INSIGHT: Eaton’s Foreign Owners Subject to Same Principles Governing Domestic Corporations’ Earnings and Profits

Eaton Corp. must increase the earnings and profits of three upper-tier partners—all controlled foreign corporations (CFCs)—to reflect income inclusions from lower-tier CFCs under tax code Section 951(a).

There are no special earnings and profits rules concerning a CFC partner’s distributive share of partnership income, the U.S. Tax Court ruled in Eaton Corp. v. Commissioner, 152 T.C. No. 2 (2/25/19).

Eaton Corp. was the parent of an affiliated group of corporations (Eaton Group) that filed consolidated Federal income tax returns. Subsequent to the years in issue, Eaton became an “inverted corporation” by the mechanism of a business combination with an Irish corporation, named Eaton Corporation plc. Members of Eaton Group were shareholders of foreign corporations that were controlled foreign corporations. These CFCs collectively held 100 percent of the membership interests in Eaton Worldwide LLC, a domestic partnership. The CFCs that held membership interests in Eaton Worldwide LLC were Eaton Holding III S.a.r.l., Eaton Finance N.V., and Eaton B.V. (upper tier CFC partners).

Eaton Worldwide owned equity interests in, and was the sole U.S. shareholder of, several CFCs (lower tier CFCs). Eaton Worldwide included in income the “subpart F” income earned by the lower tier CFCs and amounts calculated under Section 956 with respect to such lower tier CFCs. The lower tier CFCs did not make any distributions of property to Eaton Worldwide during the years in issue, 2007 and 2008.

On March 16, 2007, Eaton Worldwide purchased the stock of AT Holdings Corp. (ATH), a Delaware corporation, for nearly $388 million. Eaton Worldwide’s interest in ATH constituted “U.S. property,” which was treated as held by the upper tier CFC partners. Each upper tier CFC partner was thus treated as holding an interest in U.S. property by virtue of Eaton Worldwide’s ownership of ATH.

During the years in issue, Eaton Worldwide issued Schedules K-1 to the upper tier CFC partners reflecting their distributive shares of its “income inclusions” under Section 951(a) (i.e., Eaton Worldwide’s Subpart F income and its amount determined under Section 956). The upper tier CFC partners excluded these amounts from gross income and from the calculation of their subpart F income. None of the upper tier CFCs made any adjustments to their earnings and profits corresponding to their distributive shares of Eaton Worldwide’s income inclusions under Section 951(a). The issue was whether the earnings and profits of the upper tier CFC partners must be increased as a result of the partnership’s Section 951(a) income inclusions.

Section 312 Applies to Foreign Corporations

To determine whether the upper tier CFC partners were required to increase their earnings and profits to reflect their distributive shares of Eaton Worldwide’s Section 951(a) inclusions, the court said it needed to analyze the interaction (if any) between Sections 312 and 964.

Section 964(a) provides that the earnings and profits of any foreign corporation “shall be determined according to rules substantially similar to those applicable to domestic corporations, under regulations prescribed by the [Treasury] Secretary.” The rules, the court noted, applicable to domestic corporations are set forth in Section 312 and the regulations interpreting it. Thus, the court reasoned, the reference to regulations in Section 964 “is reasonably read to include regulations promulgated under section 312 as well as under section 964.”

While the tax code “does not comprehensively define ‘earnings and profits’, but provisions of the Code and regulations relating to earnings and profits ordinarily take taxable income as the point of departure,” the court said. A corporation’s earnings and profits, therefore, are calculated by making certain adjustments to its taxable income. For example, in converting taxable income into earnings and profits, we add to the former ”income exempted by statute“ and ”income not taxable by the Federal Government under the Constitution.“

The regulations issued under Section 964, the court noted, “do not provide comprehensive guidance for calculating the earnings and profits of a foreign corporation. Rather, they specify a preliminary process by which a foreign corporation’s [profit and loss] statement is first conformed to, or made to resemble, that of a domestic corporation by making a series of tax accounting adjustments.” Section 964(a) then incorporates the rules of Section 312 by requiring that the foreign corporation’s earnings and profits shall be computed “according to rules substantially similar to those applicable to domestic corporations.” The rules set forth in Section 312, the court opined, must be applied in determining the earnings and profits of the upper tier CFC partners of Eaton Worldwide.

The upper tier CFC partners are, of course, partners of a domestic partnership, Eaton Worldwide. In determining its income tax, a partner is required to take into account its distributive share of each item of partnership income, gain, loss, deduction, and credit. See Section 702. Each partner is taxed on its distributive share of partnership income without regard to whether the income is actually distributed to the partner. See Treasury Regulation Section 1.702-1(a).

Under these rules, the upper tier CFC partners must include in their gross income their distributive shares of Eaton Worldwide’s income. Eaton Worldwide’s income, in turn, includes subpart F income and Section 956 inclusions from the lower tier CFCs. The gross income of the upper tier CFC partners thus includes their distributive share of Eaton Worldwide’s gross income, whether or not distributed.

Treas. Reg. Section 1.312-6(b) explicitly states that earnings and profits “shall be determined by taking into account all items includible in gross income under section 61.“ Because the upper tier CFC partners’ distributive shares of Eaton Worldwide’s Section 951(a) inclusions are includible in their gross income, it follows that their earnings and profits must be increased by those amounts. Therefore, the court concluded, each upper tier CFC partner was required to include in gross income, and make a correlative increase in earnings and profits to reflect, its distributive share of Eaton Worldwide’s partnership income, including Eaton Worldwide’s Section 951(a) inclusions with respect to the lower tier CFCs.

The court observed that Eaton’s view of Treas. Reg. Section 1.964-1(a) foreclosed resort to the general rules of Section 312 for determining the earnings and profits of a foreign corporation—in particular, to the requirement that earnings and profits shall be determined by taking into account “all items includible in gross income under Section 61.” See Treas. Reg. Section 1.312-6(b). This argument, however, was found to be abjectly unpersuasive. Section 964(a), the court reiterated, explicitly incorporates the rules of Section 312. It provides that the earnings and profits of a foreign corporation must be determined according to rules substantially similar to those applicable to domestic corporations.

Eaton said that Section 951(a) inclusions did not increase the dividend paying capacity of the upper tier CFC partners. No argument there. Pressing its advantage, Eaton argued that earnings and profits increase only where a corporation receives tangible, economic value that enhances its dividend paying capacity. In other words, “phantom” items of gross income, i.e., those items not accompanied by a concomitant receipt of cash or other property, were not properly includible in earnings and profits. The court disagreed. It noted that “there are many instances in which E&P are increased when amounts are included in income, but no cash is received.” For example, original issue discount with respect to a debt instrument must be included in gross income and in earnings and profits when such “OID” accrues, even though no cash is received until a later period, i.e., when the debt instrument matures or is called for redemption.

Eaton’s upper tier CFC partners must include their distributive shares of Eaton Worldwide’s income, including their distributive shares of Eaton Worldwide’s Section 951(a) inclusions, in their gross income and in their earnings and profits. Eaton was thus required to include in its consolidated income, under Sections 951 and 956, $73 million and $114 million for tax years 2007 and 2008, respectively.

The increase in the upper tier CFC partners’ earnings and profits increased “the amount determined under Section 956” with respect to their U.S. shareholders. In general, the amount determined under Section 956 is the lesser of the relevant CFC’s average investment in U.S. property or its applicable earnings and profits.

Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.