UNITED STATES v. GOODYEAR TIRE & RUBBER CO.
Legal provision: Internal Revenue Code
IN THE SUPREME COURT OF THE UNITED STATES
UNITED STATES, Petitioner v. GOODYEAR TIRE AND RUBBER COMPANY AND AFFILIATES
November 1, 1989
The above-entitled matter came on for oral argument before the Supreme Court of the United States at 1:53 p.m.
ALAN I. HOROWITZ, ESQ., Assistant to the Solicitor General, Department of Justice, Washington, D.C.; on behalf of the Petitioner.
BARRING COUGHLIN, ESQ., Cleveland, Ohio; on behalf of the Respondent.
CHIEF JUSTICE REHNQUIST: We'll hear argument next in Number 88-1474, United States against Goodyear Tire and Rubber Company.
Mr. Horowitz, you may proceed.
ORAL ARGUMENT OF ALAN I. HOROWITZ ON BEHALF OF THE PETITIONER
MR. HOROWITZ: Mr. Chief Justice, and may it please the Court:
The issue in this case concerns the conctruction of Section 902 of the foreign tax credit provisions of the Internal Revenue Code. This section allows U.S. corporations to take a credit against the U.S. income tax that is due on certain income dividend income that it receives. Specifically, the issue concerns the definition of the important term "accumulated profits" in Section 902 in a case where the tax laws of the foreign country establish different rules for the computation of profits than do the tax laws of the United States.
In this case the British tax laws entitled Respondent to take two large deductions from its income totaling more than three million pounds. The parties have stipulated, at page 23 of the Joint Appendix, that these deductions would not be allowable under U.S. tax laws. The federal circuit in this case upset the well-settled rule that the term accumulated profits is to be defined in accordance with U.S. tax principles and instead held that it should be determined in accordance with the tax principles of the foreign country.
We believe that the court of appeals' holding is clearly wrong and completely undermines the statutory purpose. To explain why that is so I would like to begin by describing the statutory framework out of which this case arises.
When a U.S. company engages in business in a foreign country it is likely to be subjected to tax by the foreign country on the incomes that are earned there. When it reports this income on its U.S. tax return the code allows, the code allows it to take a credit to reflect the foreign tax that has already been paid on the income, and thereby to avoid double taxation of the same income.
There are two different ways in which a U.S. company can do business abroad, and they require distinct treatment in the code. But the goal, which everyone agrees here, is that more or less the two different ways of business should be treated the same under the code, and there should be no advantage of doing one business -- one way of doing business over the other for foreign tax credit purposes.
QUESTION: That is more or less agreed?
MR. HOROWITZ: I understand that to be agreed, yes.
The simplest case is when the U.S. company operates a branch -- what is called a branch operation in the foreign country. That means if there is just one corporation, no separate taxable entity in the foreign country, the income that is earned in the foreign country flows directly to the U.S. company and it is reported directly on its return as income, and the U.S. company then gets what is called a direct credit under Section 901. The amount of foreign tax that it paid to the foreign country on that income is directly credited on its U.S. return.
Now, it is significant to note here that all that happens is that the U.S. company takes a number, the amount of British tax that it paid, and puts it on its U.S. return. It is not concerned, the U.S. tax authorities are not concerned with how the foreign government computed that tax. It could be at a given rate on the same kind of income that the United States rules would apply, or it could be at a lower rate with a different computation from United States income. But that makes very -- that makes no difference to the branch's reporting on its U.S. return.
Now, the other method of doing business overseas would be through a separately incorporated subsidiary. In that case you have a different corporation operating in the foreign country, and it is that corporation, not the U.S. parent, that pays the foreign tax. The income that is earned by that foreign corporation, by the same token, does not automatically flow to the U.S. parent. It is earned by the foreign company. And two things can happen to that income.
Either it can be distributed down to the U.S. parent as a dividend. Now, the dividend, as you probably know, is defined in the Internal Revenue Code as a distribution that is made out of earnings and profits; it is defined by Sections 316 and 312 of the code. If it is distributed as a dividend to the U.S. company it is then reported as income on the U.S. parents tax return, and it is subjected to U.S. tax.
On the other hand, the foreign subsidiary may retain the income, not distribute it to the U.S. parent. In that case the income stays in the foreign sub and it is immunized from U.S. taxation.
Section 902 is designed to provide an appropriate credit to deal with the subsidiary situation. It is called the "deemed paid" credit, because it gives the U.S. parent a credit for foreign tax that it is deemed to have paid, the foreign tax actually having been paid by the subsidiary. And the goals of Section 902 are to provide the appropriate credit. That means to -- both to avoid double taxation and to avoid undertaxation, so as not to give the subsidiary operation an advantage over the branch operation.
Now, I think the boundaries of how Section 2 -- Section 902 should operate are fairly clear. The credit should not be available when all of the sub's earnings are not distributed. If they are retained in the foreign subsidiary there should be no credit at that point to the U.S. parent, because the -- none of the earnings have been subjected to U.S. taxation and there is nothing to credit against and no possibility of double taxation.
On the other hand, when all of the foreign earnings, the earnings earned by the foreign sub, have been distributed to the parent, at that point all of the foreign tax that was paid on those earnings should be credited to the U.S. company. At that point that is the close analogy to the branch operation. When all of the sub's earnings have been distributed to the parent it is pretty much in the same position as would have been a branch, the branch having gotten the full credit. From the start the U.S. parent should now get the full credit.
