UNITED STATES OF AMERICA, PETITIONER V. THE GOODYEAR TIRE AND RUBBER COMPANY AND AFFILIATES No. 88-1474 In the Supreme Court of the United States October Term, 1988 Petition For A Writ Of Certiorari To The United States Court Of Appeals For The Federal Circuit The Solicitor General, on behalf of the United States of America, petitions for a writ of certiorari to review the judgment of the United States Court of Appeals for the Federal Circuit in this case. TABLE OF CONTENTS Question Presented Opinions below Jurisdiction Statutory and regulatory provisions involved Statement Reasons for granting the petition Conclusion Opinions Below The opinion of the court of appeals (App., infra, 1a-8a) is reported at 856 F.2d 170. The opinion of the Claims Court (App., infra, 9a-28a) is reported at 14 Cl. Ct. 23. JURISDICTION The judgment of the court of appeals (App., infra, 29a) was entered on August 31, 1988. A petition for rehearing was denied on November 8, 1988 (App., infra, 31a). On January 25, 1989, the Chief Justice extended the time within which to petition for a writ of certiorari to and including March 8, 1989. The jurisdiction of this Court is invoked under 28 U.S.C. 1254(1). STATUTORY AND REGULATORY PROVISIONS INVOLVED Sections 316, 901, and 902 of the Internal Revenue Code of 1954 (26 U.S.C.) and Section 1.902-3 of the Treasury Regulations on Income Tax (26 C.F.R.), as in effect for 1970 and 1971, are set forth in pertinent part in a statutory appendix (App., infra, 32a-35a). QUESTION PRESENTED Whether the term "accumulated profits" in the foreign tax credit provisions of Section 902 of the Internal Revenue Code means income or profits as defined by the tax law of the United States or, instead, as defined by the tax law of a foreign country. STATEMENT 1. This case involves the foreign tax credit applicable to the taxation of dividend income received by a domestic corporation from its foreign subsidiary. When a foreign subsidiary delivers all or part of its profits to its parent, that money generally is taxable to the parent as a dividend under the provisions of Sections 301 and 316 of the Internal Revenue Code. /1/ If those profits have already been subjected to income tax by the foreign country where they were earned, simple taxation as a dividend by the United States will result in double taxation of the same income. Accordingly, Sections 901(a) and 902(a)(1) of the Code allow the parent (if it owns at least 10 % of the voting stock of the foreign subsidiary) to take an "indirect" or "deemed paid" credit against its United States income tax to reflect income tax paid by the subsidiary to a foreign country. The situation is complicated somewhat when, in a particular year, the foreign subsidiary does not deliver all of its profits to its parent, but instead retains some of the profits and adds them to surplus. In that event, giving the parent a full credit for all of the foreign income tax paid by the subsidiary would be a windfall because the parent is not receiving all of the subsidiary's profits as a dividend subject to United States income tax. Therefore, the Code allows the parent to take a credit for only a prorated portion of the foreign income taxes paid by the subsidiary. See generally American Chicle Co. v. United States, 316 U.S. 450 (1942). Section 902(a)(1) provides for the computation of the allowable credit as follows: "to the extent such dividends are paid by such foreign corporation out of accumulated profits," the parent is "deemed to have paid the same proportion of any income * * * taxes paid * * * by such foreign corporation to any foreign country * * * on or with respect to such accumulated profits, which the amount of such dividends * * * bears to the amount of such accumulated profits in excess of such * * * taxes." In other words, the allowable prorated credit is computed by multiplying the foreign taxes paid by a fraction -- the ratio of the dividends paid to the subsidiary's (after-tax) accumulated profits. This computation is illustrated by the following equation (see App., infra, 4a, 15a n.6): /2/ Foreign taxes paid x Dividends divided by Accumulated profits minus foreign taxes = Section 902 credit The issue in this case is the meaning of the term "accumlated profits" -- specifically, whether it refers to the subsidiary's profits as computed under United States tax law or under the tax law of the foreign country. /3/ 2. Respondent is an affiliated group of domestic corporations that file consolidated federal income tax returns. The parent of the group (Goodyear U.S.) owns all of the stock of a British subsidiary (Goodyear U.K.) that does not join in the consolidated return. During 1970 and 1971 the subsidiary reported net income on its British tax returns, paid taxes to Britain on that income, and distributed dividends to its parent. On its 1973 British tax return, however, the subsidiary reported a loss (attributable to accelerated depreciation and special inventory adjustments) that it carried back to offset virtually all of its income for 1971 and part of its income for 1970. As a result of this loss carryback, Britain refunded almost all of the income tax paid for 1971 and part of the tax paid for 1970. The 1973 loss deductions, although recognized under British law, are not allowed in computing income under the Internal Revenue Code. App., infra, 1a-2a, 10a-11a. On the consolidated tax returns for 1970 and 1971, respondent claimed Section 902 foreign tax credits with respect to the dividends received from the British subsidiary. For purposes of computing the prorated credit, respondent determined the subsidiary's "accumulated profits" based on the British definition of taxable income, thereby eliminating almost all of the subsidiary's accumulated profits for 1971 and reducing them for 1970. This treatment resulted in a substantially larger Section 902 credit for respondent in 1970 and 1971, and therefore a correspondingly smaller United States income tax liability, than if respondent had computed "accumulated profits" based on the United States definition of taxable income. App., infra, 11a, 15a-16a. /4/ The Commissioner, based on his determination that the subsidiary's "accumulated profits" must be computed under principles of United States law, asserted deficiencies in respondent's income tax of $323,654 