Divided Tax Court Decides E&P Computation Issue in Eaton

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March 12, 2019

In Eaton Corp. v. Commissioner, 152 T.C. No. 2 (2019), a divided Tax Court decided (by a 10-2 margin) that the CFC partners in a U.S. partnership must increase earnings and profits (E&P) for the partnership’s subpart F inclusions. Members in the taxpayer’s group owned several CFCs (the “CFC partners”) that were partners in a U.S. partnership. That partnership in turn owned several lower-tier CFCs (the “lower-tier CFCs”) that generated subpart F income. There was no dispute that the U.S. partnership had to include the subpart F income of the lower-tier CFCs. The question before the Tax Court on motions for summary judgment was whether the CFC partners were required to increase their E&P in the amount of the U.S. partnership’s income inclusions (which ultimately determined whether the U.S. parent must include income from a section 956 investment in U.S. property by the CFC partners).

In an opinion by Judge Kerrigan, the majority held that the law required the CFC partners to increase E&P for the U.S. partnership’s income inclusions. Although the opinion does not expressly state so, it appears to adopt the IRS’s arguments for increasing the CFC partners’ E&P.

The court began with the language of section 964(a), which provides that “[e]xcept as provided in section 312(k)(4), for purposes of this subpart the 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….” (emphasis added). The court then held that because the rules “applicable to domestic corporations” are those in section 312 and its accompanying regulations, the computation of foreign corporation E&P under 964(a) should be made under the “elaborate, technical rules” of section 312 and its regulations.

The court observed that under Treas. Reg. § 1.312-6(b), the computation of E&P includes “all items includible in gross income under section 61….” Although there “is no explicit rule in section 312, section 964, or their accompanying regulations specifying how a CFC’s distributive share of partnership income…should be treated for purposes of computing its E&P,” the court looked to “the general rules set forth in subpart F and section 312.” Under those general rules, the court reasoned that the CFC partners should compute gross income “as if they were domestic corporations,” which meant including their distributive share of partnership income under section 702. And since the U.S. partnership’s gross income “includes subpart F income and section 956(a) inclusions from the lower-tier CFCs,” the court concluded that the CFC partners must increase their E&P by the subpart F amounts that are included in their gross income.

According to the court, the taxpayer’s “primary argument” was that “the section 964 regulations supply a freestanding, self-contained, and comprehensive system for determining the E&P of a foreign corporation” without need for recourse to section 312 or its regulations. Specifically, the taxpayer relied on Treas. Reg. § 1.964-1(a)(1), which provides that the E&P of a foreign corporation is computed “as if such corporation were a domestic corporation by” following three enumerated steps. The court portrayed the taxpayer’s argument as interpreting “the preposition ‘by’ in an extremely narrow sense, to mean ‘by doing these three things and nothing else.’”

The court rejected that reading of Treas. Reg. § 1.964-1(a)(1) on the grounds that the three enumerated steps in that regulation are insufficient for computing E&P. To compute E&P at all, it is necessary to know how corporate transactions and events—like property distributions, stock distributions, redemptions, discharge of indebtedness income, and depreciation—affect E&P. And since the regulations under section 964 address none of these transactions or events, the court held that they cannot alone determine foreign corporation E&P. Rather, recourse to section 312 and its regulations is necessary. The court also observed that the section 964 regulations specifically provide that the depreciation rules in section 312(k) do not apply in computing foreign corporation E&P. And the court inferred that this meant that section 312 and its regulations must apply in computing foreign corporation E&P, otherwise there would be no need to explicitly bar the application of the section 312(k) depreciation rules.

Presumably because it dismissed the taxpayer’s primary argument, the court took the opportunity to explain what the three steps enumerated in Treas. Reg. § 1.964-1(a)(1) are meant to do if they are not—as the taxpayer’s argument maintained—the sole mechanism for computing foreign corporation E&P. The court referred to paragraph (ii) of that regulation, which provides that foreign corporation E&P requires conforming the foreign corporation’s P&L statement to U.S. GAAP. The court concluded that the three steps under Treas. Reg. § 1.964-1(a)(1) “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.”

The court also addressed the taxpayer’s other argument that the CFC partners’ subpart F inclusions “do not increase the dividend[-]paying capacity of the upper[-]tier CFC partners.” The court observed that “[t]here are many instances in which E&P are increased when amounts are included in income but no cash is received,” citing original issue discount and income accrual as examples.

Most of the rest of the Tax Court joined Judge Kerrigan’s opinion, with Judge Pugh abstaining and Judge Morrison writing a brief concurrence (in which he clarifies his opinion that it is the language in Treas. Reg. § 1.964-1(a)(1)—and not, as the majority stated, the language in section 964(a)—that imports section 312 and its regulations into the computation of foreign corporation E&P). Judge Foley, however, wrote a dissent in which Judge Gustafson joined.

