. See sec. 1.964-1(a)(1), Income Tax
Regs. The required preparation includes ensuring that the P&L statement
conforms to U.S. Federal income tax principles applicable to the computation of
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E&P by including all items of income under U.S. tax principles. Petitioner cannot
follow local accounting or GAAP to the exclusion of U.S. tax principles. E&P are
increased upon a corporate partner’s inclusion in income of a distributive share of
partnership income, even if the partner does not receive a distribution of cash from
the partnership. See Henry C. Beck Co. v. Commissioner, 52 T.C. 5-6, 10
(concluding that a corporation’s E&P are increased even if the profit that resulted
in that increase is not taxable); sec. 1.312-6, Income Tax Regs.; Rev. Rul. 79-20,
1979-1 C.B. 137.
IV. Petitioner’s Arguments
Petitioner’s primary argument, reduced to its essentials, is that the section
964 regulations supply a freestanding, self-contained, and comprehensive system
for determining the E&P of a foreign corporation, without any need to refer to or
incorporate the rules set forth in section 312 and the regulations thereunder. As
discussed earlier section 1.964-1(a)(1), Income Tax Regs., states that a foreign
corporation’s E&P shall be computed “substantially as if such corporation were a
domestic corporation by” doing three things: taking the foreign corporation’s
P&L statement and making U.S. accounting and tax adjustments to it. Petitioner
interprets the preposition “by” in an extremely narrow sense, to mean “by doing
these three things and nothing else.”
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Petitioner contends that the upper tier CFC partners did the three required
things by making the adjustments specified in paragraphs (b) and (c) of the
regulation. That having been done, petitioner says, the E&P computation was
complete. Petitioner’s view of section 1.964-1(a), Income Tax Regs., forecloses
resort to the general rules of section 312 for determining the E&P of a foreign
corporation--in particular, to the requirement that E&P shall be determined by
taking into account “all items includible in gross income under section 61”. Sec.
1.312-6(b), Income Tax Regs.
Petitioner’s argument is unpersuasive. The section 964 regulations set forth
preliminary steps that must be taken to conform a foreign corporation’s P&L
statement to that of a domestic corporation. By its terms, section 1.964-1(a)(1),
Income Tax Regs., refers only to the “profit and loss statement” and “the
adjustments necessary to conform such statement” to U.S. accounting and tax
principles. The section 964 regulations do not tell the taxpayer how to compute
E&P. They simply require that the foreign corporation’s P&L statement first be
adjusted to U.S. standards before the E&P rules of section 312 can be applied.
Section 964(a) explicitly incorporates the rules of section 312. It provides
that the E&P of a foreign corporation shall be determined according to rules
substantially similar to those applicable to domestic corporations “[e]xcept as
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provided in section 312(k)(4).” If section 964 did not incorporate the general rules
of section 312, Congress would have had no reason to carve out an exception for
the specific depreciation rules of section 312(k)(4).
Section 1.964-1(a)(1), Income Tax Regs., reiterates the incorporation of
section 312 by stating that, “except as otherwise provided in the Code and
regulations, the earnings and profits * * * of a foreign corporation for its taxable
year shall be computed for all federal income tax purposes substantially as if such
corporation were a domestic corporation”. The phrase “except as otherwise
provided in the Code and regulations” clarifies that all of the E&P rules applicable
to domestic corporations also apply to a foreign corporation, unless there is a
provision explicitly prohibiting application. For example, section 312(m)
provides a special rule for taking into account interest paid on a bearer bond for
foreign corporations other than CFCs. If section 312 did not apply to foreign
corporations, there would be no need for section 312(m).
Without reference to the detailed rules of section 312 and the regulations
interpreting it, it would be without meaning--employing the section 964
regulations alone--to perform an E&P computation for a foreign corporation. As
noted earlier section 312 and the regulations thereunder explain how numerous
corporate transactions and events affect E&P. These include distributions of
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property, distributions of appreciated property, distributions of property subject to
indebtedness, distributions of stock and securities, tax-free distributions,
redemptions, corporate separations and reorganizations, discharge of indebtedness
income, depreciation, installment sales, and LIFO inventory adjustments. See sec.
312. The section 964 regulations do not address or even mention any of these
things. This makes it clear that the E&P of a foreign corporation must be
determined by applying the general rules of section 312 that govern E&P
computations for a domestic corporation.
Finally, petitioner contends that section 951(a) inclusions do not increase
the dividend paying capacity of the upper tier CFC partners. Petitioner refers to a
section 951(a) inclusion as “phantom income” and not a transfer of value. It
argues that E&P increase only where a corporation receives tangible, economic
value that enhances its dividend paying capacity.