for 1970 and $237,616 for 1971. Respondent paid the deficiencies and, after its administrative refund claim was denied, brought this refund action in the Claims Court. Id. at 2a-3a & n.3, 11a-12a, 23a-24a. 3. On cross-motions for summary judgment, the Claims Court held for the government, ruling that "accumulated profits" in Section 902 means income or profits as defined by the Internal Revenue Code, not by the tax law of a foreign country (App., infra, 9a-28a). The court found that this conclusion was strongly supported by Tax Court precedent (id. at 16a-19a) and by the language (id. at 19a-21a), purpose (id. at 22a-25a), and consistent administrative interpretation (id. at 25a-26a) of Section 902. With respect to the statute itself, the court explained that the dividends in the numerator of the Section 902 fraction are undeniably computed under United States law (App., infra, 20a) and the "accumulated profits" in the denominator are "the fund from which the dividends are paid" (id. at 21a). Therefore, the court concluded, it would introduce an inconsistency that would impair the proper functioning of the allocation formula if United States law is not also used to compute the profits in the denominator (ibid). Based on the legislative history, the Claims Court identified three principal purposes of the Section 902 credit: (1) to provide equal treatment for unincorporated foreign branches and foreign subsidiaries; (2) to eliiminate double taxation; and (3) to limit the allowable credit for foreign taxes paid by a subsidiary (when a portion of the profits is not distributed as a dividend). App., infra, 23a. The court found that its interpretation "effectuates congressional intent" (ibid.) in furthering these policies whereas respondent's interpretation would frustrate them. In particular, the court rejected respondent's contention that defining "accumulated profits" in terms of United States law would lead to double taxation in this case. The court explained that the relatively small credit that respondent receives under the court's interpretation is a direct result of the fact that its subsidiary paid very little British income tax in 1970 and 1971. Id. at 24a. The court concluded (ibid.): "To not recognize this fact as (respondent) urges would eviscerate the very purpose of the pro-rata credit and permit (respondent) a substantial windfall in avoiding other taxes with the phantom taxes deemed paid." Finally, the court found that its holding was supported by the longstanding administrative construction embodied in Treas. Reg. Section 1.902-3(c)(1) (1971 ed.). That regulation explicitly equates the term "accumulated profits" in Section 902 with the "earnings and profits" that are the source of dividends under Section 316 of the Code and that undeniably are computed under United States law. The court concluded that this unambiguous administrative construction is "consistent with the purposes enunciated by Congress when enacting the indirect tax credit legislation" (App., infra, 26a). 4. The court of appeals reversed (App., infra, 1a-8a). The court assesses tax liability," i.e., foreign taxable income as determined by foeign revenue laws (ibid.). The court also concluded that its interpretation is necessary to implement the statutory goal of preventing double taxation, stating that determining "accumulated profits" under United States law would defeat this goal by "severing the relationship" between the foeign taxes paid by the subsidiary and and the accumulated profits with respect to which those taxes are paid (ibid.). The court rejected the Tax Court precedent relied upon by the Claims Court as "fail(ing) to address the controversy raised in the instant case" (id. at 7a), and it did not discuss at all the settled administrative construction that is directly contrary to its decision. held that the "plain meaning" of Section 902 requires the conclusion that "accumulated profits" must be determined by applying the tax law of the foreign country (id. at 6a). The court stated that the text of Section 902(a)(1) describes the creditable foreign taxes as those paid "on or with respect to the accumulated profits of such foreign corporation," and that Section 902(c) uses similar language (App., infra, 6a (quoting the 1982 version of Section 902) (emphasis deleted)). The court concluded from this phrasing that "accumulated profits" must be "the actual basis on which the foreign sovereign REASONS FOR GRANTING THE PETITION The court of appeals has erroneously held that Congress intended the term "accumulated profits" in Section 902 of the Code to mean a foreign country's definition of taxable income. The court's decision thus overturns the construction of the statute that has long been settled. Moreover, the decision is seriously antithetical to the purposes of the statute and will reintroduce some of the disparities in tax treatment that it was designed to eliminate. And this major disruption of the statutory scheme rests on an unusually weak foundation -- a "plain meaning" discussion that manifestly misunderstands the operation of the Section 902 credit. While the court of appeals' decision involves a technical issue, it will have enormous deleterious consequences on the public fisc and on the fair administration of the tax laws if it is permitted to stand. Because the decision below is by a court of nationwide jurisdiction, the error places the Treasury in a whipsaw posture. Taxpayers whose particular situation makes it advantageous for them to invoke the erroneous construction below can arrange to have their case heard in the Claims Court where the decision below will be binding precedent. Other taxpayers for whom the Federal Circuit's erroneous construction is not advantageous can continue to use the previously well-settled rule that accumulated profits are computed under United States law. Because this issue typically involves contested tax liabilities of considerable magnitude, the decision below creates the opportunity for a substantial windfall for many multinational corporations. It is therefore appropriate for this Court to grant certiorari to correct the error of the court below and establish uniformity in the application of the indirect foreign tax credit. 