Now, the complication that we have to deal with in this case arises when the subsidiary distributes only a portion of its earnings and retains some of the others. Clearly, some sort of a partial credit must be given to the parent in that situation, and the code's mechanism for doing that is the allocation formula that we have here in Section 902. Now, the formula is set forth on page 4 of our brief, it is a fairly simple formula that sets up a ratio. The numerator of the ratio is the dividends that are paid to the U.S. parent, and the denominator is defined as the accumulated profits of the foreign corporation, that is, after tax -- accumulated profits.
Now, it is our submission that the profits in the denominator of the fraction must be computed according to U.S. tax principles, just as the profits are that govern the determination of the amount of dividends that will be reported as income on the U.S. return. That is the two things that are being compared and the necessary correlation. The whole point of the formula is to compare the amount of the sub's profits that have been distributed, and therefore subjected to U.S. taxation, with the amount of the subs profits that have been retained in the sub, and therefore still immunized from U.S. taxation. For the formula to work properly the denominator must reflect the total amount that is available for distribution to the U.S. parent as a dividend. And that number is the profits as determined under U.S. law.
Now, there is one other point that I want to explain about the statutory framework, and that is the notion of sourcing, which Respondent discusses at great length in his brief. It is possible, if the subsidiary does not distribute the earnings as they are earned, year by year, but instead accumulates the earnings for a period of time, that in some year it will make a large distribution of earnings that are greater than its earnings in that particular year. The code provides that these earnings are to be sourced on a year -- excuse me, these, the dividends distributed is to be sourced on a year by year basis to the earnings of each year. And this is done according to the statute, Section 902(c)(1) under what we call the LIFC system, that is you start with the current year and then go back year by year exhausting the earnings as you go.
So, for example, if the subsidiary had earned $800 in a particular year, and that year distributed $1,000, but it had accumulated earnings from previous years, then $800 of that distribution would be treated by the code as a distribution in the current year. And 200 -- the extra $200 would be treated as a distribution of profits earned in the previous year. And the tax credit calculation would then be kind of a two-step calculation. They would get the full credit for the current year of all the foreign tax they paid in that year, because all the profits for that year were distributed. And then they would be treated as having made a $200 distribution in the previous year, and would get a foreign tax credit given to them by a formula for that year.
QUESTION: Well, Mr. Horowitz, I guess you have conceded that at least in one circumstance, where the -- there are no profits under the application of U.S. tax principles for a year, and yet the foreign subsidiary has paid a tax, that there is nothing by way of a credit, and there is in effect double taxation. Is that right?
MR. HOROWITZ: That is correct. I mean, we discussed that point at some length in our reply brief, Justice O'Connor. I mean --
QUESTION: Well, that certainly is a concern.
MR. HOROWITZ: Well, it is a concern. It is something that arises out of the mathematics that when you multiply anything by zero, what you get is zero. I should say that it is --
QUESTION: Is there no way that the IRS in that situation could devise a means of recognizing foreign losses and carrybacks or something, or some mechanism for adjusting so that you achieve the purpose of the statute?
MR. HOROWITZ: Yes, there may well be. As far as I know there has never been any -- that issue has never come up in litigation, or litigation that has at least gone to a decision.
There are -- there was a recent article in Tax Notes which I got a copy of in the mail, and I gather the Court got a copy of in the mail also, which cites a lot of commentators and mentions that a couple of the commentators, although they agree with the government's basic position here that U.S. tax principles govern, believe that there should be some way of taking account of foreign carryback rules.
MR. HOROWITZ: That's a separate issue. That is a detail at the margins of the issue, I think, that is presented in this case. And I don't think it is necessary for the Court to get into it here.
I think the zero, the zero income question --
QUESTION: Yes, but it is a concern if you know that the rule you adopt is going to result in some defeating of the statutory goal in some circumstances.
MR. HOROWITZ: Well, I guess I am not acknowledging that, Justice O'Connor, because the zero -- as a practical matter, the zero income case is not going to come up except in the area of a loss carryback. I mean, there is not going to be a case where they are subjected to a lot of foreign tax and yet there is absolutely no U.S. income for that year. All the examples that are given by the amici and by the Respondent all involve cases where there is a deviation in the carryback rules of a loss --
QUESTION: And how do the taxpayers here get in difficulty with the application of your principle?
MR. HOROWITZ: The tax -- I am sorry, I am not sure I understand.
QUESTION: How are the taxpayers here adversely affected, then, by your interpretation?
MR. HOROWITZ: Well, they are not adversely affected at all. They are trying to get a tremendous -- they are trying to get a tremendous tax benefit from the rule that they apply. There is clearly no zero income problem in this case, and there is no issue of carryback in this case. As I said before, it is stipulated that the deductions, tremendous deductions that they got under British law here are not available at all under U.S. law.
But, just to finish my answer here to your question before, I mean, the zero income thing can come up where the carrybacks are made to different years under different -- under the different tax systems. And what I was just pointing out is that there is more of an argument there, that there is some -- that the general principle that U.S. tax principles apply to the definition of profits might be adjusted by that for carrybacks. That is made by several commentators. So I don't think the decision in this case is going to resolve that one way or another. That would be left for further litigation.
QUESTION: Is your position embodied in a Treasury regulation?
MR. HOROWITZ: Our position in this case? Yes, Section --
MR. HOROWITZ: -- 109 --
QUESTION: So it is, this is in a Treasury regulation.
MR. HOROWITZ: Yes. Well, the Treasury regulation is not very detailed. It says that accumulated profits are determined according to earnings and profits of the corporation for the year.
QUESTION: Under United States law?
MR. HOROWITZ: Yeah, under United States law.
