Nebraska Denies DRD for Section 965 Income

In August, the Nebraska Supreme Court ruled in Precision Castparts Corp. v. Nebraska Department of Revenue that income representing retained earnings of Precision Castpart’s foreign subsidiaries that were included on its 2017 federal tax returns based on IRC Section 965 (IRC Section 965 income) did not satisfy Nebraska’s DRD requirements. The court found that IRC Section 965 income is not a dividend or deemed dividend, but rather is pass-through income operating in the same basic way as the taxation of partnerships, S corporations, and Subpart F income. The decision has left many questions about how IRC Section 965 income should have been treated on Nebraska returns.

Background

Enacted as part of the Tax Cuts and Jobs Act of 2017, IRC Section 965 imposes a one-time transition tax on untaxed foreign earnings of foreign corporations owned by U.S. shareholders. The tax is computed by including the unremitted earnings in the income of the U.S. shareholders of those corporations.

On June 20, prior to the Nebraska Supreme Court’s decision in Precision Castparts, the U.S. Supreme Court in Moore v. United States considered a challenge to the constitutionality of IRC Section 965. The Moore challenge was based on the premise that the tax was imposed on unrealized amounts deemed to be received that are not gross income under the IRC. In its decision upholding the constitutionality of the provision, the Supreme Court stated that IRC Section 965 does not operate by deeming that a distribution was made to its shareholders. Instead, it said that IRC Section 965 “treats the inclusion as pass-through income and attributes the retained earnings of a CFC to its shareholders … [IRC Section 965] operates in the same basic way as Congress’ longstanding taxation of partnerships, S corporations, and Subpart F income.”

Nebraska Supreme Court decision in Precision Castparts

Nebraska statutorily allows corporate taxpayers a DRD applicable to dividends received or deemed to be received.

Precision Castparts argued that IRC Section 965 income is deductible for state tax purposes under Nebraska’s statute allowing for a DRD. A lower court denied the deduction and Precision Castparts appealed to the Nebraska Supreme Court.

The Nebraska Supreme Court engaged in a strict construction analysis of the Nebraska DRD’s statutory language. The court noted that general rules of statutory construction require exemptions from taxation to be strictly construed against taxpayers.

Using this framework, the court concluded that IRC Section 965 income does not qualify as a dividend because no actual distribution was made by Precision Castparts’ controlled foreign corporations (CFCs) or received by Precision Castparts. Furthermore, the court determined that no federal statutory provision indicates that Congress specifically intended to deem such income a dividend.

The Nebraska Supreme Court followed the Supreme Court’s analysis in Moore when it found that IRC Section 965 does not deem shareholders to have received a distribution, but rather operates similarly to pass-through and Subpart F income.

Nebraska Revenue Ruling 24-21-1

While most states provide an exemption for Subpart F income, the Nebraska Department of Revenue limits that exemption. In February 2021, it issued Revenue Ruling 24-21-1, which limits Nebraska’s DRD to certain Subpart F inclusions that the department of revenue determined satisfy the dividends received or deemed to be received requirement to be eligible for the DRD.

Crowe observation

The decision in Precision Castparts appears to support the department’s position restricting the application of its DRD in the case of Subpart F income.

Looking ahead

Treating IRC Section 965 income as pass-through income raises questions regarding whether taxpayers can treat such income as pass-through income for all purposes under Nebraska law. For example, the decision raises the question about whether the apportionment factors of a CFC flow up to the recipient if a unitary relationship exists. Nebraska taxpayers with a 2017 tax year that is still open or that have Subpart F income should consult with their tax advisers about their reporting positions in light of the Nebraska Supreme Court’s decision in Precision Castparts.