Tax Court requires taxable income inclusion of over $180 million
Earnings and profits (E&P) are a tax measure of earnings – essentially a corporation’s dividend-paying capacity. U.S. shareholders of a controlled foreign corporation (CFC) include amounts of the CFC’s E&P in their U.S. taxable income when the CFC pays a dividend, makes a deemed dividend distribution, or recognizes income in certain categories, known as subpart F income.
In a recent opinion, the U.S. Tax Court held that CFCs that are partners in a U.S. partnership must account for the partnership’s subpart F income inclusions when determining their E&P. The amount of taxable incme at stake was apparently over $180 million.
In the matter before the court, Eaton Corporation PLC argued the domestic partners’ subpart F income inclusion did not affect the E&P of its upper tier CFC partners. The Court, in siding with the IRS, found that the upper tier CFCs must increase their E&P with respect to the subpart F income inclusions under the general principle that all items includable in gross income must be taken into account in determining E&P.
During the years in question, Eaton’s U.S.-based companies owned several CFCs, which in turn owned several lower tier CFCs through a U.S. partnership. The U.S. partnership included in its income the subpart F income earned by the lower tier CFCs. However, the distributive share of the partnership’s subpart F income inclusions were excluded by the upper tier CFC partners when calculating their subpart F income and basis adjustments. The IRS assessed Eaton with a deficiency under the theory that the CFC partners should have increased their E&P to account for the subpart F inclusion.
In siding with the IRS, the Court noted that while section 964 addresses the determination of E&P of a foreign corporation, neither the code nor regulations provide comprehensive guidance on how the E&P should be calculated. The Court looked to section 964(a) which incorporates the rules under section 312 for determining how corporate distributions affect the E&P of a foreign corporation. The Court reasoned that the regulations under section 312, which require all items includable in gross income under section 61 to be taken into account when determining E&P, must apply to the CFC partners of Eaton’s U.S. partnership.
While it is not immediately clear, it seems likely that Eaton will appeal the Tax Court’s ruling. In the interim, U.S. taxpayers may wish to review their CFCs’ E&P calculations to make sure they are in accordance with the rules under section 312. Taxpayers should consult with their tax advisers when considering CFCs’ E&P computations or other E&P and subpart F income issues.