QUESTION: Is that what it says?
MR. HOROWITZ: Yes. Well, it says, it uses the term earnings and profits, which is a United States concept and which is understood to mean the United States principles.
QUESTION: In other words the regulation is ambiguous in the same way the statute is?
MR. HOROWITZ: No, I don't think it is ambiguous in the same way as the statute is, because the regulation uses a term of art of the United States tax law, earnings and profits, which is the base on which U.S. dividends are paid out of. If the statute uses the term accumulated profits, which appears nowhere else in the code; it doesn't have an established meaning and is, for these purposes, is not defined by the code. So, it is left to the parties to fight over what it means. But accumulated profits is not a term of art in the same sense that earnings and profits is. It is our argument that it should mean pretty much the same thing. Congress left some things --
QUESTION: It is the their argument that it is very suggestive that they used the word that isn't used anywhere else in the code, instead of just using earnings and profits, which makes some sense.
MR. HOROWITZ: Not too much sense, Justice Scalia.
MR. HOROWITZ: I mean, they -- it was necessary to come up with some term there because we are talking about a foreign corporation here. So to just say earnings and profits would not be meaningful, because foreign corporations --
QUESTION: It only makes sense in a Treasury regulation? It wouldn't have made sense in the statute?
MR. HOROWITZ: Well, in the Treasury regulation --
QUESTION: I mean, I don't see why it makes any less sense in -- any more sense in the Treasury reg. You just told us it is very clear what it means in the Treasury reg, that there is no ambiguity. Justice Kennedy said that is ambiguous too, you said no, it is not ambiguous.
MR. HOROWITZ: Well, I guess the Treasury reg is issued in the context of a lot of rulings and court decisions already that have discussed this issue. But, as far as the intent of Congress in using this phrase, I think I should make clear that it is not the government's contention that the Congress in 1918 and 1921 sat down and considered the question whether these -- these profits will be determined in accordance with U.S. law or in accordance with foreign law, and then decided to use the term accumulated profits. I don't think there is any reason to think that the issue occurred to the Congress that there would possibly be a difference. I think what we -- we know what the intent of the Congress was, generally, in enacting the credit, and our position is that only by using U.S. profits can that -- can that attempt be effectuated. Obviously, if Congress was aware of this litigation, had the prescience to know that this litigation, they would have used a different word no matter who was right in this case. They wouldn't have used something ambiguous.
QUESTION: I suppose that -- don't you -- all you have to say is that your construction of the statute is a defensible one or a reasonable one, even if those -- even if there is another construction?
MR. HOROWITZ: Well, to the extent -- yeah, the administrative construction is entitled to deference. I guess we tend to rely, in those cases where we think there is a reasonable argument on the other side. In this case I think it is so clear that the only way of reading the statute is the government's. But we'll save that ammunition for another case. But, I agree with you, Justice.
There are two ways in which the variation in accumulated profits can affect the computation of the credit. One is in the allocation ratio, that is the formula that I quoted before for a given year, for a single year's profits. If the number in the denominator is changed and, as they have done in this case, if the number in the denominator is reduced by using a smaller foreign definition of profits, that will necessarily increase the ratio and the amount of credits that you get for a particular distribution.
The second way that it can make a difference is in connection with this sourcing mechanism that I spoke of before. If the accumulated profits are smaller than a given distribution of earnings, which is what happened here, can swallow up the earnings of a given year sooner, thus resulting in a full credit for that year, and get back to earlier years and end up soaking up more of the credit, so to speak. Both of those factors are present in this case that affected the tax computation.
There are a lot of numbers in the Joint Appendix here on schedules, but I would just call the Court's attention to pages 30 and 31, which are, I think, the key schedules, and include the different computations of both parties. And I guess if I get a chance I might go through these in a little more detail later. But at least for now I just mentioned those two pages in the Joint Appendix.
What I want to emphasize now about sourcing, because Respondent put so much emphasis on it, is that sourcing is a secondary point in this case. I mean, the issue here is the definition of accumulated profits. Once that is determined, then how the sourcing calculation is done, how the allocation formula is applied, all follow as a matter of course. But there is no suggestion by anyone, I think, that there is a special rule for sourcing, that accumulated profits means something different when it is used for sourcing purposes than it does when it is used in the regular application of the allocation formula. And we have given in our brief a lot of examples of how messed up the application of the credit gets, if the other sides petition is correct.
The other side, I think, particularly the single-year examples, which are the simplest way of looking at it, the other side hasn't really responded to those, and I think in part because they suggest that this case is about sourcing. And I do want to emphasize that you can't escape the effect of the -- of their position on a single-year application of the formula by hiding behind the sourcing idea.
We suggest that the use of foreign profits will mess up the application of the 902 credit in several ways. One is in the allocation formula itself. The ratio is simply not meaningful if foreign profits are used in the denominator. It is essentially comparing apples and oranges. It is undisputed in this case that the pool of potential dividends that can be distributed by the subsidiary and that would be recognized by the U.S. parent as taxable income is the earnings and profits defined according to U.S. law. That was held by the Untermyer case back in 1931, and at page 37 of their brief, Respondent admits to that.
Well, if U.S. profits are used in the formula, what you are doing is computing the proportion of those potential dividends, which proportion is being distributed and which proportion is still being immunized from U.S. taxation. That is, was what the is formula supposed to do. If you put foreign income into the denominator, you are getting numbers that don't correlate to that purpose. You will get a fraction as a mathematical matter, but you won't get something that is doing what the credit is designed to do.
