Tax Court Sides With IRS in Calculating Corporation's Dividends Received Deduction

(Parker Tax Publishing April 2026)

The Tax Court held that, in determining the amount of a parent corporation's dividends received deduction under Code Sec. 245A, the required holding period under Code Sec. 246(c) was not satisfied with respect to the parent company's lower tier controlled foreign corporations (CFCs), since the shares of the lower tier CFCs were held by intermediate foreign corporations and not by the parent company. The court also held that the formula used to calculate the parent company's foreign tax credit disallowance under Code Sec. 245A(d)(1) must include the deduction under Code Sec. 965(c). Varian Medical Systems, Inc. and Subs. v. Comm'r, 166 T.C. No. 8 (2026).

Background

Varian Medical Systems, Inc. is the parent company of a consolidated group of medical device and software manufacturers. Its principal place of business is in Palo Alto, California. Varian operates through corporations in many different countries, at least some of which are controlled foreign corporations (CFCs). Varian and its CFCs are fiscal year taxpayers. As relevant for this case, the fiscal year of Varian and its CFCs started on September 30, 2017, and ended on September 28, 2018 (2018 Year).

During the 2018 Year, 22 CFCs owned directly and indirectly by Varian and members of its U.S. consolidated group had Accumulated Post-1986 Deferred Foreign Income, as defined in Code Sec. 965 and the regulations thereunder. Shares in nine of those CFCs were held directly by a member of Varian's U.S. consolidated group (first-tier CFCs). Shares in the remaining 13 CFCs were held indirectly (i.e., through one or more foreign corporations) by a member of Varian's U.S. consolidated group (lower tier CFCs).

Varian filed a consolidated federal income tax return for the 2018 Year. On the return, Varian elected to claim foreign tax credits for foreign taxes that it was deemed to pay under Code Sec. 960 and was therefore required to "gross up" its taxable income under Code Sec. 78 by reporting a dividend of approximately $159 million. Varian also claimed a deduction of approximately $60 million under Code Sec. 245A in connection with the dividend it was treated as receiving under Code Sec. 78 from its first-tier CFCs.

The IRS examined Varian's tax return and issued Varian a Notice of Deficiency in which, among other things, the IRS disallowed Varian's claimed deduction under Code Sec. 245A. The IRS also increased Varian's Code Sec. 78 dividend by nearly $1.9 million. The IRS further determined, in the alternative, that if Varian was entitled to deduct its Code Sec. 78 dividend under Code Sec. 245A, then Code Sec. 245A(d) would disallow any foreign tax foreign tax credits attributable to that amount. Accordingly, Varian's foreign tax credits would be reduced by approximately $6.3 million.

Varian petitioned the Tax Court for a redetermination of the IRS's determinations. In Varian Medical Systems, Inc. and Subs. v. Comm'r, 163 T.C. No. 4 (2024), the Tax Court held that Varian was entitled to a deduction under Code Sec. 245A and that its foreign tax credits would be commensurately reduced by Code Sec. 245A(d). After working to compute Varian's deduction under Code Sec. 245A and its disallowed foreign tax credits under Code Sec. 245A(d)(1), the parties filed cross motions for summary judgment addressing issues that arose during that process. Varian maintained that the IRS forfeited any argument that Code Sec. 246 disallowed a portion of Varian's claimed deduction under Code Sec. 245A, and, in any event, Code Sec. 246 allowed Varian's claimed deduction in full. Varian further contended that, in determining the amount of its foreign tax credit disallowance under Code Sec. 245A(d)(1), Varian's net Code Sec. 965 inclusion must be determined without regard to the deduction under Code Sec. 965(c). The IRS disagreed with Varian on each point and contended that Varian's arguments regarding Code Sec. 245A(d)(1) came too late.

Analysis

The Tax Court held that the IRS did not forfeit its argument under Code Sec. 246(c). While the court agreed with Varian that the IRS had an opportunity to raise its argument earlier in the litigation, the court also noted that the questions being raised in this case were recurring ones and were present in other cases pending before the Tax Court. Additionally, since there was no trial and Varian's qualification under Code Sec. 246 was purely a legal issue with no disputed facts, the court found that allowing the IRS to raise the matter now did not improperly prejudice Varian. The court further held that the Varian did not forfeit its arguments regarding Code Sec. 245A(d)(1).

Turning to the merits, the court noted that the Code Sec. 78 dividends in dispute were dividends "on" the shares of Varian's lower tier CFCs. Under its terms, an amount equal to the taxes paid by each CFC (the first-tier and the lower tier CFCs) was treated as a dividend received by Varian "from the foreign corporation" -- i.e., the one that paid the tax. The court said that two points were important here: First, Varian was treated as receiving the Code Sec. 78 dividends directly from each CFC, and not indirectly through the chain of ownership. Second, the amount of Code Sec. 78 dividend Varian received from each CFC was equal to the taxes paid by that CFC. According to the court, because a Code Sec. 78 dividend represents the taxes paid by a particular CFC, each Code Sec. 78 dividend is "on [the] share[s] of stock" of the CFC whose taxes it represents for purposes of Code Sec. 246(c)(1). Thus, for the Code Sec. 78 dividends attributable to the lower tier CFCs to be deductible, the shares of those CFCs must have been "held by the taxpayer" (Varian or a member of its U.S. group) for purposes of Code Sec. 246(c)(1).

In the court's view, the shares held by Varian's foreign subsidiaries were not treated as Varian's assets and were not held by Varian or members of its U.S. group within the meaning of Code Sec. 246(c)(1). The court reasoned that Varian and its foreign subsidiaries were different taxpayers whose separate identities had to be respected. Given the requirement in Code Sec. 246(c)(1) that the taxpayer must "hold" the shares, the court concluded that indirect ownership through a foreign corporation did not suffice.

Next, the court turned to the parties' computational disagreement with respect to the foreign tax credit disallowance in Code Sec. 245A(d). In its 2024 opinion, the Tax Court held that, because Varian was allowed a deduction under Code Sec. 245Aa with respect to its Code Sec. 78 dividend, Code Sec. 245A(d)(1) required a corresponding reduction to its foreign tax credit. The amount of the reduction, the court said, would be the amount of Varian's deemed paid foreign tax credit that was attributable to the foreign earnings reflected in its deductible Code Sec. 78 dividend. The parties disagreed on the meaning of the term "net Section 965 inclusion," which was required to be calculated in order to determine Varian's disallowed foreign tax credit. On that issue, the court agreed with the IRS that the "net Section 965 inclusion" was equal to (1) the Code Sec. 965(a) inclusion amount (the "accumulated post-1986 deferred foreign income of Varian's CFCs), reduced by (2) the amount established in Code Sec. 965(b) (the "aggregate foreign earnings and profits deficit") and further reduced by (3) the deduction under Code Sec. 965(c). The court said that Varian's approach (i.e., using the pre-Code Sec. 965(c) amount for the net Section 965 inclusion) created an inflated denominator and a meaningless ratio.

For a discussion of the taxation of U.S. shareholders of certain foreign corporations, see Parker Tax ¶201,500.

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