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

> Briefs, arguments, decisions, and more.

URL: https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385012_1483%3A08

## Record

- **Collection:** Supreme Court brief
- **Document type:** Reply Brief
- **Published:** January 1, 1990
- **Citation:** 493 U.S. 132

## Text

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

---

Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385012_1483%3A08. Public record. Not legal advice.