Another problem that is created by this is that it destroys the symmetry that Congress many times tried to preserve, and enhance actually, between branch operations and subsidiary operations. As I said at the outset, the branch operation is not at all concerned with how foreign income is computed, or how the foreign tax is computed. It just takes the number from the foreign tax return. All of its -- it recognizes income on the U.S. return according to U.S. principles of taxation, directly into the U.S. company. And for the sub to approximate the treatment of a branch it must similarly look to U.S. principles in order to determine the income that it is taking into effect.
If you use foreign principles in the allocation formula for the subsidiary, then you will have a case where there is a complete distribution of all of the earnings and profits by the subsidiary, which is -- which puts it in the same position as the branch which took all those earnings into account in the beginning, and yet you won't get the full credit.
There are a lot of examples given in our brief that illustrate the distortions that you will get, and I would like to emphasize that if foreign income is used there will be a distortion of the way the credit is supposed to work in every single case, not just in a case where zero is used as one of the years. Every time the foreign income is higher than the U.S. income, a full distribution of all the money available for dividends, which should yield the full credit, will in fact not yield the full credit, and it may be lost forever. That is because the denominator of the fraction will be too high.
I should -- I guess I should mention the page numbers of which our examples are: pages 21 to 22 of our opening brief, and some more detail at pages 14 to 17 of our reply brief.
On the other hand, if you have this case --
QUESTION: And you claim that your system only doesn't make sense when you got a zero figure?
MR. HOROWITZ: That is right. It still makes sense, but it leads to -- I mean, because of the zero multiplication problem, it leads to a result that is not one that Congress I think would have wanted to have.
QUESTION: It doesn't make sense, really.
MR. HOROWITZ: All right.
If the foreign income is lower, which is the fact in this case, what happens is that you can get all the credit out without distributing all of the available profits. And I would like to emphasize that because that is -- the legislative history of the 1921 amendment and really just the text of the statute makes it clear that this is the whole point of the allocation formula, is to prevent the sub from getting an advantage over the branch operation by being able both to take the full credit and to keep earnings in the subsidiary and immunize them from U.S. taxation.
And maybe I can illustrate this now by looking at the actual figures in this case. If you can look at pages 30 to 31 of the Joint Appendix. Those are the fold-out pages that are in the middle of the appendix. Page 31 is the government's calculation of how the formula should work here, using U.S. tax concepts. And you will see that the numbers at the very top of the page there are the income, the earnings of the British corporation for these years. Those numbers are not in dispute, at that point. And when you subtract the taxes out you get down, a couple lines down I guess, to the second total there, which is adjusted accumulated profit. This is the U.S. profits for these years. 1970 and 1971 are the tax years. And you see in both years the U.S. profits are more than three million pounds for each year, sizable profits.
Now, again, as we understand it, Respondent would agree that this is the pool of potential dividends, that if all of these three million pounds were distributed they would be recognized as dividends and taxed as income on the United States return. Now, the rest of the government's calculation --
QUESTION: Excuse me. And all of those are computed under U.S. rules, you said?
MR. HOROWITZ: That is right.
QUESTION: Up to there.
MR. HOROWITZ: That is right, computed under U.S. rules.
QUESTION: You are all in agreement.
MR. HOROWITZ: Well, they don't agree that that is how they should be computed. But as far as the numbers go that is how it is computed.
Now, the calculation on this schedule is fairly simple after that. There are, the next total line is the dividends that are paid out in that year. That is just a fact, the dividends that were paid out by the foreign subsidiary, and there is no dispute about those numbers either.
Now, the way the government allocates these, according to the sourcing is very simple, because under our theory the dividends were always less than the total earnings for that year, so the dividends were just apportioned to the year in which they were distributed. So, the 1971 dividend is fully apportioned to 1971; the 1970 dividend is fully apportioned to 1970. And then the calculation is made down at the bottom using the formula, and you see that for -- take 1970 as an example, about one third of the earnings in that year were distributed as a dividend, and therefore they get about one third of the foreign taxes that were paid as a credit.
QUESTION: Mr. Horowitz, about the middle of the page, allocation of dividends 94621 -- 946421. Why is that $100 different from the figure immediately above?
MR. HOROWITZ: I don't know. I think it's a misprint. I'm pretty sure it's a misprint.
QUESTION: So do I.
MR. HOROWITZ: Now, on the other side -- I guess I had better go through this quickly -- but it starts off with the same income numbers, but there is, on the second line down where there are numbers, there is this tremendous British loss that is carried back to 1970 and 1971, and that wipes out a large portion of the earnings for the purposes of the British taxing authority for those years. Now, what you end up with is the sourcing calculation that this formula was done, and you see --
QUESTION: Mr. Horowitz, could I ask this one question? Why, on your exhibit on page 31, why isn't there the credit for 1973 calculated?
MR. HOROWITZ: Well, I'm not sure why 1973 is included on the schedule. The year, this case only involves the tax years 1970 and 1971. So, actually neither schedule calculates the credit for 1973.
QUESTION: I see.
MR. HOROWITZ: I think just some of the numbers are there for completion.
QUESTION: That is just the source of the carryback, in '73.
MR. HOROWITZ: That is right.
QUESTION: Okay. Thank you.
QUESTION: What are the two numbers further down, after the years, to 1968 to '69 to '70, '71, '73, there. There are two more numbers that don't have any --
MR. HOROWITZ: I think that is also --
QUESTION: They are the credit.
MR. HOROWITZ: Well, that is the credit, which is then explained how we got the credit further down. That probably shouldn't be in that spot.