The brunt of that dissent is that if Treasury wanted to import the section 312 regulations into the computation of foreign corporation E&P under section 964, then it should have done so expressly. After criticizing the majority’s inference about the 312(k) depreciation rules excluded under section 964(a), the dissent offers support for the taxpayer’s primary argument that the regulations under 964 are the exhaustive source of instruction on computing foreign corporation E&P. The dissent observes that there were previously five steps under Treas. Reg. § 1.964-1(a)(1) and that the calculation of E&P “was complete upon the conversion to U.S. dollars.” Moreover, the dissent argues that Treasury could have expressly incorporated the rules under section 312 but did not do so. (The majority held that the language under 964(a) instructing that foreign corporation E&P is computed “under regulations prescribed by the Secretary” could be “reasonably read to include regulations promulgated under section 312,” even if those regulations predate section 964(a). The dissent disagreed, asserting that the majority’s analysis “sets bad precedent and is a rickety analytical construct.”)

Given that it involves a purely legal issue and a divided Tax Court, the case seems destined for appeal, so stay tuned for further updates.

Eaton Tax Court Opinion

Treasury and IRS Issue Joint Policy Statement on the Tax Regulatory Process

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March 7, 2019

Earlier this week, the Treasury Department issued a policy statement on the tax regulatory process.  A significant section of the statement describes the approach that will be taken in Tax Court litigation to arguments based on judicial deference to regulations.  Treasury states that it will not claim Auer deference in such litigation to interpretations set forth in subregulatory guidance, such as revenue rulings, nor will it claim Chevron deference to such interpretations.  That apparent abandonment of Auer deference arguments goes beyond the position the Justice Department has taken in the Supreme Court in the Kisor case, where the government has argued for a significant narrowing of Auer but stops short of stating that it should be overruled.  See our reports on Kisor here.  Note that the Treasury Department statement by its terms applies only to Tax Court litigation, which is handled by the IRS, not to refund suits where the Justice Department handles the litigation.

The Treasury Department statement also addresses topics other than judicial deference, including: when to issue subregulatory guidance; legislative vs. interpretative regulations; and temporary regulations.  For a fuller analysis of the Treasury Department statement, please read this Miller & Chevalier Tax Alert.

Government Brief Filed in Kisor

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March 6, 2019

The government was faced with something of a dilemma in filing its response brief in the Kisor case addressing the level of deference owed to an agency’s interpretation of its own regulation. See our prior reports here. On the one hand, the government was defending the agency action in this case and the decision below, which rested on paying Auer deference to the agency’s interpretation. On the other hand, conservative legal theorists have long been critical of Auer deference, following Justice Scalia’s lead, and the views of the political appointees in this administration about Auer likely range from unenthused to hostile. But on the third hand, the government’s institutional interests would generally be better served by a strong principle of Auer deference, since that would make challenges to agency action more difficult.

The government’s brief attempts to juggle these conflicting imperatives, and the result is a bit schizophrenic. The bottom line is that the government argues that Auer should not be overruled, but that its applicability should be substantially narrowed. In the end, the government does not rely on Auer to defend the agency action in this case, but instead argues that the regulation is clear on its face without the need to consider the agency interpretation at all.  (Although outgunned by the cascade of amicus briefs filed in support of the petitioner, two amicus briefs were filed on the government’s side, including one by a group of administrative law professors (linked below) who argue that Auer “is sound and should be maintained.”)

The first, and longest, section of the government’s brief is a full-fledged assault on the doctrine of Auer deference. The government contends that the doctrine: (1) is not well grounded historically; (2) is not supported by any consistent rationale; (3) is in tension with the APA’s distinction between interpretive and legislative rules; and (4) can have harmful practical consequences by discouraging agency resort to notice-and-comment rulemaking. Notably, the government states that the reasons that support Chevron deference do not apply to Auer, and thus the brief does not signal that the current administration will argue against Chevron deference in a future case.

The government argues, however, that Auer should not be overruled because of stare decisis considerations, including that doing so “would upset significant private reliance interests” because it allegedly “could call into question” earlier decisions that rested on Auer deference. In contrast to the opening part of its brief, this section praises Auer deference where it is limited to “its core applications,” such as “when the agency announces its interpretation in advance in a widely available guidance document.” The government states that the task of choosing among reasonable interpretations is more appropriately performed by administrators than by judges, that Auer deference would promote national uniformity, that it recognizes the technical expertise of agencies, and that it fosters regulatory certainty and predictability—in contrast to a system “in which the meaning of a regulation must be determined de novo in every judicial proceeding.” In addition, the government disagrees with the petitioner’s argument that Auer deference poses a separation-of-powers problem, stating that an agency’s actions in making rules and conducting adjudications are both exercises of “executive power.”

Accordingly, the government proposes “significant limits” on the doctrine that will thread the needle, neither overruling Auer nor further entrenching it. First, the government states that deference should not be paid to an agency interpretation that is “unreasonable,” describing this seemingly benign limitation as a “rigorous predicate.” If the agency interpretation is judged to be within the range of reasonable readings of the regulation, then the government argues that deference is appropriate “only if the interpretation was issued with fair notice to regulated parties; is not inconsistent with the agency’s prior views; rests on the agency’s expertise; and represents the agency’s considered view, as distinct from the views of mere field officials or other low-level employees.”

It is hard to say at this point what the Court will do with the various permutations that have been presented to it for moving forward, but it appears that Auer deference in its current form stands on very shaky ground.

Oral argument is scheduled for March 27.

Kisor – Government Response Brief

Kisor – Amicus Brief by Administrative Law Scholars in Support of Auer