Tax Court rules CFCs must compute earnings and profits under Section 312 rules

Tax Hot Topics newsletterIn Eaton Corp. v. Commissioner , T.C. No. 2 (2/25/19) the United States Tax Court held that upper-tier controlled foreign corporation (CFC) partners in a U.S. partnership are required to increase their Section 964 earnings and profits (E&P) for their distributive share of the partnership’s Section 951(a) inclusions.

In the case at hand, Eaton Corporation was the parent of a U.S. consolidated group with members owning interests in three upper-tier CFCs. The upper-tier CFCs held partnership interests in Eaton Worldwide, a U.S. partnership. Eaton Worldwide was a U.S. shareholder with respect to a number of lower-tier CFCs. Additionally, on March 16, 2007, Eaton Worldwide purchased AT Holdings Corp. for roughly $388 million. For purposes of applying Section 956, Eaton Worldwide’s interest in AT Holdings Corp. was an investment in U.S. property treated as being held by the upper-tier CFCs.

The issue in the case was how the upper-tier CFCs’ E&P was impacted by its distributive share of the lower-tier’s Subpart F income earned through the partnership. The Tax Court considered the interaction of Sections 964(a) and 312 when arriving at its decision. Section 964(a) provides “…the earnings and profits of a 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…” The rules that that apply to domestic corporations for purposes of determining earnings and profits are found within Section 312 and its underlying regulations. Neither Section 964 nor Section 312 contain a rule stating how a CFC partner of a U.S. partnership should treat its distributive share of a Section 951(a) inclusion for purposes of computing the E&P of the partner. However, rules provided in Subpart F assisted the Tax Court in its determination of the proper treatment.

CFC partners are required to compute their gross income under the Subpart F rules found within Section 952, which treat the upper-tier CFCs as domestic corporations. In this case, the upper-tier CFCs are partners in a domestic partnership, Eaton Worldwide. Section 701 provides that partners of a partnership are individually liable for their share of the Federal income tax of a domestic partnership. Accordingly, the upper-tier CFCs in this case must take into account their distributive share of Eaton Worldwide’s Subpart F inclusion when computing gross income. The gross income to those upper-tier CFCs which resulted from the distributive share of Eaton Worldwide’s Subpart F inclusions increase E&P in accordance with Treas. Reg. Sec. 1.312-6(b). In this case, the increase in E&P results in an increased Section 956 inclusion for the U.S. shareholder of the upper-tier CFCs. Therefore, the Tax Court ruled that Eaton Corporation must include roughly $73 million in its gross income in 2007 and roughly $114 million in its gross income in 2008 resulting from the increased E&P of the upper-tier CFCs.

The Tax Court’s decision may have a limited utility. In 2010, Notice 2010-41 was released by Treasury and the IRS providing that they intended to issue regulations that would classify certain domestic partnerships as foreign partnerships when identifying U.S. shareholders that must include a Section 951(a) inclusion in their gross income. The regulations to be issued with respect to the notice are to be effective for taxable years of a domestic partnership ending on or after May 14, 2010. If the rules prescribed under this notice were applied to the instant case, the Subpart F income of the lower-tier CFCs would have been includable in the gross income of Eaton Corporation as opposed to Eaton Worldwide.

David Sites
Washington National Tax Office 
T +1 202 861 4104

David Zaiken
Managing Director
Washington National Tax Office 
T  +1 202 521 1543

Cory Perry
Senior Manager
Washington National Tax Office 
T +1 202 521 1509

Mike Del Medico
Washington National Tax Office 
T +1 202 521 1522

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