QUESTION: I got you, I see. It is the same numbers --
MR. HOROWITZ: And I think, since I am running out of time, I will just say that if you look at -- if you look later -- at the Respondent's calculation you will see that they, by attributing only $26,000 of their -- thousand pounds of their 1971 dividend to 1971, they take out the full credit for that year and move on to the next year, even though there were more than three million pounds in earnings and profits for that year. What they do essentially is to create these islands of large amounts of earnings and profits that they treat as either distributed or just ignore, while taking the full credit out.
So, the real evil of the Respondent's position here is not that they get credit for more tax than they ever paid; that doesn't happen. But what they do is that they manage to get the full credit while still retaining a lot of earnings in the foreign subs.
I would like to reserve the remainder of my time.
QUESTION: We're doing pretty well on this one, we're only about 20 years behind.
MR. HOROWITZ: The complaint was filed in 1985.
QUESTION: Thank you, Mr. Horowitz.
ORAL ARGUMENT OF BARRING COUGHLIN ON BEHALF OF THE RESPONDENT
MR. COUGHLIN: Mr. Chief Justice, and may it please the Court:
Counsel for the government has already explained that this case is here on certiorari to the court of appeals for the federal circuit. If there is no objection I am going to try to avoid confusion and slips of the tongue by referring to the Petitioner as the government and to the Respondent, the Goodyear Rubber and Tire Company and its affiliates, as Goodyear. Another corporation involved here as Goodyear's wholly-owned British subsidiary, which will be referred to as Goodyear England.
The court of appeals granted Goodyear's motion for summary judgment, thus allowing Goodyear's claim for refund of federal income taxes for 1970 and 1971. Since the question was answer -- asked earlier, I will say here that the year 1973 is not involved as far as the claim for refund is concerned. It is involved in the sense that the loss which Goodyear England had in 1973 gave rise to the net operating loss carryback deduction which affected the years 1970 and 1971. That is the reason that '73 is in the schedule.
In 1970 and 1971 Goodyear received dividends from its subsidiary Goodyear England, dividends of about $946,000 for 1970 and about $729,000 for 1971. Goodyear reported the dividends in its U.S. income tax returns, and in this case its claim for refund is on the ground that it is entitled to foreign credits, to foreign tax credits for foreign taxes paid by the subsidiary on its own income, out of which those dividends were paid.
Counsel for the government has already explained that there are two sections of the Internal Revenue Code which relate to the foreign tax credit. One is Section 901, which allows a credit for all foreign taxes paid by the taxpayer, that is by the U.S. taxpayer. The other one, Section 902, says that under certain circumstances the U.S. taxpayer is deemed to have paid the taxes paid by its subsidiary. It doesn't have to be a wholly-owned subsidiary; it can be only 10 percent, so that you could have more than one parent, which may be important. So that in this case the parent, Goodyear, is claiming credit for taxes paid by its subsidiary.
The dispute relates to the computation of the credit, which, as has been pointed out, depends on just two words, the phrase "accumulated profits" in Section 902. The parties have stipulated that if Goodyear's definition of accumulated profits is correct, the credit is to computed in accordance with Exhibit I, which has already been discussed here. And on the other hand, if the government's definition is correct, Exhibit J governs.
The parties have also stipulated what their respective positions are as to the definition of the phrase. There is a little confusion here which might be alluded to in that the stipulation was that the -- that Goodyear's position is that in this case what we are applying is what the British determined to be the taxable income in Britain, not what some agent in the United States applying British law might determine it to be, but what it was determined to be. That is the tax base. I think that is fairly clear in the stipulation.
The other side of it is that the government stipulated that the taxable -- that what it is talking about is the taxable income of the subsidiary computed under U.S. law, which does require, of course, a recomputation. Now, in this Court, the government has been arguing that it is the earnings and profits or something like it. It says it is not exactly thee earnings and profits, but something related to it and close to it, but somewhat different from the earnings and profits is involved. We think we are really talking about the foreign tax base, or the recomputed taxable income as if it were a U.S. corporation. But, whether it is earnings and profits or whether it is taxable income, we still have the problem of what accumulated profits means.
Now, before I go on further, I want to mention here four points which may lead to some misunderstanding, in fact I think perhaps already have. There are four points. Number one, the credit Goodyear is seeking is not a credit for foreign taxes that have already been refunded. There was a refund here, but Goodyear is seeking credit for taxes of other years that have not been refunded and have not been used as the basis for a credit. The claims court misunderstood that point and thought we were trying to deduct the same foreign tax credit twice.
Number two, Goodyear is not trying to apply foreign law to the liability of a U.S. taxpayer. We are trying to interpret the U.S. law. The U.S. law that is applicable and determines Goodyear's liability is Section 902. And the question is, what does Section 902 mean.
Number three, Section 316, which has to do with whether a distribution by a corporation is a taxable dividend or is a return of capital, Section 316 has nothing whatever to do with this case. As counsel for the government pointed out, the dividends have been stipulated. They are a fact; they are not in any event controlled by the current earnings and profits of any year. There are ample earnings and profits in an aggregate sense to carry those dividends, and, after all, most corporations having foreign subsidiaries are not going to conduct their year -- their year-to-year business by making distributions out of capital. They are, most of them, growing, not declining in size, and when they pay a dividend it is taken for granted that it is ordinary income on this side. There is no issue about that. If Section 316 had been repealed the year before the two years involved here, it would not have made a particle of difference to this case. It simply is not involved.