There are many instances in which E&P are increased when amounts are
included in income but no cash is received. For example, taxpayers that are
subject to the rules governing original issue discount (OID) on a debt instrument
are generally required to include the OID in gross income, and thus E&P, even
though no cash is received until a later period. See sec. 1272(a)(1); sec. 1.312-
6(b), Income Tax Regs. Another instance in which this occurs is with an accrual
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method taxpayer. Similarly, an accrual method taxpayer may include income
before the receipt of cash. An accrual method taxpayer’s E&P increase when the
taxpayer accrues income, not in a later period when cash is received. See sec.
1.312-6, Income Tax Regs.
Section 882(b) is irrelevant in determining the gross income, and hence the
E&P, of the upper tier CFC partners. Section 882 provides for direct U.S. taxation
of a foreign corporation’s U.S.-source income and income effectively connected
with a U.S. trade or business. Secs. 881 and 882. The section 951(a) income
inclusions at issue here are not U.S. source income or income effectively
connected with a U.S. trade or business. Accordingly, sections 881 and 882(b) are
inapplicable in this case. The gross income of the upper tier CFC partners is
calculated pursuant to section 61. Their distributive shares of EW LLC’s income
are thus included in their gross income and (correspondingly) in their E&P.
V. Conclusion
Eaton’s upper tier CFC partners must include their distributive shares of
EW LLC’s income, including their distributive shares of EW LLC’s section 951(a)
income inclusions, in their gross income and their E&P. CFCs compute E&P in
the same manner as a domestic corporation, except as otherwise provided in the
Code or the regulations. See sec. 964(a). There are no special E&P rules in the
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Code or regulations concerning a CFC partner’s distributive share of partnership
income. Domestic corporations increase E&P by amounts included in gross
income under section 61, and a partner’s gross income includes its distributive
share of all items of the partnership’s income. See secs. 61(a)(13), 702(c); see also
sec. 1.312-6(b), Income Tax Regs. Eaton is thus required to include in its
consolidated income, under sections 951 and 956, $73,030,810 and $114,065,635
for tax years 2007 and 2008, respectively.
Accordingly, we will grant respondent’s motion for partial summary
judgment and deny petitioner’s cross-motion for partial summary judgment. We
have considered all of the arguments made by the parties, and to the extent we did
not mention them above, we conclude that they are moot, irrelevant, or without
merit.
To reflect the foregoing,
An appropriate order will be issued.
Reviewed by the Court.
THORNTON, MARVEL, PARIS, BUCH, LAUBER, NEGA, ASHFORD,
URDA, and COPELAND, JJ., agree with this opinion of the Court.
PUGH, J., did not participate in the consideration of this opinion.
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MORRISON, J., concurring: In my view, the opinion of the Court is
unsatisfactory to the extent it suggests that one of the rules in section 1.312-6(b),
Income Tax Regs. (the rule that E&P shall be determined by taking into account
“all items includible in gross income under section 61”), governs the computation
of the E&P of a foreign corporation solely by operation of section 964(a) without
the intervening operation of section 1.964-1(a)(1), Income Tax Regs. It is section
1.964-1(a)(1), Income Tax Regs., by requiring the E&P of a foreign corporation to
be computed “substantially as if such corporation were a domestic corporation”,
that incorporates that particular rule for the purpose of computing the E&P of a
foreign corporation.
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FOLEY, C.J., dissenting: Eschewing a plain language interpretation, the
opinion of the Court imprudently stretches the explicit terms of section 964(a) and
its accompanying regulation. Section 964(a) provides:
Except as provided in section 312(k)(4), for purposes of this subpart,
the earnings and profits of any foreign corporation, and the deficit in
earnings and profits of any foreign corporation, for any taxable year
shall be determined according to rules substantially similar to those
applicable to domestic corporations, under regulations prescribed by
the Secretary. * * *
Thus, the Secretary has wide latitude to prescribe these earnings and profits
(E&P) calculations but, pursuant to section 312(k)(4), cannot require a foreign
corporation that earns less than 20% of its gross income from U.S. sources to use
straight line depreciation. Yet the opinion of the Court concludes that “[s]ection
964(a) * * * incorporates the rules of section 312--other than the depreciation rule
of section 312(k)(4)”. See op. Ct. p. 16. To the contrary, section 964(a) explicitly
incorporates section 312(k)(4) but makes no other reference to section 312.
