Federal Circuit Reverses Lower Court; Allows Partial Exclusion of Extraterritorial Income

(Parker Tax Publishing May 2018)

The Federal Circuit reversed a Federal Claims Court's decision and held that Sec. 101(d) of the American Jobs Creation Act of 2004 unambiguously provides transitional relief for all extraterritorial income (ETI) received from transactions entered into in 2005 and 2006, even if the income is received in later years. The Federal Circuit found that the lower court erroneously interpreted the language of Sec. 101(d) and held that the plain language and legislative history showed Congress's intent for partial exclusions from income to apply to ETI derived from transactions entered into in 2005 and 2006, not just to income recognized in those years. DWA Holdings LLC v. U.S., 2018 PTC 131 (Fed. Cir. 2018).

DWA Holdings LLC (DWA) is a U.S. corporation that was spun off from DreamWorks Studios in a 2004 public offering. DWA produces animated motion pictures and relies on third parties to distribute its films. In 2005, DWA entered into a distribution agreement with Paramount Pictures Corp., giving Paramount exclusive worldwide rights to distribute some of DWA's animated films. After Paramount acquired DreamWorks in 2006, a new distribution agreement was executed. The 2006 agreement gave an affiliate of Paramount the rights to distribute DWA's films outside of the United States and Canada. The films that were the subject of the 2006 agreement were produced in the U.S., and all licenses granted under the 2006 transaction were for use abroad.

DWA attempted to exclude 60 percent of the extraterritorial income (ETI) it received from the 2006 transaction under a provision of the American Jobs Creation Act of 2004 (AJCA). The AJCA was the result of decades of dialogue between the U.S. and other countries with whom it has treaty obligations. Congress believed that the exemption from tax for income earned abroad in European and other tax systems put domestic exporters at a disadvantage. However, the U.S.'s European trading partners objected each time Congress enacted laws intended to level the playing field for U.S. companies. With the passage of each new tax regime, Congress sought to ease the burden on U.S. companies by providing transitional relief for transactions occurring during specified years.

In 2000, Congress enacted the FSC Repeal and Extraterritorial Income Exclusion Act (ETI Act). The ETI Act allowed previously established foreign sales corporations (FSCs) to continue receiving favorable tax treatment for transactions occurring before 2002. The European Union (EU) challenged the ETI Act's transitional relief for FSCs in the World Trade Organization (WTO), which ruled against the U.S. in 2004. Congress responded by repealing the ETI Act and enacting the AJCA.

The AJCA phased out the relevant portions of the ETI Act in order to help U.S. companies transition to a new regime. The AJCA repealed Code Sec. 114, the provision that excluded ETI from tax, effective for transactions beginning in 2005. A grandfather provision in Sec. 101(f) of the ACJA exempted certain preexisting binding contracts.

The AJCA provision at issue in this case, Sec. 101(d), provided transitional rules for 2005 and 2006. Under Sec. 101(d)(1), the amount includible in income for transactions during 2005 and 2006 was subject to the percentages specified in Sec. 101(d)(2). For 2006, the year at issue, 40 percent of ETI was includible in gross income. The EU objected to the AJCA before the WTO, and Congress responded by repealing Sec. 101(f). However, it did not repeal or revise the Sec. 101(d) transition rules.

Under the 2006 DWA transaction, DWA recognized qualifying ETI as provided under former Code Sec. 114 for 2006. DWA excluded 60 percent of its ETI for that year under Sec. 101(d) of the AJCA. DWA continued to receive income from the 2006 license in years 2007-2009. It did not exclude ETI income attributable to the 2006 transaction for those years until its returns were selected for a routine IRS examination. DWA then realized that it had not applied Sec. 101(d) for those years and filed refund claims totaling in excess of $4.4 million. The IRS disallowed the refunds.

