Executive summary: A partial summary judgment granted
The United States District Court for the Western District of Tennessee granted FedEx Corp.’s motion for partial summary judgment March 31 in FedEx Corp. v. United States. The District Court awarded FedEx an $89 million refund for wrongfully denied foreign tax credits (FTCs) on the grounds that the government’s regulation is “contradicted by the plain terms of the tax code.”
The fundamental dispute under litigation was whether FedEx should be entitled to a credit for foreign taxes paid on “offset earnings,” a term used to refer to “the portion of earnings from profitable foreign corporations that are offset by losses from other foreign corporations.” FedEx argued they should be entitled to a FTC for those foreign taxes based on the interaction of sections 959, 960 and 965. The government argued that the statute forbids FTCs on such earnings and that, even if the statutory language were ambiguous, section 1.965-5(c)(1)(ii) closes this gap by prohibiting a credit. The government further adds that the purpose of the FTC is to prevent double taxation and because offset earnings are not subject to U.S. tax in the first place, a credit would be inappropriate.
FedEx awarded $89 million refund in successful FTC lawsuit
The section 965 transition tax
Congress enacted the so-called transition tax (contained in section 965 of the Internal Revenue Code) as part of the Tax Cuts and Jobs Act of 2017 (TCJA). Section 965 required U.S. shareholders to pay a transition tax on the untaxed foreign earnings (e.g., earnings and profits (E&P)) of certain ‘specified foreign corporations’ by deeming those earnings to be repatriated to the United States. Section 965 applied to the last taxable year of the relevant specified foreign corporation that began before Jan. 1, 2018, and the amount included in income under section 965 was includible in the U.S. shareholder’s year in which, or with which, such specified foreign corporation’s tax year ended. The vast majority of taxpayers took the section 965 liability into account on their returns for the 2017 and 2018 tax years.
Prior to the TCJA, the United States employed a worldwide system of taxation, meaning all U.S. citizens and corporations were taxed on all income, regardless of whether that income was generated domestically or abroad. However, the U.S. generally did not tax earnings of U.S. owned foreign corporations until there was a distribution to the U.S. owner. The narrow exception to this was Subpart F. The result was that multinational companies could retain large amounts of wealth overseas by failing to make a distribution thereby deferring paying tax they would otherwise owe (e.g., a deferral regime).
The TCJA replaced this worldwide corporate system of taxation with a partial territorial system. The territorial system allows domestic corporations to bring back foreign-source earnings to the U.S., tax-free and U.S. corporations pay tax generally on their domestic sourced income (subject to certain significant exceptions). Congress imposed the transition tax as a one-time toll charge into the territorial system. However, Congress also recognized that many multinational corporations had foreign subsidiaries that had lost money for years (i.e., historical losses), while other foreign subsidiaries had earned money for years (i.e., historical income). In establishing the transition tax, Congress allowed U.S. corporations to lower their overall transition tax by netting (or offsetting) the historical income of their profitable foreign subsidiaries with the historical losses of their unprofitable foreign subsidiaries. The District Court refers to the portion of earnings from profitable foreign corporations that are offset by losses from other foreign corporations as “offset earnings.” Under sections 959 and 965(b), offset earnings can be repatriated to the U.S. owner without ever being included in taxable income.
Analysis
Both FedEx and the government agreed that offset earnings could be repatriated tax-free, but the dispute focused on how the FTC rules applied to foreign taxes paid on offset earnings. The Treasury regulations at issue generally deny a credit for foreign taxes paid on offset earnings but the taxpayer disagreed.
FedEx argued that they are entitled to a credit under the plain language of section 960(a)(3) which in part provides that “any portion of a distribution from a foreign corporation received by a domestic corporation which is excluded from gross income under section 959(a) shall be treated by the domestic corporation as a dividend, solely for purposes of taking into account under section 902 any . . . taxes paid to any foreign country . . . on or with respect to the accumulated profits of such foreign corporation from which such distribution is made, which were not deemed paid by the domestic corporation under [section 960(a)(1)] for any prior taxable year.”
The government also relied on the language in section 960(a)(3), but concluded that section 960(a)(3) instead denied a credit:“Because offset earnings are treated as included in income under section 951 … they cannot produce a credit under the plain terms of section 960.”
FedEx argued that the government ignored “crucial limiting language.” In particular, section 965(b)(4)(A) treats offset earnings as included in income “for purposes of applying section 959” (i.e., not sections 951 or 960). FedEx further goes onto say, “offset earnings are treated as previously included in income under section 959, which shields those earnings from inclusion in income when they are distributed. Offset earnings are not treated as included in income when applying section 960, which controls the grant of tax credits.” The District Court concluded that the language of the statute was unambiguous and sided with FedEx.
Implications of the ruling
Taxpayers who wish to amend their prior year returns to claim FTCs under the authority of this ruling may still have time to do so under the extended statute of limitations that applies to refund claims based on a claim of credit. However, the District Court’s decision does not apply to taxpayers outside of its jurisdiction so taxpayers should consider carefully whether to file an amended return although filing a protective return may be wise.
Coincidently, another taxpayer, Sysco Corp., brought a similar dispute to the Tax Court on April 18. Sysco Corp. has petitioned for a redetermination of a $108 million deficiency and $21.6 million in penalties. It will be interesting to see whether the Tax Court follows the District Court’s decision or decides to take another path.
Over the course of this past year, Treasury and the IRS have released FTC guidance (e.g., 2022 final regulations, 2022 proposed regulations, Notice 2023-55) all aimed at addressing the creditability of foreign income taxes for purposes of the FTC. The rules are generally applicable to foreign income taxes paid or accrued in tax years beginning on or after Dec. 28, 2021. Taxpayers who are unable to rely on the temporary relief outlined in Notice 2023-55 could find that historically creditable taxes may no longer be creditable, and thus, may find it harder to take a FTC on a go-forward basis. Amending prior-year tax years, based on this decision, may provide taxpayers with a beneficial FTC carryover to mitigate the initial impact of the new FTC guidance.
Final reminders
The ruling described in this alert is subject to appeal. RSM US LLP will continue to monitor additional guidance. Nonetheless, taxpayers should contact their advisors now to better understand how this ruling may affect their tax obligations.