Undaunted by the plain language, the opinion of the Court continues,
misquotes the statute, and proceeds to interpret language that Congress did not
write:
Section 964(a) provides that the same general rules apply to E&P
computations for domestic and foreign corporations. Since those
rules are set forth both in section 312 and in the regulations
interpreting it, the reference to “regulations” in section 964(a) is
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reasonably read to include regulations promulgated under section 312
as well as under section 964(a). There is nothing in the text of section
964(a) that limits the scope of “regulations” to regulations that might
later be promulgated under that specific provision. [Fn. ref. omitted.]
See op. Ct. p. 12-13 (emphasis added). Section 964(a) does not, however, provide
that the “same general rules apply” to E&P computations for domestic and foreign
corporations. The statute provides that the E&P of a foreign corporation “shall be
determined according to rules substantially similar to those applicable to domestic
corporations, under regulations prescribed by the Secretary.” See sec. 964(a)
(emphasis added). Without citing any precedent, the opinion of the Court goes on
to state that the phrase “under regulations prescribed by the Secretary” also refers
“to regulations that the Secretary had previously promulgated, or might in the
future promulgate, under section 312.” See op. Ct. p. 12 (emphasis added). This
analysis sets bad precedent and is a rickety analytical construct.
Section 964(a) delegates broad regulatory authority to the Secretary, and he
exercised that authority by promulgating section 1.964-1(a)(1), Income Tax Regs.,
which states: “[E]xcept as otherwise provided in the Code and regulations, the
earnings and profits * * * of a foreign corporation for its taxable year shall be
computed for all federal income tax purposes substantially as if such corporation
were a domestic corporation by” following a specific three-step process. The
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opinion of the Court states that “[p]etitioner interprets the preposition ‘by’ in an
extremely narrow sense, to mean ‘by doing these three things and nothing else.’”
See op. Ct. p. 21. Yet that is precisely what the regulation dictates. Indeed, the
prior version of section 1.964-1, Income Tax Regs., provided that a foreign
corporation’s E&P shall be computed according to a five-step process. See T.D.
6764, 1964-3 C.B. 260, 260-261. The regulation’s first three steps were identical
to the three steps in the current regulation. The last two steps, made obsolete by
the enactment of section 985, provided rules for converting a foreign corporation’s
E&P calculation to U.S. dollars. The first three steps of the prior regulation were
not preliminary or subject to additional revision under section 312. The
calculation was complete upon the conversion to U.S. dollars and, like the current
version of section 1.964-1(a), Income Tax Regs., section 312 played no part in that
calculation. See T.D. 6764, 1964-3 C.B. 260. Similarly, the E&P calculation
process in the current regulation is self-contained and complete. The Secretary
certainly had, and still has, the authority to promulgate regulations incorporating
the rules of, or similar to, section 312. He has not.1
1
In 2009 the Secretary identified transactions similar to the transaction at
issue as a “Transaction of Interest” that had the “potential for tax avoidance.” See
Notice 2009-7, 2009-3 I.R.B. 312. In 2010 the Secretary stated he would
promulgate regulations to address these purported “tax avoidance” transactions.
(continued...)
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We need not opine on whether the Secretary’s inaction is the result of
bureaucratic indolence or inertia, but we know this: The Secretary has not
promulgated the rule respondent espouses and is now imploring us to do his
bidding. The opinion of the Court acquiesces. We should decline. Our role is to
review and construe, not adjust and reconstruct, the statute and the regulations.
See Dodd v. United States, 545 U.S. 353, 359 (2005) (stating that courts “are not
free to rewrite the statute that Congress has enacted”). The Secretary is bound by
the terms of the rules he created. Similarly, taxpayers are bound by the applicable
rules, but they are not required to employ their imagination to divine them.
Petitioner may have found a hole in the dike, but the closing of the hole “calls for
the application of the * * * [Secretary’s] thumb, not the court’s.” Fabreeka Prods.
Co. v. Commissioner, 294 F.2d 876, 879 (1st Cir. 1961), vacating and remanding
34 T.C. 290 (1960), Friedman v. Commissioner, 34 T.C. 456 (1960), and Sherman
v. Commissioner, 34 T.C. 303 (1960). In short, we must interpret, not make, the
law.
GUSTAFSON, J., agrees with this dissent.
1
(...continued)
See Notice 2010-41, 2010-22 I.R.B. 715. He has not. Curiously, respondent now
asks the Court, rather than his Office of Tax Policy scriveners, to interpret sec.
1.964-1, Income Tax Regs., to halt a transaction similar to those he has for a
decade deemed problematic.