1. The court of appeals in this case has overturned, with little more than perfunctory analysis, the well-settled construction of an important statute governing the taxation of multinational corporations. For more than 50 years, the Treasury has consistently interpreted accumulated profits using principles of United States taxation. In 1933, the Commissioner took the position that "the amount of the accumulated profits" is "based as a fundamental principle upon all income of the foreign corporation available for distribution to its shareholders, whether such profits be taxable by the foreign country or not." I.T. 2676, XII-1 C.B. 48, 50 (1933) (emphasis added). Accordingly, he ruled that, in order to determine "accumulated profits" under the predecessor of Section 902, the income on which the foreign taxation of a subsidiary is based must be adjusted for special deductions unique to foreign law that do not reduce the subsidiary's income or surplus available for the distribution of dividends under United States law (XII-1 C.B. at 51). This position was embodied in a formal regulation in 1965. Treas. Reg. Section 1.902-1(e) (originally promulgated as Treas. Reg. Section 1.902-3(c)(1) (1965 ed.)) defines the accumulated profits of a foreign subsidiary for a taxable year as "the sum of (1) the earnings and profits of such corporation for such year, and (2) the foreign income taxes imposed on or with respect to the gains, profits and income to which such earnings and profits are attributable" (emphasis added). "Earnings and profits" is an established term that represents the source of payments treated as dividends under Section 316 of the Code, and there is no doubt that its calculation is based upon the rules for determining United States taxable income. See, e.g., I.R.C. Section 312; B. Bittker & J. Eustice, Federal Income Taxation of Corporations and Shareholders, Paragraph 7.03 (5th ed. 1987). The Commissioner has explained that "accumulated profits" under Section 902 are similar to "earnings and profits" under Section 316 because the term "dividends" has precisely the same meaning in both sections and "both "accumulated profits" and "earnings and profits" denote the same source from which "dividends" are paid" (Rev. Rul. 63-6, 1963-1 C.B. 126, 128). The Commissioner has consistently adhered to this position. See, e.g., Rev. Rul. 87-72, 1987-2 C.B. 170; Rev. Rul. 87-14, 1987-1 C.B. 181. Although this established administrative interpretation has, for the most part, not been challenged in litigation, it has been approved by the Tax Court on two occasions. In its reviewed decision in Steel Improvement & Forge Co. v. Commissioner, 36 T.C. 265, 276-282 (1961), rev'd on other grounds, 314 F.2d 96 (6th Cir. 1963), the Tax Court held that a foreign subsidiary's accumulated profits under Section 902 were not reduced by a loss and carryback that were allowed by Canadian law but would not be allowed under United States tax law, stating that "the accumulated earnings and profits from which the dividends are paid are to be determined under American rather than foreign law" (36 T.C. at 277). In Champion International Corp. v. Commissioner, 81 T.C. 424, 446-447 (1983), the Tax Court discussed Steel Improvement and reaffirmed this holding. The court unequivocally stated that "(a)ccumulated profits are determined under American law rather than foreign law" (id. at 447). The leading treatises and commentaries on the foreign tax credit likewise have concluded that accumulated profits must be computed under concepts of United States taxation. /5/ And Congress, in the course of amending the foreign tax credit provisions in other respects in 1986 (see pages 24-25, infra), explicitly noted its recognition that, under existing law, "accumulated profits * * * are generally calculated in accordance with the principles governing the calculation of earnings and profits for U.S. tax purposes" (S. Rep. No. 313, 99th Cong., 2d Sess. 299 (1986)). The Senate Report cited Steel Imrovement, Treas. Reg. Section 1.902-1(e), and Rev. Rul. 63-6, supra, as evidencing this settled proposition. S. Rep. No. 313, supra, at 299 n.6. See also H.R. Conf. Rep. No. 861, 98th Cong., 2d Sess. 841 (1984) (for purposes of the "deemed paid" credit, "accumulated profits are essentially equivalent to earnings and profits"). This established interpretation of "accumulated profits" accords with the general principle concerning the construction of the foreign tax credit provisions that was laid down by this Court in Biddle v. Commissioner, 302 U.S. 573 (1938). The Court there stated that, because the subject matter of the Code is the computation of United States income tax, it should be presumed that Congress intended that "its own criteria" would be used to interpret the terms of the statute (id. at 578). The Court explained that this presumption could be rebutted only if "the statute, by express language or necessary implication, makes the meaning of the phrase * * * depend upon its characterization by the foreign statutes" (ibid). Under this principle, the Court in Biddle held that the phrase "income taxes paid or accrued" in a predecessor to Section 901(b)(1) was to be interpreted in accordance with United States tax law, finding "nothing in (the statute's) language to suggest that in allowing the credit for foreign tax payments, a shifting standard was adopted by reference to foreign characterizations and classifications of tax legislation" (id. at 578-579). 