Mixed dividends ruling in Varian case

The Tax Court has held in Varian Medical Systems, Inc. v. Commissioner (163 T.C. No. 4 (2024)), that the taxpayer is entitled to a dividends received deduction (DRD) under Section 245A for amounts treated as dividend under Section 78 for its 2018 tax year, but further held that foreign tax credits attributable to the amounts treated as dividends are disallowed.

The case centered around an effective date mismatch on Varian’s fiscal year-end 2018 income tax return. Varian claimed a DRD for its Section 78 gross-up, citing the mismatch in dates between the enactment of Section 245A and amendment of Section 78. The issue before the Tax Court was the effective date mismatch between:

• The newly enacted Section 245A deduction for the foreign source-portion of dividends received by domestic corporations from specified 10% owned foreign corporations
• The amendments to the gross-up for deemed paid foreign tax credits in Section 78

Before the enactment of the Tax Cuts and Jobs Act (TCJA), Section 78 provided that for taxpayers claiming foreign tax credits (FTCs), an amount of the taxes “shall be treated for purposes of this title (other than Section 245) as a dividend received by such domestic corporation from the foreign corporation.” When the TCJA was enacted, Section 245A introduced a DRD for distributions made after Dec. 31, 2017. Section 78 was also amended to give the effect that a gross-up under Section 78 would not be treated as a dividend for purposes of Section 245A. The amendment to Section 78 applied “to taxable years of foreign corporations beginning after Dec. 31, 2017, and to taxable years of United States shareholders in which or with which such taxable years of foreign corporations end.”

The gap arose because a taxpayer and its controlled foreign corporations could have a fiscal year ending in 2018 that began before Dec. 31, 2017, while distributions may still be made after Dec. 31, 2017, and before the controlled foreign corporation’s fiscal year-end. That created a mismatch between the timing of Section 245A's application and the amendments to Section 78 that otherwise disallowed the application of Section 245A.

The IRS attempted to correct this mismatch by issuing regulations, which provided that a dividend under Section 78 that relates to the taxable year of a foreign corporation beginning prior to Jan. 1, 2018, should not be treated as a dividend for purposes of Section 245A.

Varian included a $159 million Section 78 gross-up on its tax return for the fiscal year-end on Sept. 28, 2018, primarily related to its Section 965 transition tax amount. In its decision, the Tax Court agreed with Varian “that the disparate effective dates for new Section 245A and the amendments to Section 78 resulted in a gap period in which its Section 78 dividend qualified for a deduction under Section 245A.” Additionally, the Tax Court addressed Treas. Reg. Sec. 1.78-1(c), noting that the regulation does not alter the court’s conclusion on Varian’s claimed deduction and stated that, “the plain text of the statutes provides for the deduction.” 

Although the Tax Court sided with Varian on the gap period and effective dates, the Tax Court also granted the IRS’s motion to limit Varian’s foreign tax credit under Section 245A(d)(1). The effect of granting the commissioner’s motion is that Varian must reduce its foreign tax credit by the amount that its deemed paid foreign taxes are attributable to the foreign earnings reflected in the gross-up.

Taxpayers with the specific issue addressed by the court in Varian should review the relevant statute of limitations and consider filing refund claims or making necessary amendments for any open tax years.

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