Reply Brief — United States v. Goodyear Tire & Rubber Co.

No. 88-1474

§Jn the Supreme Court of the United States

OCTOBER TERM, 1989

UNITED STATES OF AMERICA, PETITIONER

V.

THE GOGDYEAR TIRE AND RUBBER COMPANY

AND AFFILIATES

ON WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE FEDERAL CIRCUIT

REPLY BRIEF FOR THE UNITED STATES

KENNETH W. STARR

Solicitor General

Department of Justice

Washington, D.C. 20530

(202) 633-2217

TABLE OF AUTHORITIES

Cases: Page

American Chicle Co. v. United States, 316 U.S. 4580

er 4.9

H.H. Robertson Co. v. Commissioner, 59 1.C. 53

(1972), aff'd, 500 F.2d 1399 (3d Cir. 1974) 2

Steel Improvement & Forge Co. v. Commissioner,

36 T.C. 265 (1961), rev'd, 314 F.2d 96 (6th Ci

eee ey i4

United Dyewood Corp. v. Bowers, 56 F.2d 603 (2d

Cir. 1932), affg 44 F.2d 399(S.D.N.Y. 1930) 3

Statutes and regulations:

Internal Revenue Code (26 U.S.C.)

§ 312 g

§$ 316 R

$ 902 passim

§ 902(a)1) S

» 904 $. 10

§ 960 14

Treas. Reg. (1971 ed.)

§ 1.902-3(c) 2

§ 1.902-3(c)(1) 17

Miscellaneous:

B. Bittker & J. Eustice, Federal Income Taxation of

Corporations and Shareholders (Sth ed. 1987) 12

H.R. Cont. Rep. No. 861, 98th Cong., 2d Sess.

(1984) yee eee ee 14

H.R. Rep. No. 1447, 87th Cong., 2d Sess. (1962) .. 14

Ae e- oie fo. Perr ee 14

E. Owens, The Foreign Tax Credit (1961) ........ 2,9, 15

1 E. Owens & G. Ball, The Indirect Credit (1975) .. 6, 12 }

Rev. Rul. 63-6, 1963-1 C.B. 126......... _ 17

(II1)

lV

Miscellaneous — Continued: Page

S. Rep. No. 1039, 96th Cong., 2d Sess. (1980) .... 14

S. Rep. No. 313, 99th Cong., 2d Sess. (1986) .... 6, 12, 14

Staff of Joint Comm. on Taxation, 99th Cong.,

2d Sess., General Explanation of the Tax Reform

Act of 1986 (Comm. Print 1987) .............. 14

——

Yn the Supreme Court of the United States

OCTOBER TERM, 1989

No. 88-1474

UNITED STATES OF AMERICA, PETITIONER

Vv.

THE GOODYEAR TIRE AND RUBBER COMPANY

AND AFFILIATES

ON WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE FEDERAL CIRCUIT

REPLY BRIEF FOR THE UNITED STATES

1. Respondent mistakenly asserts (Br. 5-7) that the govern-

ment in its opening brief has taken “new position(s}” for the first

time in this Court. There is manifestly no substance to respond-

ent’s suggestion (Br. 6-7, 16, 38) that the government has argued

that “accumulated profits” in this case should be computed on

an aggregate basis, as under the 1986 legislation, rather than on

an annual basis. In our opening brief (at 4.n.4, 17 1.6, 25 n.11),

we repeatedly note that the Section 902 credit for the years al

issue is computed on an annualized basis and that the dividends

must be “sourced” to the profits of the years out of which they

are paid, We also explain (Br. 7 n.5) that the difference between

respondent’s and the government’s calculation of tax liability ts

caused-in large part by a dispute over whether the dividend in

question can be “sourced” to respondent’s relatively high

foreign tax years of 1968 and 1969. We do, however, question

(1)

2

respondent’s statement (Br. 16) that the concept of “sourcing” is

“critical” to the resolution of this case; it is actually quite sec-

ondary to the question presented. The critical question here is

whether the term “accumulated profits” in Section 902 of the In-

ternal Revenue Code (26 U.S.C.)—i.e., the profits to which the

dividends are “sourced”—is determined in accordance with

principles of U.S. law or of foreign law. Once that determina-

tion is made, the “sourcing” calculation and the application of

the Section 902 apportionment formula follow as a matter of

course.