2. a. The court of appeals departed from the well-established interpretation of Section 902 in a remarkably casual fashion. Despite this Court's repeated admonition that Treasury regulations, "if found to "implement the congressional mandate in some reasonable manner," must be upheld" (National Muffler Dealers Ass'n v. United States, 440 U.S. 472, 476 (1979), quoting United States v. Cartwright, 411 U.S. 546, 550 (1973)), the court of appeals did not discuss, or even acknowledge, the applicable regulation. The court barely adverted (see App., infra, 6a) to this Court's decisions construing the foreign tax credit. And the court dismissed the Tax Court's clear approval of the interpretation embodied in the regulations by concluding that the Tax Court has misconstrued its own precedent (id. at 7a-8a). Instead, the court relied almost entirely on what it found to be the "plain meaning" of Section 902. The court's analysis, however, is based on a faulty reading of the text of the statute. Moreover, the court's holding is clearly antithetical to the statutory design and purposes. The court of appeals' holding rests almost exclusively on one phrase in Section 902 read in isolation. Because the statute refers to foreign taxes paid "on or with respect to * * * accumulated profits" (Section 902(a)(1); see also Section 902(c)(1)), the court held that "accumulated profits" must be defined as the "actual basis on which the foreign sovereign assesses tax liability," i.e., taxable income computed under foreign law (App., infra, 6a). But this reasoning, which in any event hardly represents a "plain meaning" construction, completely loses its force when the entire statute is examined. Section 902(a)(1) goes on to refer to the "dividends * * * paid by such foreign corporation out of accumulated profits." It is these "dividends" that are subjected to United States income tax, and Section 316 of the Code makes clear that payments are treated as "dividends" to the extent that their source is "earnings and profits". /6/ Hence, the text of Section 902 essentially identifies "accumulated profits" with "earnings and profits." Even the court below recognized "the undisputed and well-settled fact that "the determination of a foreign corporation's earnings and profits * * *, for purposes of the imposition of the U.S. tax, is to be made by the application of U.S. tax principles" (App. infra, 7a, quoting H.H. Robertson Co. v. Commissioner, 59 T.C. 53, 69 (1972), aff'd, 500 F.2d 1399 (3d Cir. 1974)). Thus, the court of appeals' approach to parsing the statute equally points to the conclusion that "accumulated profits" are computed under United States law. It is therefore apparent that the "plain meaning" of the statute does not provide an adequate basis for the court of appeals' decision. Indeed, if any "plain meaning" can be gleaned from examination of the statute alone, it is the meaning suggested by the general principle of Commissioner v. Biddle, supra -- namely, that provisions of the Internal Revenue Code governing the computation of domestic income taxes are to be interpreted in accordance with United States law in the absence of some express indication to the contrary. When one examines the purposes of Section 902 and the way in which the credit is designed to work, it becomes manifest that the amount of "accumulated profits" is to be determined in accordance with United States tax law. b. The term "accumulated profits" was introduced into the ratio for computing the indirect foreign tax credit by Section 238(e) of the Revenue Act of 1921, ch. 136, 42 Stat. 259. As this Court explained in American Chicle Co. v. United States, 316 U.S. 450, 453-454 (1942), this change was made because the original version, which computed the credit on the basis of the ratio between dividends and total taxable income, did not adequately achieve its purpose of preventing double taxation. "The difficulty with it was that it did not relate the credit to the accumulated profits or surplus of the subsidiary out of which the dividends were paid" (id. at 453 (emphasis added)). For example, if the subsidiary made no profit and paid no foreign tax in a particular year, yet distributed a dividend out of surplus, the pre-1921 statute would not have allowed any credit because there was no taxable income in the year in which the dividend was distributed. The new statute was designed "to permit identification of the accumulated profits out of which the dividend might have been paid and to give credit for a proportion of the subsidiary's taxes attributable to such accumulated profits" (id. at 454). Since the correct computation of the credit requires identification of the profits out of which the dividend was paid, which is a concept defined under United States law (see I.R.C. Sections 312, 316; page 12, supra), the Claims Court correctly stated that the interpretation subsequently adopted by the court of appeals introduces an "(a)lgebraic (in)consistency" (App., infra, 21a) that prevents the Section 902 credit from working properly to preclude double taxation. The goal of the prorated credit is to apportion the foreign tax to the domestic parent based on the "dividends" that it receives from the subsidiary and must treat as taxable income on its United States return. Accordingly, the term "dividends" in the numerator of the Section 902 fraction plainly has the meaning assigned to it by Section 316 of the Internal Revenue Code. The "accumulated profits" in the denominator simply represent the fund from which the dividends are paid; the total accumulated profits are the pool of potential dividends, i.e., the maximum earnings of the subsidiary that would be taxed as dividends if distributed to the parent. Just as United States tax concepts determine whether the actual distribution made by the subsidiary is taxed as a dividend, so too they must determine what is the maximum amount of the subsidiary's earnings that could be distributed as a dividend, i.e., the "accumulated profits." The determination of "accumulated profits" under principles of United States law thus is required to correlate the Section 902 fraction's numerator (the actual dividends) with its denominator (the potential dividends), thereby providing a coherent ratio by which to compute the share of foreign tax that has been borne by the distributed portion of the subsidiary's total earnings. The extent to which the court of appeals' interpretation of Section 902 disrupts the proper functioning of the credit is illustrated by the simple example provided earlier (see note 2, supra). If the foreign subsidiary earns $100 of profit, pays $20 in foreign taxes and distributes the remaining $80 to its parent as a dividend, the parent is entitled to the full $20 credit ($20 x $80/($100 - $20)). This result is obviously correct; when the subsidiary distributes to the parent all of the funds available for dividends, the parent should be entitled to a credit for all of the foreign taxes paid. This result is achieved, however, only if "accumulated profits" are defined under United States law. If, on the same facts, the foreign country does not allow an $80 deduction that is permitted by United States law and therefore the "accumulated profits" determined under