The Tax Times: Tax Court Tell Varian You Can't Have It Both Ways - 100% Section 245A DRD on Section 78 Gross-Up & Foreign Tax Credits

Varian Medical Systems, Inc. and Subsidiaries v. Commissioner, 163 T.C. No. 4 (Aug. 26, 2024), is a key U.S. Tax Court decision on whether a fiscal‑year corporate taxpayer could claim a section 245A participation‑exemption DRD on a section 78 gross‑up during the TCJA “gap period,” and what that meant for its foreign tax credits.

Case overview

Varian, a U.S. parent filing a consolidated return, owned controlled foreign corporations (CFCs) and for its 2018 fiscal year both elected foreign tax credits and was required to include a section 78 gross‑up in income tied to deemed‑paid foreign taxes. On its return, Varian reported a section 78 dividend of roughly 159 million dollars and claimed an approximately 60‑million‑dollar deduction under section 245A related to that gross‑up, while also claiming significant foreign tax credits. Following examination, the IRS issued a notice of deficiency disallowing the section 245A deduction on the section 78 amount and increasing the section 78 dividend by about 1.9 million dollars, and alternatively asserted that if the deduction were allowed, Varian’s foreign tax credits must be limited.^[2]^[5]^[1]

The statutory “gap period” issue

The dispute grew out of a mismatch in effective dates created by the TCJA between new section 245A and the contemporaneous amendment to section 78. Section 245A, the participation exemption, generally applies to certain dividends received by U.S. corporations from specified 10‑percent owned foreign corporations, allowing a 100 percent DRD for qualifying distributions. Section 78, which treats deemed‑paid foreign taxes as a dividend “gross‑up,” was later amended to say that amounts taken into account under section 245A are not eligible for a section 78 gross‑up, but for fiscal‑year taxpayers there was a period in 2018 where the new section 245A applied while the amended section 78 did not yet apply. Varian’s position was that, during that window, the text of section 245A permitted a DRD for the section 78 dividend, because the statute did not carve out gross‑ups, and no other operative provision barred the deduction.

The Commissioner relied heavily on Treasury Regulation section 1.78‑1, as amended in 2019, to argue that the section 78 gross‑up could not be treated as eligible for the section 245A DRD. The IRS also argued that, even if a deduction were allowable, section 245A(d)(1) and related rules operate to limit foreign tax credits to prevent a double benefit when a taxpayer both claims a DRD and foreign tax credits on the same earnings.

The Tax Court’s holding

On cross‑motions for partial summary judgment, the Tax Court held that Varian was entitled to a 100 percent DRD under section 245A on the section 78 gross‑up for the 2018 fiscal year gap period. The Court found that the operative statutory text of section 245A, as in effect for Varian’s year, encompassed the section 78 gross‑up and that the government’s attempt to exclude such amounts via regulation was inconsistent with the statute. In doing so, the Court invalidated the long‑standing regulation under section 78 to the extent it barred section 245A treatment for the gross‑up, and it invoked the Supreme Court’s Loper Bright framework to reject deference to the IRS’s interpretation.

However, the Tax Court also agreed with the Commissioner that section 245A(d)(1) required a reduction in Varian’s foreign tax credits attributable to the same earnings covered by the DRD. The Court concluded that allowing both a full section 245A DRD on the section 78 dividend and an unreduced foreign tax credit on the related deemed‑paid taxes would confer an impermissible double benefit, so Varian’s foreign tax credits had to be proportionately disallowed under the statutory limitation formula.

Practical implications for corporate taxpayers

Varian confirms that, for fiscal‑year taxpayers caught in the TCJA effective‑date gap, section 245A can reach section 78 gross‑up amounts, notwithstanding contrary regulatory language, allowing a 100 percent DRD on those deemed dividends. At the same time, the decision underscores that taxpayers cannot stack both full participation‑exemption benefits and full foreign tax credits on the same pool of foreign earnings; section 245A(d)(1) will require a calculated reduction in foreign tax credits to offset the DRD.

Beyond the technical DRD and FTC computation, the case has broader significance in tax administration because it represents a unanimous Tax Court willingness to invalidate an IRS regulation where it conflicts with the statute, using the post‑Loper Bright approach to agency deference. For multinational groups with similar fact patterns, Varian provides both an opportunity—asserting DRDs for section 78 gross‑ups in the gap period—and a warning that collateral issues, especially around the foreign tax credit limitation, can materially affect the net benefit even when the primary statutory interpretation issue is decided in the taxpayer’s favor.

Have A Tax Problem?