Income attributed to a US taxpayer resulting from the IRC Section 965 transition tax does not qualify for the Nebraska dividends-received deduction (DRD), the Nebraska Supreme Court (court) has held in Precision Castparts Corp. v. Nebraska Department of Revenue, 317 Neb. 481 (Aug. 30, 2024). In so holding, the court concluded that "the language of [IRC] Section 965 does not deem the income included to be dividends, and … that [IRC] Section 965 employs pass-through treatment to attribute earnings to shareholders without deeming a distribution to have been made to shareholders."

Background

Neb. Rev. Stat. Section 77-2716(5) provides a subtraction adjustment for dividends "received or deemed to be received" from corporations not subject to the Internal Revenue Code (IRC). This provision was enacted in the mid-1980s as part of an overhaul of the state's corporate tax system in response to the state Supreme Court's decision in Kellogg.¹

In response to Kellogg, the Nebraska legislature amended its law to limit the extent of Nebraska taxpayers' apportionment factors to domestic values, meaning no controlled foreign corporation (CFC) factors, by providing that, "in the computation of the factors[,] only the part of a unitary business group that is subject to the [IRC] shall be included."² The tradeoff was the enactment of the subtraction modification at issue — the subtraction of "dividends received or deemed to be received from corporations which are not subject to the [IRC]."³ In effect, Nebraska eliminated from taxation any distributions, actual or deemed, from a taxpayer's CFCs that are not themselves subject to federal income tax. Included within that amount are subpart F income inclusions, which as discussed previously, are "deemed" dividends, i.e., distributions of income (property) made by a CFC out of its earnings and profits to the CFC's shareholders.

In line with the post-Kellogg tax reform, the Nebraska Department of Revenue (Department) consistently advised that subpart F income was a "deemed" dividend that should be subtracted from taxpayers' federal taxable income in calculating their respective Nebraska corporate income tax liabilities under Neb. Rev. Stat. Section 77-2716(5), thereby treating subpart F income as eligible for the DRD.

Responding changes made by the federal Tax Cuts and Jobs Act, specifically the one-time transition inclusion of IRC Section 965(a), the Department revisited this practice in 2018 and issued guidance denying DRD treatment to IRC Section 965(a) income (see Tax Alerts 2019-0062, 2019-1639). In 2021, the Department supplemented this guidance in Revenue Ruling 24-21-1 (see Tax Alert 2021-0404), which discussed certain parts of subpart F that are expressly identified as dividends or deemed dividends by Congress and allowed a DRD for those items only. Any other items of subpart F income would not be afforded DRD treatment according to the guidance. The Department has been active in assessing taxpayers on these issues.

The taxpayer in Precision Castparts filed a refund claim regarding its inclusion of deemed repatriated income under IRC Section 965(a) on its amended 2017 return. The Department denied the refund claim, and the taxpayer appealed the decision. The Lancaster County District Court affirmed the Department's decision (see Tax Alert 2023-1572), and the taxpayer appealed to the Supreme Court. On appeal, the court upheld these determinations.

Court finds IRC Section 965 inclusion income did not qualify for the DRD deduction

The court said that the issue was one of statutory interpretation; specifically, the proper interpretation of the phrase "dividends … deemed to be received" in Neb. Rev. Stat. Section 77-2716(5). The court observed that nothing in the language of IRC Section 965 explicitly deemed the income inclusion to be a dividend, noting that when Congress decides to treat certain inclusions as dividends, it explicitly says so.⁴

The court then turned to the taxpayer's argument that IRC Section 965 deems shareholders to have received distributions from their controlled foreign corporations (CFCs) and that such distributions, if received, would be dividends. While acknowledging that the argument had "some appeal" based on pre-TCJA provisions where earnings of CFCs were generally not taxed to shareholders unless and until they were distributed as dividends, the court concluded that was not how the IRC Section 965 inclusion operated.

Citing the U.S. Supreme Court's recent decision in Moore v. United States, 602 U.S. __, 144 S. Ct. 1680, 219. L. Ed. 2d 275 (2024),⁵ the court indicated that IRC Section 965 treats the inclusion as pass-through income, attributing the CFCs' retained earnings to the shareholders without regard to whether the earnings are distributed to the shareholders. Accordingly, the court concluded⁶ that the IRC Section 965 inclusion did not qualify for the deduction under Neb. Rev. Stat. Section 77-2716(5).

Implications

With the release of the court's opinion, similar cases that have been pending with the Department are expected to move forward in the near future. The court's decision applies only to whether IRC Section 965(a) inclusion income is eligible for the deduction. Left unanswered is whether the court would approve the Department's disallowance of the DRD for of other types of subpart F income in Revenue Ruling 24-21-1. Furthermore, the court's reliance on Moore for the proposition that IRC Section 965 uses pass-through treatment to attribute earnings to shareholders leaves the door open for taxpayers' continued argument for apportionment-factor representation of the CFC factors generating the IRC Section 965 income.⁷