Number four, there is no way, under either view of this case, that the U.S. parent can ever claim credit for more foreign taxes than its subsidiary paid, or more than it would have paid if it had been in a branch operation. Under the government's view, however, the U.S. taxpayer may be restricted to considerably less than it would have got in a branch operation. And it is this windfall to the treasury that the government is trying here to preserve.
Now, before going on further with the facts, it is necessary to understand the working of the deemed paid credit a little more than has been explained so far. There has been reference to sourcing. It is involved in this case; it is involved in many cases, and the definition of accumulated profits has to be something that is going to fit that. Section 902 in general provides that the U.S. parent receiving a dividend from its foreign subsidiary is deemed to have paid that proportionate part of the foreign taxes of the subsidiary that the dividend bears to the accumulated profits of the subsidiary, in excess of the foreign taxes on those profits.
Now, our problem is what does accumulated profits mean in that sense. Abbreviating somewhat the statutory language, the foreign tax deemed paid equals the total foreign tax times the dividend divided by the accumulated profit after subtracting the tax. In algebraic terms this formula is T times D divided by P. It will be noted that that formula is made up of three factors, the foreign law -- excuse me, the foreign tax, the dividends paid by the subsidiary and, in the denominator, the accumulated profits of the subsidiary after tax.
Now, until you become familiar with the workings of Section 902 you might suppose that T, the tax, and P, the accumulated profit after tax, were to be figured on an aggregate or pooling sort of a basis. The word accumulated seems to suggest that. I think perhaps it led the Respondent astray in that the government's brief initially talked about pooling, except in some of the footnotes, all the way through, and is still talking about it being the total fund out of which dividends could be paid. That is not quite it.
Accumulated profits is an annual theory, not a pooling theory. The pooling theory, which we have been referring to from time to time as the bucket theory --
QUESTION: May I just interrupt to get one thing clear?
MR. COUGHLIN: Yeah.
QUESTION: It is not totally an annual theory. If the dividend in the year in question is larger than the earnings in that year, then is it not necessary to look to another year?
MR. COUGHLIN: In the application of Section 316, ordinarily a corporation paying a dividend has some kind of accumulated --
QUESTION: I didn't expect you to respond by referring to Section 316, because you just told us that had nothing to do with the case.
MR. COUGHLIN: Well, it doesn't, and I think that may be true of this --
QUESTION: But just for purposes of 902, is it not true that if the dividend is larger than the earnings in that year, whether computed by British or American standard, it is necessary to look at a prior year to do this arithmetic?
MR. COUGHLIN: If the dividend exceeds the accumulated profits of the year in which the dividend is paid, then it must be applied to an earlier year. Whether the accumulated profits represent the foreign tax base or something else is what is at issue in this case. But you are quite right, Your Honor, in saying that if the dividend exceeds the accumulated profits, whatever those are, then you go back to earlier years. That is pooling --
QUESTION: Well, if they exceed --
MR. COUGHLIN: That is sourcing.
QUESTION: If they exceed, just to get away from -- I mean, we're using the answer to frame the question in a way when you use accumulated profits that way, but if they exceed the taxable income, however you denominate it, under British or American sources, in that year, then you must look at something that was earned in a prior year.
MR. COUGHLIN: That is correct.
QUESTION: And one arguably could say that the term accumulated was meant to pick up the extent to which you have to look at other years.
MR. COUGHLIN: The term accumulated was brought in in order to permit looking at what had been earned in earlier years.
MR. COUGHLIN: When the statute was first enacted in 1918, it didn't say accumulated profits. It said taxable income. It was found that that phrasing was leading to a conclusion that whenever you paid a dividend you could apply the formula and get a credit for the year in which you paid the dividend, with respect to the foreign tax of that year. But if the dividend exceeded the taxable income, the word Your Honor used, for the dividend year, it wouldn't go back to the earlier year. And in 1921 they amended the statute and put in accumulated profits in the place of taxable income.
Now, that suggests that perhaps Congress at that time was thinking of the bucket theory, that we pool all the taxes together and we pool all the earnings together, and we divide one by the other, and we get kind of an average rate of foreign tax, which we then apply to the dividend that was paid. That is actually the principle that has been adopted under the 1986 act, which got rid of Section 902.
However, in the General Foods case it was held, and this has been followed since, it was held that you don't use a bucket theory, you use what we have referred to in our brief as the pigeonhole theory. The idea that you are going to take the dividend for the current year out of a current pigeonhole of this year's earnings, and you are going to take the tax that the foreign subsidiary paid out of the same earnings. And if the dividend exceeds what is in the current pigeonhole, you look in the next pigeonhole. And now you have exhausted the income and the tax for the current year and you are looking at the earlier year. And so on back.
Now, this means that in every year, except the farthest one back, D in the formula is going to always equal P, the accumulated profits after tax, because you have exhausted what is in that pigeonhole, and you have just exhausted it. But when you get back to the end, you will find a place where you don't quite exhaust it and you have something left over. Now, this is important to the whole statutory scheme, and as several cases have said, it is necessary to have a precise matching between the income that goes into that pigeonhole and the tax, or the whole thing isn't going to make sense.
Now, the problem is what you are going to do in determining what accumulated profits really means. I want to quote Judge Raum in the Rob -- H.H. Robertson case. It is of critical importance to determine the accumulated profits of each year so that they can be matched against the foreign taxes paid for that year. And so that when dividends are paid out of, or from such accumulated profits, a foreign tax credit may properly be computed as a portion, in accordance with the statutory formula, of the foreign taxes paid in respect of the accumulated profits for that year.
Now, let's go back to the facts for a moment. When Goodyear originally filed its 1970 and 1971 returns, the accumulated profits for each of those years was sufficient to yield a substantial tax credit, without sourcing into any earlier years. And it recovered credits for taxes paid accordingly.