DWA sued the government in the Court of Federal Claims. The government moved for summary judgment, arguing that the benefits provided in Sec. 101(d) were limited to income recognized in 2005 or 2006. The Claims Court agreed; it concluded that the phrases "for 2005" and "for 2006" in Sec. 101(d)(2) referred to the phrase "the amount includible in gross income" in Sec. 101(d)(1) rather than to "transactions during 2005 and 2006." The Claims Court found that the binding contract rule in Sec. 101(f) supported the government's position because it found that this provision was the only way in which Congress sought to confer long term benefits to taxpayers. The Claims Court reviewed the legislative history and concluded that nothing in it supported DWA's position. The Claims Court also concluded that Congress's decision to repeal Sec. 101(f) supported the government's interpretation, because it showed a congressional desire to comply with the WTO rulings. DWA appealed the Claims Court's decision to the Federal Circuit.

The Federal Circuit reversed the Claims Court's decision and held that Sec. 101(d) unambiguously provides transitional relief for all ETI received from transactions entered into in 2005 and 2006, even if the income is received in later years. The Federal Circuit found that the plain language of Sec. 101(d) strongly suggests Congress's intent to provide tax benefits for ETI derived from transactions entered into in 2005 and 2006, regardless of the year in which the income was earned. The court focused on the word "transaction," which the AJCA's predecessor statute defined to include deals such as leases or rentals, from which income would be received in installments over time.

The Federal Circuit found that the phrase "in the case of transactions during 2005 or 2006" in Sec. 101(d)(1) describes the circumstances in which transitional relief is available. Sec. 101(d)(2) specifies the applicable percentages to be used for purposes of Sec. 101(d)(1), providing that "for 2005" the percentage was 20 percent and "for 2006" the percentage was 40 percent. Thus, the court found that Sec. 101(d)(2) explains how to calculate the treatment of a given transaction by plugging the percentages into Sec. 101(d)(1), and did not, as the Claims Court concluded, act as a standalone provision limiting the scope of available transitional relief. The Federal Circuit also noted that in Sec. 101(d)(1), the word immediately preceding "during 2005 or 2006" is "transactions," not "income." The Federal Circuit characterized the Claims Court's interpretation as an effort to read the word "transactions" out of the statute. The Federal Circuit further found that other provisions in the AJCA demonstrated that the drafters knew how to craft a transitional rule based on when income was recognized, and that such language was absent in Sec. 101(d).

The Federal Circuit also noted that the IRS's continued use of Form 8873, Extraterritorial Income Exclusion, supported its finding that Sec. 101(d) was transaction based. The court explained that, if the transitional benefits were not available after 2006, Form 8873 would be obsolete.

Although the Federal Circuit concluded that the text of Sec. 101(d) was unambiguous, it reviewed the legislative history of the AJCA and found that it also supported DWA's interpretation. The court noted that the 2004 House Report referred to the ETI benefits applicable to "transactions" during 2005 and 2006. The court also observed that the ETI regime enacted years before the AJCA used a broad definition of transaction that included not just sales but leases or rentals from which income would be received in installments over time. The court further determined that all of the prior tax regimes relating to the taxation of ETI employed a transaction based structure.

The Federal Circuit found that by repealing the grandfather provision in Sec. 101(f), but not Sec. 101(d), Congress was focused on halting benefits for transactions entered into after 2006, rather than on altering tax rules for transactions that had already occurred. The court noted a senator's remark that the EU's only real objection to the AJCA was to the grandfather clause, and that the EU was willing to accept the remaining time on the two year transition period, including "the grandfathering of leasing contracts."

Finally, the Federal Circuit disagreed with the government's contention that in enacting both the ETI Act and the AJCA, Congress was attempting to comply with WTO rulings indicating that the U.S. should withdraw prohibited subsidies "without delay." In the court's view, this argument failed to recognize that even under the government's interpretation, Sec. 101(d) would run afoul of the U.S.'s treaty obligations. The court reasoned that it was just as likely Congress intended to quell concerns over Sec. 101(f), the most objectionable provision in the AJCA, while leaving relief in place for all other transactions. The court concluded by pointing out that, in any event, WTO decisions are not binding on the U.S. or on the Federal Circuit.

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

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