Varian: Tax Court applies Loper Bright

Over the past several years, the Supreme Court has handed down landmark rulings that have reshaped the contours of federal administrative authority. The court's 6-3 conservative majority, solidified during Donald J. Trump's first presidency, continues to exert influence well into his second term and beyond.

In the realm of tax administration and the Internal Revenue Service, these shifts have redirected power away from the agency's interpretive discretion and toward judicial forums, notably the United States Tax Court. The court's decision in Loper Bright Enterprises v. Raimondo last year overturned the long-standing Chevron doctrine, ending decades of deference to agency interpretations of ambiguous statutes. This change has funneled fresh challenges to IRS regulations into the Tax Court, fostering new lines of judicial precedent in tax law.

One illustrative case is Varian Medical Systems, Inc. v. Commissioner. There, the Tax Court confronted the question of whether a fiscal-year taxpayer could claim a dividends-received deduction under Section 245A of the Internal Revenue Code for amounts treated as deemed dividends under Section 78 during a transitional "gap period" created by the Tax Cuts and Jobs Act of 2017—or whether a subsequent Treasury regulation could retroactively deny that deduction.

The IRS possesses broad authority to interpret and enforce tax laws, often through regulations that fill in statutory details. But under the pre-Loper Bright regime, courts deferred to those interpretations if they were reasonable, even when statutes were ambiguous. The core issue in Varian was whether this deference extended to a regulation that appeared to override clear effective-date provisions in the statute, or whether the court must now independently determine the best reading of the law without such deference.

The case arose from the complexities of international tax reform under the TCJA, which aimed to transition the U.S. from a worldwide to a more territorial tax system. At its heart was Section 245A, a new provision allowing U.S. corporations a 100% deduction for the foreign-source portion of dividends received from specified 10%-owned foreign corporations. This deduction was designed to prevent double taxation on repatriated earnings, applying to distributions made after December 31, 2017.

Intersecting with this was Section 78, a longstanding rule dating back to 1962. Under Section 78, when a U.S. shareholder claims a foreign tax credit for taxes deemed paid by a foreign subsidiary, it must "gross up" its income by treating an amount equal to those foreign taxes as a dividend received from the subsidiary. This ensures that the credit offsets U.S. tax on the full pre-tax foreign earnings. Before the TCJA, such gross-up amounts could qualify for dividends-received deductions under older provisions like Section 245.

The TCJA amended Section 78 to specify that these gross-up amounts would no longer be treated as dividends eligible for the new Section 245A deduction—or its predecessor, Section 245. However, the effective date for this amendment was tied to the taxable years of foreign corporations beginning after December 31, 2017, and the corresponding U.S. shareholder years in which those foreign years ended.

This created a mismatch for fiscal-year taxpayers like Varian Medical Systems, a California-based company specializing in medical devices and software, whose taxable year ran from September 30, 2017, to September 28, 2018. For Varian, the Section 245A deduction became available for distributions after December 31, 2017, but the amendment to Section 78 excluding gross-ups from that deduction did not apply until foreign corporate years starting in 2018. As a result, during this "gap period"—from January 1, 2018, to the end of Varian's fiscal year—the company was deemed to receive Section 78 gross-up dividends that, under the plain statutory text, appeared eligible for the full Section 245A deduction.

Varian claimed foreign tax credits under Section 960 for taxes deemed paid by its foreign subsidiaries, including amounts tied to the TCJA's one-time transition tax on accumulated foreign earnings under Section 965. This triggered a Section 78 gross-up of approximately $165 million, for which Varian sought the Section 245A deduction on its 2018 return. The IRS, during an audit, issued a notice of deficiency disallowing the deduction, arguing that the gross-up did not qualify as a "dividend" or "distribution" under Section 245A's terms.

To address this gap across all fiscal-year taxpayers, the Treasury Department and IRS promulgated Treas. Reg. § 1.78-1 in 2019. The regulation retroactively treated Section 78 gross-ups as dividends for most purposes but explicitly excluded them from eligibility under Sections 245 and 245A for dividends received after December 31, 2017, where the underlying foreign taxes were deemed paid for foreign corporate years before January 1, 2018. In essence, it aligned the effective dates to deny the deduction during the gap period, overriding what taxpayers like Varian saw as the statute's clear allowance.

Varian challenged the disallowance in the Tax Court, arguing that the statutory text unambiguously permitted the deduction and that the regulation exceeded Treasury's authority. The IRS countered that the regulation was a valid interpretation of an ambiguous interaction between Sections 78 and 245A, deserving deference under the then-prevailing Chevron framework. But by the time the case was decided on August 26, 2024, the Supreme Court had issued its ruling in Loper Bright, fundamentally altering the landscape.

In Loper Bright, the Supreme Court held that courts must exercise their independent judgment in deciding whether an agency has acted within its statutory authority, rather than deferring to the agency's interpretation merely because a statute is ambiguous. The decision overruled Chevron U.S.A. Inc. v. Natural Resources Defense Council Inc., a 1984 precedent that had required courts to uphold reasonable agency interpretations in such cases. Chief Justice John G. Roberts Jr., writing for the majority, emphasized that "courts need not and under the APA may not defer to an agency interpretation of the law simply because a statute is ambiguous." Instead, agencies' views may receive "careful attention" under Skidmore v. Swift & Co., a 1944 case that evaluates an interpretation's persuasiveness based on its thoroughness, validity of reasoning, and consistency with earlier pronouncements.

