U.S. District Court Invalidates Treasury Regulation Denying Section 965 Offset Earnings Foreign Tax Credit

The U.S. District Court for the Western District of Tennessee on March 31 in the case of FedEx Corp. v. United States, granted FedEx’s motion for partial summary judgment over the denial of foreign tax credits (FTCs) related to earnings from profitable related foreign corporations offset by losses from other foreign corporations (“offset earnings”) pursuant to Section 965 implemented as part of the 2017 Tax Jobs and Cuts Act (TCJA). With its ruling, the court invalidated the Treasury’s transition tax regulation provision limiting the FTC on offset earning distributions from Section 965(b) previously taxed earnings and profits (965(b) PTEP).  

Background 

The TCJA introduced, as part of its fundamental changes to the U.S. international taxation system, mandatory taxation of unrepatriated foreign corporation earnings under Section 965, referred to as the “transition tax.”¹  The transition tax applied to unrepatriated earnings of foreign corporations invested offshore.²  Because it was expected that not all of a U.S. taxpayer’s foreign corporations would be profitable, the transition tax was computed by offsetting the earnings and profits (E&P) deficits of a U.S. taxpayer’s foreign corporations against the positive E&P of other related foreign corporations. The amount of the positive E&P offset by deficits was referred to as the “offset earnings,” which was classified as Section 965(b) PTEP for purposes of Section 959 (excluding previously taxed earnings and profits (PTEP) from U.S. gross income when distributed to the U.S. shareholders of such foreign corporations).³  

While Section 965(g), among other provisions, placed limitations on FTCs associated with income taxed under the transition tax, neither Section 965(g) nor any other section under the TCJA explicitly eliminated FTCs on offset earnings. The IRS and Treasury, however, issued a regulation denying FTCs for foreign taxes paid on those offset earnings.⁴ 

District Court Ruling

Applying step one of the analysis in Chevron,⁵  the court examined whether Congress had directly addressed an issue in determining the validity of a regulation. When a statute is unambiguous, courts are required to enforce the statute.⁶  According to the District Court, the government failed step one of Chevron. Specifically, the court reviewed Section 960(a). Former Section 960(a)(1) provided an immediate deemed paid FTC when a U.S. company included foreign subsidiary earnings in income as Subpart F income under Section 951(a), while former Section 960(a)(3) provided a deemed paid FTC for foreign taxes paid on a subsequent distribution of PTI. 

FedEx argued that Section 960(a)(3) unambiguously provided an FTC for offset earnings because those earnings were never included in income under Section 951 and, therefore, the taxes remained available for use on a future PTI distribution. However, the government referenced Section 965(b)(4)(A) and stated that offset earnings were treated as if they were included in income. FedEx countered that argument by stating that the government did not give proper attention to the limiting language in Section 965(b)(4)(A), which states “for purposes of applying section 959,” and, therefore, that would not apply to Section 960. 

The District Court ultimately agreed with FedEx and refused to “stretch” Section 965(b)(4)(A) by applying it to both Sections 959 and 960. The court ruled that under the plain language of the tax code, which is not ambiguous, FedEx is entitled to an FTC for foreign taxes paid on the offset earnings that were distributed as PTEP in 2018 and set aside the regulation.

BDO Insights

This case is the latest example of courts finding in favor of taxpayers that challenge the validity of Treasury regulations issued under TCJA international provisions.⁷ Taxpayers that repatriated Section 965(b) PTEP should consider their position on potential foreign tax credit claims, depending on the statute of limitations related to the years in which such PTEP was distributed. BDO can assist companies in assessing the impact of the FedEx case and associated tax positions they may have taken regarding the FTC implications.  

¹ The transition tax resulted from the U.S. moving from a worldwide taxing system to a quasi-territorial taxing system.

² The transition tax applied to earnings of specified foreign corporation, as defined in section 965(e). 

³ Section 965(b)(4)(5).

⁴ “Regulations Regarding the Transition Tax Under Section 965 and Related Provisions,” 84 Fed. Reg. 1838, 1901 (Feb. 5, 2019).

⁵ Chevron U.S.A Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984).

⁶ Id.

⁷ See Liberty Global, Inc. v. United States, 1:20-cv-03501 (D. Colo. April 4, 2022) invalidating a part of the Section 245A temporary regulations.