There is likewise no merit to respondent’s assertion (Br. 5)

that, in stating that “accumulated profits” should be computed

according to the principles governing the determination of

“earnings and profits” under U.S. law, the government is argu-

ing for a different definition from that reflected in the stipula-

tion. As respondent states (Br. 5), the language used in the

stipulation was “computed under United States income tax con-

cepts,” and this phrase clearly encompasses the concept of

“earnings and profits.” Nothing in the stipulation suggests an in-

tent not to invoke that concept, which is the one explicitly iden-

tified in the relevant regulation (Treas. Reg. § 1.902-3(c) (1971

ed.)) and understood by the commentators (see, e.g., E. Owens,

The Foreign Tax Credit 121-122 (1961)), by the Tax Court

(H.H. Robertson Co. v. Commissioner, 59 T.C. 53, 78-79

(1972), aff'd, S00 F.2d 1399 (3d Cir. 1974)), and by Congress

(see U.S. Br. 39 n.17) to be the benchmark for defining “ac-

cumulated profits.”'

2. Conspicuously absent from respondent’s submission is

any analysis of the congressional purpose in establishing the

allocation formula of Section 902. Respondent merely states

that the purpose of the foreign tax credit in general is to prevent

' As we noted in our opening brief (at 25 n.i1), the concepts of “ac-

cumulated profits” and “earnings and profits” are not identical becawse the

former are computed on a year-by-year basis. Hence, there is no force to

respondent's reliance (Br. 27-28) on the failure of Section 902 to use the term

“earnings and profits” or on the fact that the statute uses the phrase “to the ex-

tent * * * dividends are paid * * * out of accumulated profits.” See, e.¢.,

H.H. Robertson Co. v. Commissioner, 59 T.C at 78-79, 86-87.

3

double taxation, and respondent also notes that the indirect

credit is intended to equate the treatment of subsidiary opera-

tions with that of branch operations —in the limited sense that

the domestic owner of a branch always receives full credit for

the foreign tax in the year paid. See Resp. Br. 7, 11-13, 20. This

incomplete view of Section 902 conveniently leads to the conclu-

sion that the allocation formula is to be interpreted so as to

maximize the allowable credit; in respondent’s words, “the com-

putation that produces the greater credit must necessarily ap-

proach most closely the result applicable to a branch operation”

(Resp. Br. 47).

Obviously, respondent’s limited view of the purpese of Sec-

tion 902 is mistaken. If Congress wanted to advance the goal of

inaximizing the credit (because branch operations get the full

credit in the year the tax is paid), it could simply have allowed

the parent of a foreign subsidiary to take the full credit. There

would be no need for the apportionment formula of Section 902

at all. But there is a need for apportionment, and respondent

completely ignores its basic function—namely, to prorate the

foreign tax deemed paid when the subsidiary distributes less

than all of its earnings to the U.S. parent. Congress realized that

when a subsidiary does not distribute all of its earnings to its

parent, the parent is not currently taxed on those earnings and

should not be entitled to a credit for all of the foreign tax paid.

In that situation, in sharp contrast to the branch operation, the

parent has not received all of the earnings subjected to the

foreign tax; some of those earnings have been retained by the

foreign subsidiary and thereby insulated from U.S. tax. Thus,

as we explained in detail in our opening brief (at 26-28 & n.12),

the purpose of Section 902 is to guard not only against double

taxation, but also against undertaxation. In cases of partial

distributions, Congress determined that equal treatment of

branch and subsidiary operations would be achieved if the

parent could take a partial credit; if no credit were allowed, the

parent would be subjected to double taxation, but if the full

credit were allowed, there would be undertaxation and the sub-

sidiary operation would receive preferential treatment as com-

pared to the branch operation. The allocation formula of Sec-

4

tion 902 is designed to allow a prorated credit that bears the

same proportional relationship to the total foreign tax paid as

the dividend distribution bears to the total earnings.

Respondent seeks to have subsidiary operations treated the

same as branch operations with respect to the amount of the

credit received, without focusing on whether the two operations

are reporting an equivalent amount of income. But it is critical

to the goal of nondiscrimination to consider the income that is

distributed to the U.S. parent. In the case of a branch opera-

tion, all of the earnings are immediately received by the parent

and subjected to U.S. taxation. In the case of a subsidiary

operation, like respondent’s, the profits earned by the foreign

subsidiary are generally not included in the income of the U.S.

taxpayer until they are distributed as dividends. As this Court

has noted, “[sJuch dividends, not its subsidiary’s profits, con-

Stitute its income to be returned for taxation.” American Chicle

Co. v. United States, 316 U.S. 450, 452 (1942). Here, during the

years in question, respondent’s subsidiary did not distribute ail

of the earnings that could have been distributed as dividends:

rather, it retained a substantial portion of those earnings as

surplus. Respondent’s approach to the apportionment formula

essentially ignores these retained earnings (to the extent they ex-

ceed the income recognized under foreign law) or pretends that

they have been distributed (see U.S. Br. 45-46), thus allowing

respondent both to receive credit for all of the foreign tax paid

by the subsidiary and also to have its subsidiary retain earnings

immune from U.S. taxation. That approach would give the sub-

sidiary operation a decided advantage over a branch operation

in derogation of Congress’s clear purpose in enacting Section

902. See also point 7, infra.

3. Respondent’s mistake in focusing solely on the credit

received in a branch operation, but not on the income subjected

to U.S. tax, leads it to a fallacious premise that seriously under-

mines its argument. Respondent states (Br. 12) that a 40%

British tax rate is the “touchstone” for determining whether its

tax credit is “consistent” with that of a branch operation.