foreign law would be $180, application of the court of appeals' interpretation would have the parent's credit to $10 ($20 x $80/($180 -- $20)), even though the parent took into income 100% of the amount of earnings available for distribution as a dividend. Thus, the court of appeals' approach, in divorcing the credit from the fund out of which the dividends are paid, would reintroduce some of the "eccentric results" that the 1921 legislation was designed to eliminate (see American Chicle Co. v. United States, 316 U.S. at 453). The above analysis is reflected and strongly supported by this Court's decision in American Chicle itself. The court there construed the very phrase upon which the court of appeals placed reliance -- taxes "paid * * * with respect to the accumulated profits" of the subsidiary (see 316 U.S. at 451). At that time, the predecessor of Section 902 defined "accumulated profits" as after-tax profits. The question presented was not the meaning of that term, but rather the meaning of the entire "taxes paid" clause -- whether the foreign tax that is the starting point for computing the credit should be the total tax paid on the subsidiary's pre-tax profits or instead a smaller amount that reflects the proportion of total tax attributable to the after-tax profits. The Court agreed with the government that Congress had intended the latter result. /7/ The Court explained (id. at 452-453): If, as admitted, the purpose is to avoid double taxation, the statute, as written, accomplishes that result. The parent receives dividends. Such dividends, not its subsidiary's profits, constitute its income to be returned for taxation. The subsidiary pays tax on, or in respect of, its entire profits; but, since the parent receives distributions out of what is left after payment of the foreign tax, that is, out of what the statute calls "accumlated profits," it should receive a credit only for so much of the foreign tax paid as relates to or, as the Act says, is paid upon, or with respect to, the accumulated profits. The lesson of American Chicle is that the touchstone for computing the prorated Section 902 credit is the maximum amount of the subsidiary's earnings available for distribution as dividends. Amounts that are not available for distribution as dividends are not relevant in making the proration. Thus, in American Chicle, the amount of the subsidiary's earnings paid as foreign taxes would never be available for distribution as dividends; hence, the amount of foreign tax attributable to those earnings was not creditable. Correspondingly here, the amount of the subsidiary's income computed under foreign law principles does not define the maximum amount available for distribution as a dividend. It is that latter amount, the "earnings and profits" computed under United States law, that must be the benchmark for computing the allowable portion of the credit. In sum, the statutory design is that the allowable credit shall be the proportion of the foreign tax that the dividends actually received bear to the potential dividends. That approach confines the credit to the amount necessary to prevent double taxation. It can be implemented only if "accumulated profits" are computed under United States law so that they reflect potential dividends. By contrast, the court of appeals here fallaciously reasoned that its interpretation furthers the statutory purpose of preventing double taxation (App., infra, 6a-7a). But determining "accumulated profits" under United States law does not prevent "tax payments already made to the foreign country" from being "fully recoverable as tax credits," as the court of appeals claimed (ibid.). The fact that respondent's credit on its 1970 and 1971 tax returns is reduced when accumulated profits are determined under United States law is a consequence, not of double taxation, but of the fact that respondent's subsidiary paid little foreign tax in those years as a result of the special loss and carryback available under British law. Because most of the subsidiary's profits carried out by the dividend distribution had escaped British taxation owing to the loss carryback, they were taxed for the first time, not the second, when included in respondent's United States income. What respondent is seeking is a tax credit based on "phantom taxes" that the British subsidiary was able to escape paying to Britain because of the loss carryback; the Claims Court correctly characterized that result -- adopted by the court of appeals -- as a "substantial windfall" to respondent (App., infra, 24a). c. As the Claims Court found (App., infra, 23a, 24a-25a), the interpretation subsequently adopted by the court of appeals also undermines one of the primary congressional policies that pervades the foreign tax credit provisions -- namely, to provide companies, like respondent, that operate their foreign business through a separately incorporated foreign subsidiary with the same relief from double taxation that is provided to companies that operate through a foreign branch. A foreign branch is simply a part of the larger domestic company, and all of its income earned in a foreign country is automatically income to the larger domestic company and subject to taxation on its United States income tax return. Since 1918, the domestic company has been entitled to take a credit against its United States income tax for the foreign income taxes paid by its branch; this is the "direct" credit provided in Section 901 of the Code. The purpose of the indirect credit of Section 902 is to extend the benefit of the foreign tax credit to domestic companies that operate through a foreign subsidiary (and therefore do not "directly" pay the foreign tax). As a Treasury spokesman stated in connection with the 1921 legislation that made the amount of the credit depend upon the subsidiary's "accumulated profits" (see pages 14-15, supra), an American corporation operating through a foreign subsidiary is "economically and practically" in the same position as one operating through a foreign branch and "(t)he proposal is to give this American corporation about the same credit as if conducting a branch" (Hearings on H.R. 8245 Before the Senate Comm. on Finance, 67th Cong., 1st Sess. 389 (1921) (statement of Dr. Adams)). See also Associated Telephone & Telegraph Co. v. United