But in 1973 Goodyear England had a loss, which the British tax authorities allowed as a net operating loss carryback deduction for 1971 and 1970. This resulted in refunds of the foreign taxes that had been claimed as credits for 1970 and 71, but the law required that the entire credit be recomputed at that point. And there doesn't seem to have been any difference of opinion about the fact that it had to be recomputed, except that the U.S. recomputed it without allowing the carryback deduction because it didn't allow the loss at all. It recomputed the 1973 loss and said it was a very large profit. And since there was no loss there was nothing to carryback.
However, while it didn't adjust the accumulated profits in the formula, it did adjust the tax for the refund which the British had paid. And this, of course, considerably distorts the fraction from what it would have been if you adjusted neither the numerator or the denominator, or if you adjusted both.
Now, keep in mind that of the three factors in the formula, accumulated profits is the only one in dispute. The foreign taxes are facts. The dividends are facts. The government is making some argument that because the dividends might have been affected by Section 316, but were not, that therefore the numerator is being determined under U.S. law. It really isn't. The numerator is being determined by the man who wrote the check. That part of the numerator, the dividend part of it, the board of directors of the corporation declares a dividend and the corporation pays it. And that is a fact, and it has been stipulated, not affected by U.S. law.
QUESTION: All money that a corporation sends to its shareholders is treated precisely the same under British law and under American law --
MR. COUGHLIN: As far as this case --
QUESTION: -- with regard to its status?
MR. COUGHLIN: -- is concerned, all money --
QUESTION: Well, but I'm not talking about with regard to this case. I'm talking about the validity of the government's argument that you ought to be logically consistent, and if you are computing the dividends, deciding whether it is a dividend on the basis of U.S. law, you ought to decide the other amount under U.S. law Now, you're saying you don't decide it on U.S. law, that money is money.
MR. COUGHLIN: I'm saying we didn't have to decide it.
QUESTION: Not in this case, but we're talking general principles. If there were any difference between whether the receipt of the money constituted a dividend not, if there were a difference between U.S. and British law, do you concede that it would be U.S. law that would govern?
MR. COUGHLIN: If -- yes. If there -- if the dividend for, under U.S. law, would have -- let's say [ILLEGIBLE WORD] Goodyear England had been a U.S. corporation and a distribution had been made to its parent, the question whether that distribution is a dividend or is a capital distribution is a matter of U.S. law.
MR. COUGHLIN: If there is any difference of opinion on that point.
QUESTION: But you say there happens to have been none in this case.
MR. COUGHLIN: There happens to have been none in this case.
Now, it might be worth mentioning this at this point because there was something said about this which I think is a little confusing, about the possibility that the distribution made -- excuse me, that the possibility that the foreign income tax base might have been less than or more than the amount of the taxable dividend or of the earnings and profits, and what the effect might have been. And the fact of it is that under the theory, as we understand it to be, if the accumulated profits, in any sense of the word, should exceed the foreign income tax base, and the dividend also exceeded that amount, then you would carry it back. But if it went the other way around, you would not, because you would have exhausted the earnings and profits in the dividend you paid, and there isn't anything left to carryback. So that, it is not quite right to say that 316 is governing it in either case.
Now, in arguing that the term accumulated profits means the foreign tax base, Goodyear relies first on the wording of the statute, second on the decided cases, then on the fact that any other view produces distortions in the credit allowed, whether or not we have any zero years, and finally on the fact that practical difficulties appear in applying any contrary rule.
Section 902(a)(1), when it sets out the formula, refers to the foreign taxes paid by the foreign corporation on or with respect to the accumulated profits. This seems to me to suggest that accumulated profits means the foreign tax base, because the taxes are paid on or with respect to that amount. But Section 902 goes on and defines accumulated profits. I am going to read part of it.
For purposes of this section the term accumulated profits means, with respect to any foreign corporation, the amount of its gains, profits or income computed without reduction by the amount of the income or profits and excess profits taxes imposed on or with respect to such profits or income by any foreign country or any possession of the United States.
Literally, that says that accumulated profits means gains, profits or income, because it says it means gains, profits or income, not adjusted. Our problem now shifts to finding out what gains, profits or income means. The language is clear. Surely if the foreign taxes are imposed on or with respect to the gains, profits or income, then the gains, profits or income must necessarily be the amount on which the foreign tax was imposed. The statute has now told us the same thing twice. Accumulated profits and gains, profits and income are the same thing. And both represent -- both represent the amount on or with respect to which the foreign tax was imposed. That is the foreign tax base. The foreign country doesn't impose its tax on or with respect to the income recomputed under U.S. standards.
And at that point I would like to say on the side about part of the argument that was made here for the government, and that is we have not agreed that the deduction of the loss in 1970 and '71 was not allowable under U.S. rules. Under 902 we claim that it was allowable, because 902 is the U.S. rule, and we think it must be taken into account because it is a part of the base.
Now, the first case on this was the United Dyewood case, and the United Dyewood case said specifically, the total taxable income upon which such taxes were paid, that was the language in the '18 Act, means the sum used by the foreign government as a base to compute the foreign tax.
Now, the government has pointed out that it is a dictum, but on the other hand, this was a case in which they had to apply the formula. It was a complicated matter because there were two tax bases, there being an excess profits tax as well as an ordinary income tax. So they spelled out the formula. The government had tried to add one-half to one-third and get two-fifths, which obviously wasn't very good arithmetic, and the court straightened it out and figured that the way to do it was to figure out the excess profits tax credit first and then the income tax one. But in both cases they clearly were talking about the foreign tax base.
