On March 31, 2023, FedEx, by virtue of a favorable court ruling on its challenge of Treasury regulations, delivered a same-day gift to many U.S.-based multinationals. In FedEx Corp. v. United States, the U.S. District Court for the Western District of Tennessee (the Court) addressed a subtle foreign tax credit issue, bringing into question the validity of regulations concerning the repatriation of controlled foreign corporation (CFC) earnings under the 2017 Tax Cuts and Jobs Act (the TCJA), which included a one-time transition tax on previously deferred earnings and profits (E&P) of CFCs. As discussed in this alert, FedEx’s gift delivered to unsuspecting corporations could be worth millions of dollars.
Code section 965, enacted by the TCJA, imposed a one-time tax (at reduced rates) on the E&P of CFCs for which U.S. taxation had been deferred under pre-2017 rules. In computing the amount taxable, taxpayers could offset the earnings of their previously profitable subsidiaries by the losses of its previously loss-generating subsidiaries. As a result, those losses reduced the amount of positive E&P subject to the transition tax. FedEx and the Court referred to the positive CFC E&P that was offset in that manner as “Offset Earnings.”
Although the Offset Earnings were not subject to tax, section 965(b) allowed those earnings to be treated as previously taxed earnings and profits (PTEP) when repatriated. As a result, the Offset Earnings would not be subject to tax when distributed.
Under a pre-existing foreign tax credit rule, a credit is allowed for foreign taxes with respect to the distribution of PTEP to the extent a credit had not been previously allowed for those taxes. As FedEx correctly pointed out, Congress (in the TCJA) did not modify the foreign tax credit rules to disallow credits for taxes allocable to Offset Earnings. FedEx also noted that Congress went to great pains to disallow credits for a portion of foreign taxes for an entirely different reason (i.e. the reduced U.S. tax rate on section 965 inclusions), but it left the credit for taxes allocable to Offset Earnings intact.
In the wake of the TCJA, Treasury exercised its interpretive rulemaking authority to promulgate regulations (reg. section 1.965-5(C)(1)(ii)), which purport to disallow foreign tax credits allocable to Offset Earnings. In its motion before the Court, FedEx concisely summarized its argument that Treasury exceeded their authority with that regulation:
Congress unambiguously foreclosed any regulatory attempt to disallow foreign tax credits on Offset Earnings beyond the disallowance provisions expressly set forth in the Code. Nothing in the TCJA changed that result. More pointedly, the Code’s comprehensive foreign-tax-credit provisions left no gaps to fill when it came to determining the creditability of foreign taxes paid on Offset Earnings. Congress can change the Code; Treasury cannot.
The Court concluded that the statutory provision granting foreign tax credit benefits with respect to PTEP distributions is unambiguous, leaving Treasury with no interpretive authority to disallow foreign tax credits allocable to PTEP distributions consisting of Offset Earnings. Therefore, the Court held the regulations invalid and granted FedEx’s motion for partial summary judgement, possibly creating a substantial refund opportunity for many U.S. shareholders (e.g., U.S. parent corporations) if they are in a similar situation:
For taxpayers with distributions of Offset Earnings that have not been reported, the Court’s reasoning in FedEx provides support for disregarding the applicable regulations and claiming foreign tax credits allocable to the Offset Earnings on their original returns reporting those earnings. Taxpayers claiming a foreign tax credit benefit contrary to the regulations (whether on an original or amended return) should include a Form 8275-R, “Regulation Disclosure Statement,” indicating that they are taking a position contrary to a Treasury regulation. Failure to do so may result in a penalty.
The FedEx case represents another win for taxpayers challenging the validity of regulations promulgated by Treasury, either on a substantive or procedural basis. With the Court’s decision — like the decisions in Liberty Global Inc. v. United States and Farhy v. Commissioner — taxpayers in similar situations can reap potentially substantial benefits. It remains to be seen whether Treasury will appeal this decision or simply refuse to follow it in jurisdictions other than the Western District of Tennessee. Given the importance of this issue to both parties, this case could make it all the way to the U.S. Supreme Court. Although there is a 10-year statute of limitations for refunds relating to foreign tax credits, it may be prudent for taxpayers who previously repatriated Offset Earnings to proceed with filing their protective refund claims while the issue is top of mind. If you would like to discuss the implications of the FedEx decision, or other court cases, on your previously filed or future returns, please feel free to contact Kevin M. Jacobs or Kenneth Brewer.