Respondent then proceeds to argue (id. at 25-27) that the

government’s approach to Section 902 must be incorrect

because it yields an effective British tax rate significantly lower

than 40%. Respondent confuses the “actual” foreign tax rate

with the “effective” foreign tax rate applied to U.S. income. In

fact, when income computed under British law differs from that

computed under U.S. law, the effective British tax rate on U.S.

income will never equal 40%, and the divergence from the ac-

tual rate identified by respondent is precisely what should be ex-

pected if the Section 902 credit is properly serving its function of

promoting equal treatment of branch and subsidiary opera-

tions.

The British tax is laid at 40% on income as computed by Bri-

tain; it necessarily follows that, in cases where the U.S. defini-

tion of income differs from that of Britain, the British tax will

not be 40% of the U.S. income. Clearly, it is the effective rate

imposed on U.S. income that is significant to the taxation of a

branch operation. Foreign concepts of taxable income are irrele-

vant in determining how much of the earnings of a foreign

branch constitute income to its domestic owner; those earnings

flow directly to the owner and are included in its income under

U.S. tax principles. Thus, if the income of the branch is higher

under United States law than under British law, the foreign tax

imposed at 40% on the foreign tax base necessarily wiil be less

than 40% of the larger sum that the owner must report as in-

come on its United States return. And, consequently, the direct

tax credit available to the owner of the branch will also be less

than 40% of the income.? It is this “effective” rate of foreign

? For example, suppose the United States does not allow a $40 deduction

that is allowed by Britain and therefore the income of the branch is defined as

$100 under United States law but as $60 under British law. The British tax will

be $24 ($60 x 40%), and the owner of the branch will be entitled to a direct

foreign tax credit in that amount. This credit is only 24% of the income of the

branch that is subject to United States taxation. The converse is also true —it

the profits of the branch are lower under United States law than under British

law, the foreign tax will be greater than 40% of the profits that constitute in-

come to the domestic owner (although Section 904 prevents the owner from

taking a credit that exceeds the U.S. income tay attributable to the income

from the foreign country (see Resp. Br. 20)).

6

tax, /.e., the foreign tax paid expressed as a percentage of the

branch’s income computed under United States law, that is rele-

vant in measuring whether the Section 902 tax credit for a

domestic company with a British subsidiary is essentially

equivalent to that available to a domestic company with a

branch.?

Contrary to respondent’s contention, examining the effective

rate of tax on the facts of this case demonstrates the correctness

of the government’s position. The Section 902 credit that the

Commissioner allowed to respondent is entirely consistent with

the credit that would have been granted had it been conducting

the same business as a branch. If respondent had operated its

business through a branch, it would have received a credit for all

of the foreign tax paid by the branch, but it also would have

been required to include on its U.S. income tax return all of the

branch’s profits as determined under United States law —the

loss and carryback allowed only by Britain could not have been

used to offset those profits. The result in 1970 and 1971 would

have been a relatively small British tax (and therefore tax credit)

* This divergence of the “effective tax rate” from the stated foreign tax rate

is a well recognized phenomenon. See, e.g., 1 E. Owens & G. Ball, The In-

direct Credit 169-170 (1975). This effective rate is not a “synthetic tax rate in

no way related to reality” (Resp. Br. 25); to the contrary, it reflects the true

burden of the foreign tax on the earnings reported as income on the U.S.

return. indeed, one of the major reasons for the 1986 change in the computa-

tion of the Section 902 credit was to eliminate the ability of multinational cor-

porations (o obtain a tax advantage by manipulating their dividend distribu-

tions to take advantage of fluctuations in the effective rate. Congress found

that many companies sought to maximize the credit by having their foreign

subsidiaries accumulate earnings in years when the effective foreign tax rate

was low-and distribute the earnings in years when it was high, and Congress

eliminated the annualization feature of the credit largely to end the use of this

“rhythm method,” noting that fluctuations in “effective foreign tax rate[s]”

created opportunities for tax avoidance. See S. Rep. No. 313, 99th Cong., 2d

Sess. 305-306 (1986). We note that Congress's recognition of the widespread

use of this “rhythm method,” which can be used only if “accumulated profits”

are computed in accordance with U.S. concepts of taxation or if the actual

foreign tax rate fluctuates, further demonstrates how settled was the inter-

pretation of Section 902 that has been overturned by the court of appeals

below.