Now, this Court decided the American Chicle case. By that time the statute had been amended, it no longer said taxable income, it now said accumulated profits. But this Court said that the accumulated profits were the total taxable profits. Taxable by whom? Obviously, taxable by the only tax authority that affected the foreign subsidiary. It certainly did not mean profits that would have been taxable in the United States if it had been taxable in the United States, which it wasn't.
QUESTION: Mr. Coughlin, I am sorry, but can I interrupt you with a question?
MR. COUGHLIN: Certainly.
QUESTION: Earlier you say -- you quoted the language in 90(c)(1), a gains, profits or income computed, and then I got the impression you were saying those same words were repeated with -- were used when you described the amount on which the foreign -- the foreign tax base. Is that, did I understand you correctly?
MR. COUGHLIN: Yes. It says --
QUESTION: And where is the other section where the same words are used? Because that is not quite the same language.
MR. COUGHLIN: It's in the same, it says it -- it says gains, profits or income, and then it says profits or income.
QUESTION: You're reading -- the profits or income is in 901, 901(b), isn't it?
MR. COUGHLIN: I was reading from 901, wait till I get the exact wording.
QUESTION: The language there is income or profits and excess profits taxes. Is that what you were to -- your parallel here?
MR. COUGHLIN: It says -- yes.
QUESTION: Okay --
MR. COUGHLIN: The accumulated profits means the gains, profits or income --
QUESTION: And then you said --
MR. COUGHLIN: -- computed without reduction --
MR. COUGHLIN: -- by the amount of the dit dit dit taxes imposed on or with respect to such profits or income. Now, it didn't repeat the word gains, but I think the word such is probably enough to pick up the earlier language.
QUESTION: Oh, I see, that is the comparison. All right, thank you. I understand what you are --
MR. COUGHLIN: Now, when I said it had done it twice, it is because I think in the first section, when it referred to the accumulated profits in excess of the taxes imposed on such accumulated profits, that also implies that you must be talking about foreign income, because you aren't imposing a foreign tax on anything else.
Now, the tax court has also reached a result that is consistent with these others in the Champion --
QUESTION: Excuse me, may I disagree with that? I mean, it seems to me, not, not a bad use of language to speak of imposing foreign taxes on the same sum of money that would have been income under United States tax law. Why is that a distorted use of language? I mean, I --
MR. COUGHLIN: Because the foreign government does not impose its tax on an amount computed under U.S. terms. It imposes its tax on the foreign tax base.
QUESTION: That may well be, but it does impose it upon a certain sum of money.
MR. COUGHLIN: Yes.
QUESTION: And what the statute might be saying is, that portion of that sum of money which is income which is taxable under U.S. law on which that tax was imposed. I don't know why that would be -- I think the language would bear it, Mr. Coughlin. I --
MR. COUGHLIN: I think the language doesn't really carry it. I think the Second Circuit, two Judges, Hand and Judge Swan, were correct in treating it as being the foreign tax base. The tax court has ruled that you must take into account the foreign net operating loss carryback. And both courts below in the present case, even though one court decided its case the other way, both courts said that gains, profits or income as used in Section 902 means the foreign tax base.
QUESTION: Thank you, Mr. Coughlin.
Mr. Horowitz, do you have any rebuttal? You have two minutes remaining.
REBUTTAL ARGUMENT OF ALAN I. HOROWITZ ON BEHALF OF THE PETITIONER
MR. HOROWITZ: Yes, Mr. Chief Justice. Just a couple of points.
Respondent at least suggested in its argument that there might be a question whether under the government's interpretation Goodyear would ever get credit for all the foreign taxes that it paid. There is no question that it would, as soon as it gets around to distributing all the income that it has kept in the foreign sub it will get credit for all the taxes that it paid. The question here is whether it can accelerate those credits without distributing the money that is available for distribution as dividends.
He also suggested that, going away from the facts of this case to hypothetical situations, that the government's approach can lead to the denial of credit for all the taxes paid. That is true, as we discussed earlier in the limited case of the zero year, but I would like to emphasize that under Goodyear's interpretation it is similarly true that the -- that the company can lose credit for all of the taxes that are paid, and that will happen every time the foreign income definition is higher than the U.S. government definition. And that is explained in the examples of page 22 of our brief, and pages 15 to 16 of the reply brief. Now, Goodyear is not worried about that because in their case the foreign income is lower and therefore it rebounds to their benefit.
Another point I would like to make is that there is obviously, nothing wrong with the fact that the tax here was adjusted because of the change in the British taxing. Obviously they don't want to get -- they said at the outset that they don't expect to get credit for taxes that were already refunded by Great Britain. The tax is not part of the numerator of the fraction. The tax is a constant against which the fraction is multiplied, and there is no reason for there to be any correlation between the denominator and the foreign taxes.
And finally, my last point, I would just like to second what Justice Scalia said about the language of the statute. From the perspective of the U.S. tax code and the U.S. corporation, all that this language means is that the, you look to the income for the year, for the foreign -- the income on which the foreign tax is imposed is the income for that year on which the foreign tax is paid. If you look at a branch that has, say, $1,000 in income under U.S. law, it views the British tax imposed for that year as being imposed on that $1,000, and it is not concerned with how the British would compute the income. And the same should be true here.
CHIEF JUSTICE REHNQUIST: Thank you, Mr. Horowitz. The case is submitted.
(Whereupon, at 2:54 p.m., the case in the above-entitled matter was submitted.)