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CFC Partners of U.S. Partnership Had to Increase E&P for Subpart F Income

(Parker Tax Publishing March 2019)

The Tax Court held that several controlled foreign corporations (CFC) that were partners of a U.S. partnership were required to increase their earnings and profits (E&P) as a result of the partnership's income inclusions under Code Sec. 951(a) resulting from the partnership's ownership of lower-tier CFCs. The Tax Court found that under the general rules for determining E&P under Code Sec. 312, all items of income, including Code Sec. 951(a) income inclusions, are taken into account in determining E&P. Eaton Corporation et al v. Comm'r, 152 T.C. No. 2 (2019).


Eaton Corporation is a domestic corporation and the parent of Eaton Group, an affiliated group of corporations that filed consolidated federal income tax returns. Members of Eaton Group were 100 percent shareholders of foreign corporations that were controlled foreign corporations (CFCs) under Code Sec. 957. A CFC is a foreign corporation whose stock is more than 50 percent owned by U.S. shareholders. The CFCs, referred to as upper tier CFC partners, collectively held all of the membership interests in EW LLC, a domestic partnership.

EW LLC was the sole U.S. shareholder of several lower tier CFCs. EW LLC included in income under Code Sec. 951(a) the subpart F income earned by the lower tier CFCs and amounts calculated under Code Sec. 956 with respect to the lower tier CFCs. Because the upper tier CFC partners were not U.S. persons under Code Sec. 957(c), they were not U.S. shareholders of the lower tier CFCs. The lower tier CFCs made no distributions of property to EW LLC during 2007 and 2008, the years at issue.

In March 2007, EW LLC purchased all of the common stock of AT Holdings Corp. (AT Holdings) from a third party for approximately $387 million. The sole asset of AT Holdings was the stock of Argo-Tech Corp. EW LLC thereafter owned 100 percent of the common stock of AT Holdings. Each upper tier CFC partner was treated as holding an interest in U.S. property by virtue of EW LLC's ownership of AT Holdings for purposes of Code Sec. 951(a)(1)(B) and Code Sec. 956.

Tax Reporting

Under Code Sec. 951(a), EW LLC was required to include in gross income its pro rata share of the subpart F income generated by the lower tier CFCS and Code Sec. 956 amounts with respect to the lower tier CFCs. The lower tier CFCs treated the amounts included by EW LLC as previously taxed earnings and profits (E&P) under Code Sec. 959(c). EW LLC filed Forms 1065 reporting income inclusions with respect to the lower tier CFCs. EW LLC issued Schedules K-1 to the upper tier CFC partners reflecting their distributive shares of its income inclusions. The upper tier CFC partners excluded these amounts from gross income and from the calculation of their subpart F income.

None of the upper tier CFC partners adjusted their E&P as a result of their distributive shares of EW LLC's income inclusions. The upper tier CFC partners likewise made no adjustments to their respective bases in their partnership interests in EW LLC corresponding to their distributive shares of EW LLC's income inclusions.

The IRS determined deficiencies and penalties for the 2007-2010 tax years of Eaton Corp. According to the IRS, the upper tier CFC partners were required to increase their E&P by the amount of their Code Sec. 951(a) income inclusions with respect to the lower tier CFCs. As a result, the amounts to be included in Eaton Corp.'s gross income under Code Sec. 951 and Code Sec. 956 were approximately $73 million for 2007 and $114 million for 2008. Eaton Corp. challenged this determination in the Tax Court.


Foreign source income earned by a CFC is generally not subject to U.S. taxation until repatriated as a dividend or other distribution to the CFC's U.S. shareholders. However, under Code Sec. 951(a), a U.S. shareholder must include in gross income its pro rata share of certain items attributable to the CFC, regardless of whether any distribution was made. Generally, this includes both its income determined under the rules in subpart F (subpart F income) and the amount determined under Code Sec. 956. When the CFC eventually distributes the amounts previously included in the U.S. shareholder's gross income, the distribution then reduces the CFC's E&P. To avoid double taxation, the actual distribution is excluded from the shareholder's gross income.