because of the reduced British tax base, yet a relatively large

amount of U.S. income; consequently, the effective British tax

rate on the total income of a branch operation would have been

quite small. Because respondent operated its business through a

subsidiary, its U.S. income for these years includes only the

dividends distributed. When the dividends are “sourced” to

these years, however, comparability with a branch requires the

parent to recognize income according to U.S. concepis, which

will yield the same small effective British tax rate that would

have occurred in the case of a branch operation. On these facts,

computation of “accumulated profits” under U.S. concepts

yields an eftective tax rate of only 19.9% for 1970 and 1.6% for

1971, which is precisely what respondent would have paid in

1970 and 1971 had it operated as a branch. See Resp. Br. 26;

J.A. 31.4 The reason that the rates for those years were so low is

that the generous British loss and carryback allowances virtually

eliminated the British tax base for 1971 and substantially re-

duced it for 1970.

4. As we explain in detail in our opening brief (at 15-25), the

apportionment formula of Section 902 is incongruous unless ac-

cumulated profits are defined in terms of U.S. principles. When

a foreign subsidiary makes a distribution to its domestic parent,

the concept of “profits” is relevant at three stages of the Section

902 inquiry. First, the U.S. parent must determine how much ot

the distribution is a dividend reportable as income on its U.S.

return, which requires determining the extent to which it was

paid out of “earnings and profits.” Second, the amount of

* In 1970, a branch operation would have had to recognize £3,812,473 in in-

come, computed under principles of U.S. law. The British tax tor that year

was £758,437, yielding an effective rate of 19.9%. In 1971, the branch would

have recognized U.S. income of £3,224,486 and paid British tan of only

£52,567. For that year, the effective tax rate — and therefore the effective rate

of the credit — would have been only 1.6%. See J.A. 31. Thus, the tigures

computed by respondent on page 26 of its brief show that the Section 902 tor-

mula works properly when “accumulated profits” are detined in terms of US.

concepts. Conversely, if the credit is computed on the basis of an effective

" British tax rate of 40%, it will bear no relation to the credit that would have

been available to a branch operation.

“dividends” to be placed in the numerator of the Section 902

fraction must be determined, i.e., the dividends paid out of “ac-

cumulated profits.” Third, the amount of “accumulated profits”

to be placed in the denominator of the fraction must be deter-

mined. It is our submission that all of these quantities must be

determined in a consistent manner, which means according to

U.S. tax principles. The “earnings and profits” relevant to the

first determination clearly are determined according to U.S. law

pursuant to Sections 312 and 316 of the Internal Revenue Code

(26 U.S.C.). If the apportionment formula is to fulfill its pur-

pose, the “dividends” in the numerator of the fraction must cor-

relate with the “dividends” reported on the U.S. tax return, i.e.,

be based on profits compuied under U.S. principles. And, as

the Claims Court noted (Pet. App. 21a), “[a]lgebraic consisten-

cy” then demands that the profits in the denominator of the

fraction also be based on U.S. tax principles.

Respondent agrees with much of this analysis. Respondent

agrees that the determination of the amount cf dividends re-

ported on the parent’s U.S. return must be based upon profits

computed under U.S. tax principles (see Resp. Br. 37, 44; see

also National Foreign Trade Council Amicus Br. 29). Respond-

ent also appears to agree that “algebraic consistency” demands

that accumulated profits in the numerator be determined ac-

cording to the same principles as in the denominator (see Br.

46). Respondent diverges from the above analysis, however, in

insisting (Br. 44) that U.S. law does not govern the definition of

the numerator. Although respondent does not explicitly state

what does govern the definition of “dividends” in the

numerator, presumably its position is that they are distributions

made out of profits as determined by foreign law. This position

is untenable.

The ultimate goal of Section 902 is to determine the ap-

propriate tax credit that should be allowed on the parent’s U.S.