States, 306 F.2d 824, 832 (2d Cir. 1962), cert. denied, 371 U.S. 950 (1963). The provision involved in this case, which prorates the credit when the subsidiary does not return all of its earnings to the parent, was enacted to prevent the corporation operating through a subsidiary from receiving a greater tax benefit than one operating through a branch. See 61 Cong. Rec. 7184 (1921) (statement of Sen. Smoot). And subsequent amendments to the foreign tax provisions have been designed in part to improve attainment of this goal of putting the two similar modes of conducting foreign business on an equal footing for foreign tax credit purposes. See S. Rep. No. 313, 99th Cong., 2d Sess. 306 (1986) (change designed "to provide more similar results" for branch and subsidiary operations); S. Rep. No. 1881, 87th Cong., 2d Sess. 66-67 (1962) ("gross-up" adjustment of I.R.C. Section 78 necessary to eliminate tax advantage of subsidiary operation over branch operation); see generally B. Bittker & J. Eustice, supra, Paragraph 17.11, at 17-45 to 17-47. The decision of the court of appeals undermines this congressional policy by introducing major disparities in the treatment of companies depending upon whether they operate through a subsidiary or a branch. Foreign concepts of taxable income play no role in determining whether the earnings of a foreign branch constitute income in the hands of its domestic owner; those earnings flow directly to the owner and are recognized according to United States tax principles. To keep the two business arrangements on an equal footing, the accumulated profits of a foreign subsidiary must approximate the earnings that would be recognized by the parent if it were operating as a branch, i.e., they must be computed under United States law. The correctness of this conclusion is illustrated by the basic example provided earlier (page 16, supra), where the foreign entity pays $20 in foreign tax on profits computed at $100 under United States law and $180 under foreign law. A foreign branch would be treated as having funneled all of its profits (which would be $100 computed under United States law) to the domestic company, and it would receive the full $20 "direct" credit under Section 901. If the same business were conducted by a foreign subsidiary, however, and the subsidiary distributed all of its after-tax profits to the parent, the court of appeals' approach would permit it take a credit for only part of the foreign taxes paid ($20 x $80/($180 -- $20) = $10). Computing accumlated profits under United States law, conversely, would yield the correct result of a full $20 credit. In this example, the foreign measure of income is higher than that under United States law, and therefore the result under the court of appeals' approach is to understate the credit to the prejudice of the company operating through a subsidiary. If, as in the present case, the foreign definition of income yields a figure lower than that computed under United States law, the allowable credit will increase, thereby conferring a windfall benefit on the company that operates as a subsidiary. In both cases, however, the court of appeals' approach subverts the clearly expressed legislative policy to avoid discrimination between the two methods of doing business abroad. In short, like the direct credit granted to a domestic company that operates through a foreign branch, the indirect credit of Section 902 treats the amount of foreign tax paid as a fact. It is not concerned with how the foreign tax is computed or with the foreign income base on which it is imposed. It simply takes the amount of foreign tax paid and apportions it in accordance with the fractional share of the subsidiary's United States income that is actually distributed as a dividend. To make the credit work properly, the term "accumulated profits" in Section 902 must refer to income computed under United States tax principles. 3.a. The decision below is of enormous importance to the public fisc and creates a serious problem for the fair administration of the tax laws. It is doubtful whether there is any foreign country whose income tax laws accord with those of the United States in every respect. Thus, the question presented here can arise no matter where a foreign subsidiary of a domestic corporation does business; it is likely to affect many large multinational corporations. While it is too early to quantify the potential impact of the decision below with any confidence, it is clearly very substantial. According to IRS statistics, in 1982 (the most recent year for which such figures are available), domestic companies controlled more than 25,000 foreign subsidiaries doing business in more than 100 countries, and these companies claimed more than $9 billion in Section 902 credits for foreign taxes paid by those subsidiaries. A preliminary survey of IRS field offices indicates that, in cases currently under audit, there are about 30 refund claims based on the decision in this case that have been, or will be, filed -- totalling about $150 million. In addition, the IRS estimates, as a result of communications with other taxpayers, that another 150 refund claims totalling $750 million will be filed in reliance on the decision below. The massive revenue impact of the decision below is compounded by the fact that the court of appeals' decisions places the IRS in a whipsaw posture. The Federal Circuit is a court of nationwide jurisdiction. Any taxpayer, regardless of where it is domiciled or does business, is free to pay the contested tax and to sue for a refund in the Claims Court, with appellate review in the Federal Circuit. Thus, taxpayers can compute their Section 902 credit for a given tax year under both the traditional approach and the approach adopted by the court below and then elect the more favorable tax treatment by simple forum-shopping. If computation of accumulated profits under United States principles yields more favorable tax treatment, the taxpayer can rely upon the longstanding rule embodied in the Treasury regulations. On the other hand, if computing accumulated profits under foreign law principles yields a more favorable tax result, the taxpayer can realize a windfall like respondent's by litigating in the Claims Court. The Treasury would be caught in a no-win position, and