The Tax Court in Varian became the first to apply this new standard in a tax context. In a unanimous, reviewed opinion authored by Judge Emin Toro, the court conducted a detailed statutory analysis without deferring to the IRS's regulation. It examined the text of Sections 245A and 78, their legislative history, and congressional intent.

The court found the statutes' language clear and unambiguous. Section 245A provides a deduction for "the foreign source portion of any dividend received from a specified 10-percent owned foreign corporation." Section 78 states that the gross-up amount "shall be treated for purposes of this title... as a dividend received by such domestic corporation from the foreign corporation." The court noted that both provisions use nearly identical phrasing, treating the gross-up as a dividend "received" from the foreign corporation. Citing six dictionaries for the definitions of "dividend" and "with respect to," as well as canons of statutory construction from Antonin Scalia and Bryan A. Garner's "Reading Law: The Interpretation of Legal Texts," the court concluded that the best reading allowed the deduction during the gap period.

The IRS's argument that a Section 78 gross-up is not a true "distribution" under Section 245A's effective-date provision was rejected as too narrow. The court pointed out that such a reading would inconsistently exclude other deemed dividends that Congress intended to qualify, and it was at odds with the historically broad interpretation of "distribution" in tax law. Policy concerns raised by the IRS—such as the potential for unintended windfalls to fiscal-year taxpayers—were dismissed, as courts do not rewrite statutes to avoid perceived anomalies unless they rise to the level of absurdity, which was not argued here.

Turning to the regulation, the court held it invalid. Treasury's authority under Section 245A(g) is limited to issuing "such regulations or other guidance as may be necessary or appropriate to carry out the provisions of this section." This did not extend to contradicting unambiguous effective dates set by Congress. Even if the statute were ambiguous—a point the court disputed—the regulation would fail under Loper Bright's mandate for independent judicial review. The court gave the regulation Skidmore respect but found it unpersuasive, noting its inconsistency with the statutory text and lack of thorough reasoning for overriding congressional dates.

However, the court sided with the IRS on a secondary issue: Under Section 245A(d), Varian must reduce its foreign tax credits by the amount attributable to the foreign earnings reflected in the Section 78 gross-up. The court endorsed the IRS's proposed formula for this reduction, meaning the net benefit of the deduction depends on the effective foreign tax rate. For Varian, with a relatively high foreign effective rate, the deduction provided significant relief, but the credit haircut tempered it.

This ruling, while addressing cross-motions for partial summary judgment, leaves computations of exact tax liability and other unrelated issues for further proceedings. Nonetheless, its implications ripple through the tax community.

For taxpayers, particularly those with fiscal years straddling the TCJA's effective dates, Varian opens the door to refund claims. Any U.S. corporation with open 2018 taxable years and fiscal-year foreign subsidiaries that claimed foreign tax credits tied to Section 965 or other provisions should evaluate whether they can now assert the Section 245A deduction for Section 78 gross-ups. The statute of limitations for refunds generally runs three years from filing or two years from payment, so timely action is essential. Calendar-year taxpayers with fiscal-year subsidiaries may also benefit, depending on their structures.

Tax professionals—lawyers, accountants, and advisors—must adapt to a post-Chevron world where regulations are more vulnerable to challenge. Pre-Loper Bright, practitioners often counseled clients based on the presumption that IRS interpretations would hold unless arbitrary. Now, with courts empowered to independently assess statutes, planning involves deeper scrutiny of regulatory validity. This could lead to more litigation, as taxpayers test boundaries in areas like the TCJA's global intangible low-taxed income rules or extraordinary disposition regulations, where ambiguities abound.

The decision underscores a broader power shift: from executive agencies like the IRS to the judiciary. The conservative Supreme Court majority has consistently curtailed administrative authority, as seen in cases limiting the Environmental Protection Agency's regulatory reach or the Securities and Exchange Commission's in-house adjudications. In tax, this means the IRS may hesitate to issue aggressive regulations, knowing they face heightened judicial skepticism. Congress, too, may need to draft statutes with greater precision to avoid unintended gaps.

Yet challenges remain. IRS examiners, bound by regulations during audits, may continue applying them, creating a disconnect with what courts ultimately enforce. This could strain the IRS's Independent Office of Appeals, which has proposed rules limiting consideration of regulatory validity challenges. In a Loper Bright era, such policies risk funneling more disputes into court, increasing costs for taxpayers and the government alike.

Varian illustrates how Loper Bright amplifies statutory text's primacy. As Judge Toro wrote, "The best reading of the operative provisions... is that Varian is entitled to a section 245A DRD for the section 78 dividends it was deemed to receive during the gap period." This textualist approach, echoing the court's conservative bent, prioritizes what Congress wrote over what agencies infer.

For the IRS, the loss is a setback in enforcing TCJA uniformity. Fiscal-year taxpayers, comprising a minority but including major corporations, now gain an edge unintended by the legislation's drafters. Estimates suggest the gap could affect billions in potential deductions, though precise figures depend on individual circumstances.

Taxpayers and professionals must navigate this evolving terrain carefully. While Varian provides clarity for Section 78 interactions, it signals broader uncertainty for regulations unmoored from clear statutory anchors. Advisors recommend reviewing returns for 2018 and later years, modeling net benefits after foreign tax credit reductions, and considering protective claims to preserve rights.

In sum, Varian exemplifies the Supreme Court's reshaping of administrative law, empowering courts to check agency overreach. As Trump's second term unfolds, with potential for further conservative judicial appointments, this trend may accelerate, fundamentally altering how tax laws are interpreted and applied. For now, the case stands as a beacon for taxpayers seeking to reclaim deductions through rigorous statutory reading, free from the shadow of Chevron deference.