return to reflect the foreign tax that is “deemed paid” on the

dividend income reported on that return. In the words of the

Statute, the foreign tax shall be allowed as a credit in “the same

proportion” as the “amount of such dividends * * * bears to the

amount of such accumulated profits” (§ 992(a)(1)). Clearly, the

9

dividends in the fraction must correlate with the dividends

reported on the U.S. return in order to obtain the correct pro-

portion for allowing a partial credit against the U.S. income tax

on those dividends. As this Court explained in American Chicle

Co. v. United States, 316 U.S. 450 (1942), the foreign tax is to

be “proportioned to the dividends made available to the parent

in this country” (id. at 454), which means that “the numerator is

the dividends received by the parent” (id. at 452). If the

dividends in the ratio do not correlate with the dividends being

taxed on the parent’s return, then the apportionment exercise

becomes meaningless.’ See generally E. Owens, The Foreign

Tax Credit 121-122 (1961). Thus, as the Tax Court has held on

several occasions (see U.S. Br. 19-20), the “dividends” in the

numerator of the Section 902 fraction must be determined on

the basis of profits computed under U.S. concepts.® If so, the

principle of “algebraic consistency” recognized by respondent

demands that the term “accumulated profits” in the denominator

> For example, suppose a subsidiary pays $80 in British tax on income com-

puted as $200 under British law and as $1000 under U.S. law. If the subsidiary

distributes 50% of its after-tax earnings and profits to the parent ($460), one

would expect Section 902 to allow the parent to take 50% of the foreign tax

($40) as a credit on its return. But under respondent's erroneous definition of

“accumulated profits,” the numerator of the fraction—the “dividends” paid

out of “accumulated profits” — would be only $120 (the after-tax earnings of

the subsidiary according to foreign law principles). A ratio containing this

figure cannot be expected to yield the correct proportional credit to be applied

against the tax on the $460 dividend; in this example, respondent's approach

would allow the parent to take the full $80 credit on this 50% distribution

($80 x $120/($200 — $80) = $80).

* Respondent seeks to blunt this argument by asserting that the amount of

foreign taxes paid “is part of the numerator” (Br. 46), and therefore the

denominator must also be determined in accordance with foreign tax prin-

ciples. This assertion is incorrect. The Section 902 fraction measures the ratio

of dividends to after-tax profits. The amount of foreign taxes paid simply

represents the maximum credit, to which this ratio is applied to determine the

proportional credit. In mathematical terms, the amount of tax paid is the

“multiplicand” (American Chicle Co. v. United States, 316 U.S. at 452), not

part of the fraction, and there is no logical reason why the derivation of the

amounts in the ratio should be affected by the manner in which the tax ts com-

puted,

10

must also be defined under U.S. concepts, and therefore the

decision below cannot stand.

5. Respondent relies heavily (Br. 20-24) on two examples

(numbered 2 and 3), which it claims illustrate the distortions

caused by the Commissioner’s interpretation of Section 902.

Amicus curiae National Foreign Trade Council presents its own

ex ples (Br. 15-17, 21-25), also claiming that they demonstrate

the error of the Commissioner’s approach. These examples will

not bear the weight ascribed to them, however, for they do not

illustrate anything about the general operation of the Section

902 credit.

The crucial feature common to all of these examples is

hypothesizing a year in which the subsidiary pays foreign tax,

but has zero profits under U.S. principles. Because a dividend

cannot be “sourced” to a year in which there are no accumulated

profits, the foreign tax paid in that year can never be matched to

a dividend and therefore it can never be credited as “deemed

paid.” Thus, the narrow point illustrated by the various ex-

amples is that defining accumulated profits in terms of U.S.

concepts yields an anomalous result in one specific situation:

where foreign tax is paid in a year in which the subsidiary’s ac-

cumulated profits under U.S. concepts are zero, the credit for

the foreign tax paid in that year wili be “blocked,” resulting in

some degree of double taxation after a full dividend distribu-

tion. The examples, however, illustrate nothing about a case in

which there is not a zero year; so long as there exists even one

dollar in after-tax profits under U.S. concepts, the anomalous

result highlighted by respondent will disappear because the Sec-

tion 902 formula will credit the foreign tax paid in that year in

full when a dividend distribution is “sourced” to the U.S. profits

for that year.

These examples provide no basis for affirmance of the judg-

ment below. First, respondent’s assertion (Br. 22) that one of

the examples “presents the very essence of Goodyear’s case” is

insupportable. The theoretical possibility of an unrecoverable

payment of foreign tax is not present in most cases, and it cer-

tainly is not present here. The accumulated profits of respond-

ent’s subsidiary for 1970 and 1971, as computed by the Com-

missioner under U.S. law, are far in excess of zero. The Com-

missioner’s computation already credited respondent with a por-

tion of the foreign taxes paid for those years (based on the ratio

of the dividends paid to the accumulated profits), and the rest

of those taxes, as well as the foreign taxes paid in 1968 and 1969

whose credit respondent seeks to accelerate, remain fully ac-

cessible to be claimed as credits whenever the balance of the re-

tained profits may be distributed. See J.A. 31.’ Thus, these ex-

amples bear no relation to the facts of this case.

