Eaton, Foreign Tax Credits Denied

In a stinging rebuke to aggressive corporate tax planning, the U.S. Tax Court has ruled against Eaton Corporation, a multinational powerhouse in power management, denying it millions in deemed-paid foreign tax credits (FTCs) for the 2007 and 2008 tax years. The decision, handed down on February 24, 2025, in Eaton Corporation and Subsidiaries v. Commissioner of Internal Revenue, exposes the perils of intricate offshore structures designed to minimize U.S. tax liabilities. What Eaton likely viewed as a clever scheme—interposing a domestic partnership between tiers of controlled foreign corporations (CFCs)—has instead boomeranged, leaving the company without the credits it sought and potentially facing a heftier tax bill.

This ruling underscores a timeless principle in tax law: While companies are free to structure their affairs as they see fit, they must live with the consequences. For Eaton, that means no relief from double taxation on foreign earnings, at least not yet. The case, docketed as No. 28040-14, revolves around sections 901, 902, and 960 of the Internal Revenue Code, highlighting the IRS's vigilance against strategies that exploit gaps in subpart F rules governing CFCs.

The High-Stakes World of International Tax Planning

To appreciate the drama of this decision, one must delve into the labyrinthine world of international corporate taxation—a realm where billions hinge on the interpretation of arcane code sections. The U.S. taxes its corporations on worldwide income, but to avoid punishing double taxation, it offers FTCs under Section 901 for taxes paid to foreign governments. For indirect ownership through CFCs, "deemed-paid" credits under Sections 902 (repealed in 2017) and 960 allow U.S. parents to claim a share of foreign taxes paid by subsidiaries, treating certain inclusions as hypothetical dividends.

Eaton, headquartered in Cleveland, Ohio, during the years in question, was no stranger to this game. As the parent of a sprawling affiliated group filing consolidated returns, it orchestrated a structure involving two tiers of CFCs with a domestic partnership, Eaton Worldwide LLC (EW LLC), sandwiched in between. The upper-tier CFCs—Eaton Holding III S.a.r.l., Eaton Finance N.V., and Eaton B.V.—held interests in EW LLC, which in turn owned lower-tier CFCs generating subpart F income (anti-deferral rules under Section 952) and Section 956 amounts (related to U.S. property investments).

This setup wasn't accidental. Multinationals like Eaton often use such layered entities to defer U.S. taxes on foreign earnings, repatriate funds strategically, and optimize credit claims. In 2007 and 2008, the lower-tier CFCs racked up subpart F income and Section 956 inclusions, which flowed to EW LLC as the U.S. shareholder. EW LLC then allocated these to its upper-tier CFC partners via Schedules K-1, boosting their earnings and profits (E&P) without actual distributions. Eaton itself reported no direct inclusions from EW LLC's activities, betting that this insulation would shield it from immediate tax hits while preserving future credit opportunities.

But here's where the plot thickens: Eaton's structure aimed to have its cake and eat it too. By interposing EW LLC—a domestic partnership treated as a pass-through entity—the company sought to avoid direct Section 951 inclusions at the parent level for the lower-tier CFCs' earnings. Yet, when it came to claiming FTCs, Eaton argued that these inclusions should "hopscotch" up the chain, allowing it to deem foreign taxes paid by the lower-tier CFCs as its own under Section 960.

The IRS, however, cried foul. In deficiency notices and amendments, the Commissioner argued that Eaton's design precluded such credits because no dividends were distributed, and the inclusions weren't taken into gross income by a domestic corporation as required by the statutes. This set the stage for cross-motions for partial summary judgment, a procedural move to resolve legal issues without a full trial.

Unpacking Eaton's "Clever" Scheme: A Tax Architect's Dream Turns Nightmare

Eaton's strategy was rooted in a nuanced reading of subpart F, a cornerstone of U.S. anti-deferral rules enacted in 1962 to curb tax haven abuse. Under Section 951(a), U.S. shareholders of CFCs must include in gross income their pro rata share of subpart F income and certain investments in U.S. property (Section 956). For Eaton, the lower-tier CFCs' activities triggered these inclusions for EW LLC, which passed them to the upper-tier CFC partners.

A prior Tax Court opinion, Eaton I (152 T.C. 43, 2019), had already dealt Eaton a blow by holding that these allocations increased the upper-tier CFCs' E&P under Section 312. This meant Eaton had to include at least $73 million in 2007 and $114 million in 2008 under Section 956 related to EW LLC's ownership of Argo-Tech Holdings Corp. (AT Holdings), a U.S. property investment.

Building on this, the IRS invoked the "loan anti-abuse rule" in Temporary Treasury Regulation §1.956-1T(b)(4), alleging additional $65.6 million inclusions for 2007 from CFC loans funded through EW LLC. Eaton countered by claiming FTCs not just for taxes paid by the upper-tier CFCs but also those from the lower-tier ones, arguing the E&P boost from lower-tier activities entitled it to "deemed dividends" under Section 960.