evenhanded enforcement of the foreign tax credit provisions would be severely compromised. Moreover, the availability of such a tax-saving option to well-counseled companies that operate foreign subsidiaries would further undermine the congressional goal of equality of treatment between companies that operate through foreign subsidiaries and those that operate through foreign branches (which always calculate their income from foreign operations under United States tax principles) (see pages 19-22, supra). Finally, the court of appeals' decision also would impose new and formidable burdens on revenue agents and the courts. Under the heretofore settled rule, the foreign tax credit is computed solely by reference to the familiar principles of the Internal Revenue Code; the vagaries of foreign tax law play no role. The court of appeals' approach, however, would require that the court determine the taxpayer's accumulated profits under unfamiliar foreign principles of tax law, which may be difficult to ascertain and may contain concepts of profits and taxable income that are profoundly different from those of the United States. This imposition of a "shifting standard * * * adopted by reference to foreign characterizations and classifications of tax legislation" (Biddle v. Commissioner, 302 U.S. at 578-579) would create an unwelcome administrative and judicial burden. For all of these reasons, review by this Court is warranted to correct the court of appeals' erroneous and troublesome interpretation of the foreign tax credit provisions. b. The prospective impact of the decision below has been diminished somewhat by Section 1202(a) of the Tax Reform Act of 1986, Pub. L. No. 514, 100 Stat., 2528. In that statute Congress prospectively changed the operation of the Section 902 credit to eliminate the "annualization" approach, i.e., the manner in which the dividend is matched to accumulated profits on a year-by-year basis (see note 3, supra). Because Congress believed that this scheme was subject to manipulation by taxpayers and also subject to other problems, it provided that retained earnings after 1986 would all go into one "pool," which would be the source of the dividends. See generally S. Rep. No. 313, supra, at 305-306; B. Bittker & J. Eustice, supra, Paragraph 17.11, at 17-47 to 17-48. Congress accomplished this change by redrafting Section 902, including replacing the term "accumulated profits" with the term "post-1986 undistributed earnings." The latter term is defined as the "earnings and profits" of the foreign subsidiary accumulated in years after 1986 and computed "according to rules substantially similar to those applicable to domestic corporations" (see 26 U.S.C. 902(c)(1) (Supp. IV 1986) and 964(a)). Thus, while the 1986 legislation was not directed at the question presented in this case, its language will not support respondent's construction, and it would appear extremely unlikely that even the Federal Circuit would hold that foreign law principles must be used to determine the post-1986 earnings to be used in the prorated indirect credit computation. /8/ Despite the 1986 amendment, however, the issue presented in this case retains substantial continuing importance. Congress recognized that may foreign subsidiaries had retained pre-1987 profits, but it nevertheless decided that the 1986 amendment would operate only prospectively on post-1986 earnings; it specifically provided that prior law would continue to govern the distribution of pre-1987 earnings. /9/ In other words, Congress deliberately perpetuated the pre-1986 statute, to the extent that a dividend distributed in later years comes out of pre-1987 earnings. It is not uncommon to have to go back a number of years to trace a dividend to the accumulated profits or earnings out of which it is paid. See, e.g., H.H. Robertson v. Commissioner, 59 T.C. at 81 (dividend issued in 1965 attributed to accumulated profits of 1952-1964). Indeed, in this case the court of appeals' approach allows respondent to treat part of its 1971 dividend as having been paid out of its 1968 accumulated profits (see note 4, supra). Moreover, because dividends are attributed to accumulated profits on a last-in, first-out basis (see 26 U.S.C. 902(c)(6)(B) (Supp. IV 1986)), a corporation's dividend could still be derived, many years into the future, from pre-1987 accumulated profits, thus triggering the issue in this case. Therefore, although its prospective impact for post-1986 tax years has been diminished by the 1986 legislation, the decision below will continue to have deleterious consequences for the administration of the foreign tax credit for tax years well beyond 1986. And, of course, the 1986 legislation has no effect at all on the numerous and substantial refund claims that are likely to be filed for open tax years prior to 1987. Accordingly, the decision below is of considerable continuing importance, and review by this Court is warranted to correct the court of appeals' error and restore even-handed administration of this important aspect of the tax laws. CONCLUSION The petition for a writ of certiorari should be granted. Respectfully submitted. WILLIAM C. BRYSON Acting Solicitor General JAMES I.K. KNAPP Acting Assistant Attorney General LAWRENCE G. WALLACE Deputy Solicitor General ALAN I. HOROWITZ Assistant to the Solicitor General ROBERT S. POMERANCE DAVID M. MOORE Attorneys MARCH 1989 /1/ Unless otherwise noted, all statutory references are to the Internal Revenue Code of 1954 (26 U.S.C.), as in effect during 1970 and 1971, the years at issue (the Code or I.R.C.). /2/ This Court described this equation in narrative form in American Chicle, stating that the foreign taxes are multiplied by a fraction, of which "(t)he numerator is the dividends received by the parent (and) (t)he denominator is the "accumulated profits" of the subsidiary" (316 U.S. at 452); the statute was later amended to require the subtraction of foreign taxes from the denominator. The operation of the proportional credit can be illustrated by some simple examples. If a foreign subsidiary earns $100 of profits, pays $20 in foreign taxes and distributes the remaining $80 to its parent as a dividend, the parent is entitled to the full $20 credit ($20 x $80/($100 -- $20)). If, however, the subsidiary distributes only $40 of its after-tax