In any event, the “zero income” anomaly illustrated by

respondent’s examples provides no support for the conclusion

that accumulated profits should be determined under foreign

law principles. At most, the examples show that Section 902

does not work perfectly in a carefully structured set of -cir-

cumstances that is not likely to occur frequently. If that anoma-

ly is unacceptable, the appropriate way to address it is through a

narrowly tailored adjustment, not to misinterpret and eviscerate

the statute by defining accumulated profits in terms of foreign

law principles. As we have explained, respondent’s interpreta-

tion would incorrectly apportion the credit, not just in unusual

“zero income” cases, but in every case in which profits are dif-

ferent under U.S. and foreign law concepts. Indeed, even with

respect to the specific problem of a “blocked” or unrecoverable

credit, respondent’s interpretation is inferior. If accumulated

profits are determined according to foreign law, in every case in

which the foreign definition of income yields a larger amount

than the U.S. definition, the taxpayer will be restricted from

recovering a portion of the foreign tax paid. This is because a

distribution in the full amount of the U.S. income will yield only

’ There is similarly no merit to respondent's effort to analogize this case to

one where there is a difference in U.S. and foreign rules regarding the timing

of a loss carryback (see Br. 22-23). Example 3, and respondent’s references to

the timing of a loss, all involve carryback of a loss that is recognized under

both foreign and U.S. law, but where the laws of the two countries differ with

respect to the timing of the carryback. Here, however, the discrepancy is over

the availability of the loss at all. If respondent's profits are computed under

U.S. principles, the loss deduction allowed by Britain in 1973 is not available.

Instead the subsidiary’s loss for 1973 is converted into a profit, and there is no

question of carryback at all. See J.A. 24.

12

a partial credit, and any additional distribution will not be a

dividend (because it is not out of “earnings and profits”) and

therefore will not give rise to any Section 902 credit. See U.S.

Br. 22; point 7, infra. Thus, although the “zero income” anoma-

ly has long been recognized, it has never been suggested that it

should be “cured” by defining accumulated profits in terms of

foreign law. See, e.g., B. Bittker & J. Eustice, Federal Income

Taxation of Corporations and Shareholders 4 17.11, at 17-44,

17-47 (Sth ed. 1987); 1 E. Owens & G. Ball, The Indirect Credit

164-165, 174 (1975).® Clearly, this discrete hypothetical situa-

tion, which is not presented here, cannot form the basis for

resolving one of the fundamental questions relating to the

general applicability of Section 902.

6. Respondent argues that the term “total taxable income”

used in the original 1918 version of Section 902 in lieu of “ac-

cumulated profits” clearly refers to a foreign definition of in-

come, and therefore the statute at issue here should be con-

strued the same way. See Resp. Br. 30; National Foreign Trade

Council Amicus Br. 13-14; Vulcan Materials Co. Amicus Br.

5-11. The premise of this argument is highly questionable.*? As

we have explained, it would have been illogical for Congress to

have based the statute’s apportionment formula upon a foreign

* The “zero income” anomaly has, for the most part, been cured prospec-

tively by the 1986 amendments that eliminate the annualized approach and

create a pool of accumulated earnings. See U.S. Br. 38-39 & n.17. One of the

reasons for this change identified in the legislative history was to eliminate the

“zero income” anomaly that could occur through the application of U.S.

carryback rules. See S. Rep. No. 313, supra, at 305-306.

* Respondent is correct in stating (Br. 30) that there is no affirmative indica-

tion that Congress in 1921 sought to change from a foreign definition of in-

come to one based on U.S. tax concepts. But there is also no reason to believe

that Congress understood the 1918 statute to refer to foreign law concepts. We

would add that there is no indication that Congress has ever intended to make

a change in Section 902 from foreign to U.S. concepts, even though it is clear

that the statute today unequivocally contemplates the use of U.S. concepts

(see U.S. Br. 39 n.17). If the statute contemplates the use of U.S. concepts

today and Congress never changed it in this respect, it would follow from

respondent’s line of argument that the statute has always contemplated the use

of U.S. concepts.

13

definition of income because that approach would not correctly

relate the apportioned credit to the dividend reported on the U.S.

return, which comes out of U.S. profits. Moreover, since the

statute was designed to provide a credit equivalent to branch

operations, which report income determined under U.S. con-

cepts, it would have upset the balance for Congress to have con-

templated the use of foreign profits in allocating the credit to sub-

sidiary operations. Because the concept that Congress had to in-

corporate in the statute was a hybrid—a measurement of the

profits of a foreign corporation intended to be used to determine

the appropriate tax credit allowed to a U.S. eerporation—no

commonly used term in the Code was appropriate, antit was rea-

sonable for Congress to invent a new one.'® The phrase that it

chose, “total taxable income,” does not by its terms clearly refer

either to foreign or U.S. concepts of income, and there is no per-

suasive evidence that Congress, simply by using this term in the

1918 legislation, deliberately chose the illogical and counter-

productive course of using a foreign definition of income.'!

'© Thus, Congress could not simply have used the term “net income,” as

Amicus Vulcan Materials Co. suggests (Br. 7). A foreign corporation has no

“U.S. corporate tax base” (ibid.), and therefore, strictly speaking, it has no

“net income.”