Code Sec. 312 and the regulations interpreting it provide rules for calculating the E&P of a domestic corporation, while Code Sec. 964(a) concerns the calculation of the E&P of a foreign corporation. Under Code Sec. 964(a), a foreign corporation's E&P are generally determined "according to rules substantially similar to those applicable to domestic corporations under regulations prescribed by the Secretary," while Reg. Sec. 1.964-1(a)(1) states that the E&P of a foreign corporation are generally computed substantially as if the corporation were a domestic corporation, with adjustments to the corporation's profit and loss statement to conform to accounting principles generally accepted in the United States. Reg. Sec. 1.312-6(b) provides that the items entering the computation of E&P include "all items includible in gross income" under Code Sec. 61.

Eaton Corp. argued that Reg. Sec. 1.964-1(a)(1) contains a comprehensive system for determining a foreign corporation's E&P which foreclosed the requirement in Reg. Sec. 1.312-6(b) to take into account items includable in gross income. Eaton Corp. also contended that Code Sec. 951(a) inclusions did not increase the dividend paying capacity of the upper tier CFC partners; the Code Sec. 951(a) inclusion was "phantom income," according to Eaton Corp., and E&P should be increased only where a corporation receives a tangible, economic value that enhances its dividend paying capacity.

The Tax Court disagreed with Eaton Corp.'s interpretation and concluded that the upper tier CFC partners had to include in their gross income their distributive shares of EW LLC's income under Code Sec. 312, and that under Code Sec. 951(a), EW LLC's income included the Code Sec. 951(a) inclusions from the lower tier CFCs.

The Tax Court determined that the reference to "regulations" in Code Sec. 964(a) could be reasonably read to include the regulations under Code Sec. 312 as well as those under Code Sec. 964(a). In the court's view, nothing in Code Sec. 964(a) limited the scope of "regulations" to regulations under that specific provision. The court also determined that Reg. Sec. 1.964-1(a)(1) did not provide comprehensive guidance for calculating a foreign corporation's E&P but only specified a preliminary process by which a foreign corporation's P&L statement is conformed to that of a domestic corporation through a series of tax accounting adjustments. Thus, the Tax Court concluded that the rules in Code Sec. 312 and its regulations applied in determining the E&P of the upper tier CFC partners.

Next, the Tax Court considered what should be included in the upper tier CFC partners' E&P. The court found no explicit rules specifying how a CFC's distributive share of partnership income generally - or its distributive share of a partnership's income inclusion under Code Sec. 951(a) specifically - should be treated for purposes of computing its E&P. Looking to the general rules of subpart F and Code Sec. 312, the court concluded that the upper tier CFC partners had to include in their gross income their distributive shares of EW LLC's income, which included subpart F income and Code Sec. 956(a) inclusions from the lower tier CFCs. The court found that Reg. Sec. 1.312-6(b) explicitly states that E&P shall be determined by taking into account "all items includible in gross income" under Code Sec. 61. Because the upper tier CFC partners' distributive shares of EW LLC's Code Sec. 951(a) inclusions were includible in their gross income, their E&P had to be increased by those amounts, the court concluded.

The court reasoned that failing to increase the upper tier CFC partners' E&P would produce an irrational result given that the lower tier CFCs treated the amounts as previously taxed E&P. The court also found that the fact that the upper tier CFC partners did not reflect their distributive shares of EW LLC's Code Sec. 951(a) inclusions on their unconsolidated financial statements had no bearing on the requirement that such amounts be included in their E&P. The court reasoned that the P&L statement referred to in Reg. Sec. 1.964-1(a)(1) is not produced by copying local financial records but by preparing from such records a financial statement conforming to U.S. tax standards. The required preparation, the court explained, includes ensuring that the statement conforms to U.S. federal income tax principles applicable to the computation of E&P by including all items of income. In the court's view, Eaton Corp. could not follow local accounting or GAAP to the exclusion of U.S. tax principles.

The Tax Court also rejected Eaton Corp.'s argument that Code Sec. 951(a) inclusions did not increase the dividend paying capacity of the upper tier CFC partners. The court found many instances in which E&P are increased when amounts are included in income but no cash is received.

For a discussion of the taxation of U.S. shareholders of CFCs, see Parker Tax ¶201,510.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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