profits to its parent, the allowable credit will be halved to $10 ($20 x $40/($100 -- $20)). The allowable credit can also be affected by a change in the denominator of the equation. If the subsidiary distributes the same $80, but the "accumulated profits" are determined in a different manner and found to be $180, the allowable credit will also be halved to $10 ($20 x $80/($180 -- $20)). /3/ The statutory definition of "accumulated profits" does not specifically address this question. It defines the term for purposes of Section 902 as "the amount of (the corporation's) gains, profits, or income computed without reduction by the amount of the income * * * taxes imposed on or with respect to such profits or income" (I.R.C. Section 902(c)(1)). The defintion goes on to provide that the Commissioner has the "full power to determine from the accumulated profits of what year or years such dividends were paid," generally "treating dividends as having been paid from the most recently accumulated gains, profits, or earnings" (ibid.). This latter provision reflects the fact that the credit is to be computed by considering the subsidiary's accumulated profits on an annualized basis. A dividend payment is allocated first to the accumulated profits of the most recent year and then, if those profits are insufficient to cover the amount of the dividend, to the profits of the next most recent year, and so forth. The credit is then computed separately for each year to which the dividend is traced by multiplying the foreign tax paid for that year by the appropriate fraction. The sum of those separate annual computations yields the Section 902 credit for the particular dividend. See H.H. Robertson Co. v. Commissioner, 59 T.C. 53, 78-83 (1972), aff'd, 500 F.2d 1399 (3d Cir. 1974); General Foods Corp. v. Commissioner, 4 T.C. 209, 215 (1944). /4/ The tax advantage was achieved by respondent in two related ways. First, the reduction in accumulated profits in 1970 correspondingly increased the ratio of dividend to profits for that year, thereby allowing respondent to take a credit for a higher proportion of the 1970 British tax. Second, because the accumulated profits for 1971 were virtually eliminated, they were not sufficient to cover the dividend paid in that year. Accordingly, under the annualization principle of Section 902 (see note 3, supra), part of the 1971 dividend was attributed to profits earned in preceding years going back to 1968. Because the foreign taxes in those years were much higher than the almost nonexistent tax of 1971, respondent's allowable Section 902 credit was increased. App., infra, 23a-24a; C.A. App. 68-69. By contrast, because the 1973 loss and resulting carryback are not allowable under the Internal Revenue Code, they do not act to reduce the subsidiary's "accumulated profits" if those profits are computed under United States law. Without that adjustment unique to British law, the profits for 1971 are adequate to cover the dividend paid that year and therefore the 1970 and 1971 dividends can simply be treated as having been derived from the accumulated profits for the years of distribution. Because the foreign tax paid in those years was relatively small, the Section 902 credit for those years is correspondingly small. Ibid. /5/ See 1 E. Owens & G. Ball, The Indirect Credit 161-162 (1975); E. Owens, The Foreign Tax Credit 119-121 (1961); B. Bittker & J. Eustice, Federal Income Taxation of Corporations and Shareholders Paragraph 17.11, at 17-44 (5th ed. 1987); Schoenfeld, Some Definitional Problems in the Deemed Paid Foreign Tax Credit of Section 902: "Dividends" and "Accumulated Profits", 18 Tax. L. Rev. 401, 407-421 (1963); Eigner, The Foreign Tax Credit, 39 Taxes 724, 729-730, 736 (1961). /6/ If a distribution to shareholders exceeds the available "earnings and profits," both current and historic, the excess is not a dividend, but rather a return of capital. See I.R.C. Section 301(c). /7/ The nature of the dispute in American Chicle is best explained with the help of an example. If the subsidiary had $200 in income and paid a foreign tax of $20, it would have had $180 in "accumulated profits" as then defined. If the subsidiary had distributed the $180 as a dividend, the taxpayer's position in American Chicle was that it would be entitled to a $20 credit. The Court rejected this position, however, finding that $20 was the amount of taxes paid on the subsidiary's pretax income, not the amount paid "with respect to the accumulated profits" of $180. Thus, under the so-called American Chicle limitation, the taxpayer was entitled to a credit of only $18, the foreign tax apportionable to the $180 of accumulated profits. In 1962, Congress amended Section 902 to accomplish a similar result by redefining "accumulated profits" as the pre-tax income of the subsidiary, but at the same time adding Section 78 of the Code, which requires the parent to take into income ("gross-up") the amount of the allowable foreign tax credit. Under that approach, applicable for the tax years at issue in this case, the credit is first computed without the American Chicle limitation, but this change is offset by treating the credit itself as income to the parent. See, e.g., H.H. Robertson v. Commissioner, 59 T.C. at 77 & n.13. This adjustment is necessary to achieve maximum parity between the tax treatment of foreign branches and foreign subsidiaries. See pages 19-22, infra; B. Bittker & J. Eustice, supra, Paragraph 17.11, at 17-45 to 17-47. /8/ As we have noted (pages 11-12, supra), Congress clearly believed that it was perpetuating existing law in defining the subsidiary's profits to be used in the proration formula in terms of United States tax principles. /9/ Section 902(c)(6)(A) (Supp. IV 1986) of the new statute provides: In the case of any dividend paid by a foreign corporation out of accumulated profits (as defined in this section as in effect on the day before the date of the enactment of the Tax Reform Act of 1986) for taxable years beginning before the 1st taxable year taken into account in determining the post-1986 undistributed earnings of such corporation -- (i) this section (as amended by the Tax Reform Act of 1986) shall not apply, but (ii) this section (as in effect on the day before the date of the enactment of such Act) shall apply. APPENDIX