'' Respondent places undue reliance on the Second Circuit’s per curiam

opinion in United Dyewood Corp. v. Bowers, 56 F.2d 603 (1932), affg 44 F.2d

399 (S.D. N.Y. 1930). The court there sought to apply the 1918 versian of the

statute to a case where the foreign subsidiary had paid two creditable foreign

taxes—an income tax and an excess profits tax—that were imposed on

overlapping foreign tax bases. While the Second Circuit stated that the term

“total taxable income” referred to the foreign tax base, it is not apparent that

there was any difference there between the U.S. and foreign definitions of in-

come or that it was even suggested to the court that U.S. concepts might con-

trol; the dispute centered on the effect upon the credit of the overlap between

the two tax bases. Moreover, the case was litigated and decided prior to the

Treasury's statement of its position in 1933 that U.S. principles govern the

definition of profits. Thus, the Second Circuit's statement concerning the

meaning of a phrase that disappeared from the statute more than 65 years ago

cannot be viewed as a reasoned rejection of the proposition that, where profits

would be computed differently under U.S. and foreign law principles, the Sec-

tion 902 credit functions proper:, only if “accumulated profits” are deter-

mined in accordance with U.S. principles.

14

Similarly, Congress’s failure in 1962 to amend Section 902 to

conform with language being used in the new Subpart F gives

rise to no inference that Section 902 refers to profits computed

under foreign law principles. Cf. National Foreign Trade Coun-

cil Amicus Br. 10-12. The meaning of “accumulated profits”

was by that time recognized as referring to U.S. law, and there

was no reason for Congress to tamper with the existing

language. See, e.g., 1.T. 2676, XII-1 C.B. 48, 50 (1933); Stee/

Improvement & Forge Co. v. Commissioner, 36 T.C. 265,

276-282 (1961), rev’d on other grounds, 314 F.2d 96 (6th Cir.

1963). Indeed, the 1962 legislative history shows Congress’s

understanding that Section 960 of the Code would operate

under “rules * * * consistent with Section 902,” which means

that Congress must have understood that “accumulated profits”

are computed under U.S. tax concepts. H.R. Rep. No. 1447,

87th Cong., 2d Sess. Al03-A104 (1962). And that same

understanding is reflected in the history of sunenqueen enact-

ments in the foreign tax credit area.'?

7. In our opening brief (at 21-22), we provide some simple

examples to illustrate how respondent’s interpretation of Sec-

tion 902 would disrupt the proper operation of the credit by fail-

ing to correlate the percentage of the credit allowed with the

percentage of earnings distributed by the foreign subsidiary.

Respondent contends (Br. 39-40; see also National Foreign

Trade Council Amicus Br. 18-20) that these examples are

misleading, arguing that the incorrect credits yielded by the use

of a foreign definition of “accumulated profits” in the govern-

ment’s examples are a consequence not of respondent’s misinter-

pretation of Section 902, but rather of the government’s failure

to use the same foreign tax rate in all of the examples. This ob-

'? See S. Rep. No. 313, 99th Cong., 2d Sess. 299 (1986); Staff of Joint

Comm. on Taxation, 99th Cong., 2d Sess., General Explanation of the Tax

Reform Act of 1986, at 858 (Comm. Print 1987) (“accumulated profits * * *

were generally calculated in accordance with the principles governing the

calculation of earnings and profits for U.S. tax purposes”); H.R. Conf. Rep.

No. 861, 98th Cong., 2d Sess. 841 (1984) (“accumulated profits are essentially

equivalent to earnings and profits”); S. Rep. No. 1039, 96th Cong., 2d Sess. 15

(1980).

a

15

jection is completely misconceived. The problem illustrated by

the examples is that, ufider respondent’s interpretation, dis-

parities between the U.S. and foreign tax base would yield either

an overstatement or understatement of the credit that should be

apportioned to a particular dividend. Specifically, when the U.S.

tax base is lower than the foreign tax base, ithe credit would be

too low, resulting in double taxation; the taxpayer would be

denied full credit for the foreign taxes paid even when it

distributes all of its earnings as a dividend. Conversely, when the

U.S. tax base is higher than the foreign tax base, the credit would

be too high; the taxpayer would be able to take the full credit

when it does not distribute all of its earnings as a dividend. These

faulty results are illustrated by the individual examples standing

alone, not by a comparison of the various examples to a “base

case,” and therefore the results clearly are not attributable to a

failure to use the same foreign tax rate in each example.

Thus, the same point can be illustrated by changing the ex-

amples (U.S. Br. 21-22) to use a constant 20% foreign tax rate.

In the second example, where the foreign definition of income

yields $180 and the U.S. definition yields $100, the foreign tax

paid at a 20% rate will be $36, which leaves after-tax U.S. prof-

its of $64. If all of that $64 of U.S. profits is distributed as a

dividend, the taxpayer should receive the full credit of $36. That

is precisely the result obtained under the Section 902 formula if

accumulated profits are defined according to U.S. concepts: $36

x $64/($100 — $36) = $36. But under respondent's approach of

defining accumulated profits in terms of foreign tax law con-

cepts, the taxpayer receives only a partial credit even though the

subsidiary has distributed 100% of the available earnings and

profits as a dividend. If $180 is used as the accumulated profits

in the Section 902 formula, the taxpayer will receive credit for

less than half of the foreign taxes paid: $36 x $64/($180 — $36)

= $16.'? Moreover, the foreign tax that is not credited here may

'' This point is cogently expressed in one detailed scholarly analysis of the

foreign tax credit (E. Owens, The Foreign Tax Credit 122 (1961) (footnote

omitted)):

{i}f all the accumulated profits of a given year are distributed and if they

are distributed to one stockholder this [Section 902] traction should have

16

be permanently blocked because any distribution that exceeds

the profits defined under U.S. law, by definition, will not be a

dividend and thus will not give rise to any Section 902 credit

(unless the foreign tax base in subsequent years is lower than the

U.S. tax base).

if the U.S. tax base is greater than the foreign tax base, the

opposite distortion will occur—namely, the taxpayer will be

able to take a credit for all of the foreign tax paid even if the

subsidiary does not distribute all of its earnings. Using the

numbers from the third example in our opening brief with a

20% foreign tax rate, i.e., $100 of U.S. income and $60 of

foreign income, the foreign tax will be $12, leaving $88 in after-

tax US. profiis. By distributing only $48 of those profits, the

taxpayer would be able to take a credit for all of the $12 of

foreign tax pe’d if respondent’s interpretation of Section 902

were correct. The formula would be as follows: $12 x

$48/($60 -$12) = $12. This result would clearly defeat the

basic statutory purpose of the Section 902 allocation formula to

prevent the parent-subsidiary operation from taking the full

credit when the subsidiary has retained some of the earnings

(thereby insulating them from U.S. tax).'* Conversely, this pur-

pose is properly served if accumulated profits are defined in

terms of U.S. tax concepts; in this example, that approach will

permit the taxpayer to take a credit for slightly more than half

no effect on the amount of foreign tax creditable. In other words, the

fraction should be one over one and the entire foreign tax should be

credited. It is clear that this result will be reached only if “accumulated

profits” in the denominator of the fraction is defined in exactly the same

way as is the source of the “dividends” in the numerator; that is, as “earn-

ings and profits” of the foreign corporation as computed under United

States tax law.

'* Amicus National Foreign Trade Council itself uses this example in Table

V of its brief (at 20). Elsewhere in its brief, however, it recognizes the unac-

ceptability of the result engendered by the use of a foreign definition of ac-

cumulated profits in the example. Amicus correctly states that “if a wholly

owned subsidiary in a particular year distributes only a part of what is

available after payment of the foreign tax, the credit should obviously not be

tor the full amount of the foreign tax” (Br. §)

17

of the foreign tax paid, which it can apply against the U.S. taxa-

tion of a dividend that reflects a distribution of slightly more

than half of the subsidiary’s earnings. The formula would be as

follows: $12 x $48/($100—$12) = $6.55.

8. Respondent’s contention (Br. 31-37, 41-43) that the deci-

sion below does not conflict with the longstanding ad-

ministrative practice is unresponsive to our prior filings in this

case and entirely without merit. The crabbed construction

respondent gives to Treas. Reg. § 1.902-3(c)(1) (see Br. 31-33)

has no basis in its text. Moreover, respondent’s argument ig-

nores the acknowledged fact (see Resp. Br. 42) that Rev. Rul.

63-6, 1963-1 C.B. 126, published just two years before the

regulation, squarely holds that “U.S. rules should govern the

determination of ‘accumulated profits.’”'*’ The regulation

plainly carries forward the substance of the revenue rul-

ing—namely, that “accumulated profits,” like “earnings and

profits,” denote the source from which dividends are paid and

must be calculated in accordance with U.S. principles of taxa-

tion. See U.S. Br. 33-34 & n.14.'*

'S As we have explained (Br. 34 n. 14; Pet. Reply Br. 5-6 & n.2), the ad-

ministrative step of declaring this ruling “obsolete” does not indicate a depar-

ture from its substance.

'® Respondent also repeats (Br. 31, 43) its contention that subparagraph (4)

of the regulation supports its position. As we explained in our reply at the peti-

tion stage (at 6-7), this subparagraph does not define accumulated profits and

is fully consistent with the explicit definition in subparagraph (1). We have

also earlier refuted respondent's claim (Br. 10, 33, 46) that the statutory phrase

“gains, profits, and income” necessarily refers to profits computed under

foreign tax principles. See U.S. Pet. Re ply Br. 7 n.3.

18

For the foregoing reasons, and those stated in our opening

brief, the judgment of the court of appeals should be reversed.

Respectfully submitted.

KENNETH W. STARR

Solicitor General

OCTOBER 1989

US GOVERNMENT PRINTING OFFICE 1969-241 699/00533