Imagine a corporate Rube Goldberg machine: Lower-tier CFCs earn subpart F income, pay foreign taxes, and trigger inclusions for EW LLC. EW LLC allocates these to upper-tier CFCs, inflating their E&P. This inflation then forces Eaton to recognize Section 956 amounts from AT Holdings. Eaton's pitch? The foreign taxes should follow the E&P trail, granting credits as if the inclusions were dividends from the lower-tier CFCs.

The Tax Court, led by Chief Judge Kathleen Kerrigan, dismantled this argument with surgical precision. Relying on the plain text of Sections 902 and 960, the court emphasized that deemed-paid credits require a domestic corporation to have a Section 951 inclusion attributable to a qualified group's E&P, treating it as a dividend. Here, Eaton—the only domestic corporation—had inclusions only from the upper-tier CFCs, not the lower ones. EW LLC, as a partnership, doesn't qualify as a "domestic corporation" under Section 960(a)(1).

"No credit under section 902 because there was no dividend distribution, and no credit under section 960 because the section 951(a) inclusions with respect to the lower tier CFCs were not taken into gross income by a domestic corporation," the court stated bluntly. This interpretation aligns with precedents like Rodriguez v. Commissioner (137 T.C. 174, 2011), which held that Section 951 inclusions aren't dividends absent explicit statutory language.

What makes this ruling engaging—and a cautionary tale—is how it flips Eaton's scheme on its head. By inserting EW LLC to defer direct inclusions at the parent level, Eaton inadvertently blocked the "hopscotch" mechanism of Section 960, which would have allowed credits if the lower-tier CFCs were owned directly. As the court noted, quoting Commissioner v. National Alfalfa Dehydrating & Milling Co. (417 U.S. 134, 1974): "Taxpayers are free to structure transactions as they choose, but they must accept the tax consequences."

In essence, Eaton's attempt to game the system created a self-inflicted wound. Without the partnership layer, credits would flow freely. With it, the company faces temporary double taxation until actual distributions occur—potentially years later, tying up capital and increasing effective tax rates.

Legal Nuances: Diving Deep into Sections 902, 960, and CFC Rules

For tax aficionados, the opinion's depth is a treasure trove. Section 902(a), pre-repeal, allowed deemed-paid credits for dividends from 10%-owned foreign corporations, proportional to post-1986 undistributed earnings. Section 902(b) extended this to qualified groups, deeming intermediate foreign corporations as domestic for credit purposes if they receive dividends.

Section 960(a)(1) bridges subpart F inclusions to this framework: If a domestic corporation includes amounts under Section 951 attributable to a qualified group member's E&P, it's treated as a dividend for Section 902 purposes. Treasury Regulation §1.960-1(i)(1) reinforces this.

But Eaton's twist? The inclusions from lower-tier CFCs went to EW LLC (domestic partnership) and then to upper-tier CFCs (foreign). No domestic corporation directly included them, failing Section 960's trigger. The court rejected Eaton's reliance on Eaton I, clarifying that E&P computations under Section 312 don't equate to gross income or credit eligibility.

This isn't isolated. Similar cases, like Chrysler Corp. v. Commissioner (436 F.3d 644, 6th Cir. 2006), stress strict construction of credit statutes as "legislative grace." Post-2017 Tax Cuts and Jobs Act (TCJA), which repealed Section 902 and introduced GILTI (Global Intangible Low-Taxed Income) under Section 951A, echoes this anti-abuse stance, though Eaton's case predates it.

Broader Implications for Corporate America and Global Tax Strategy

The Eaton decision sends ripples through boardrooms from Silicon Valley to Wall Street. With U.S. corporate tax rates at 21% post-TCJA, and Biden-era proposals eyeing hikes, companies are under pressure to repatriate earnings efficiently. Denying FTCs in layered CFC setups could discourage such complexity, pushing toward simpler direct ownership or inversions—though the latter face scrutiny under Section 7874.

Financially, Eaton's hit is substantial. The denied credits stem from foreign taxes assumed creditable under Section 901, potentially adding tens of millions to its effective liability for 2007-2010. As a diversified industrial giant with $20 billion+ in annual revenue, Eaton can absorb it, but smaller firms might not.

The case highlights IRS tools like the loan anti-abuse rule, which targets obligations funded through partnerships as U.S. property, inflating inclusions. Globally, this aligns with OECD Pillar Two efforts for a 15% minimum tax, curbing races to the bottom. For investors, it's a reminder: Tax risks can erode shareholder value.

Eaton's Response and the Road Ahead

Eaton, now based in Dublin after a 2012 inversion (itself controversial), has yet to comment publicly. In court filings, it argued double taxation violates FTC principles, but the court dismissed this as temporary, resolvable via distributions.

Appeals loom: The case could head to the Sixth Circuit, where Eaton is based, potentially clarifying CFC credit mechanics. Meanwhile, the IRS's amendment for additional inclusions under the anti-abuse rule remains unresolved, adding uncertainty.

In the end, this isn't just about Eaton—it's a parable for corporate tax avoidance. What seemed a masterstroke—leveraging partnerships to defer and credit—proved a miscalculation. As Chief Judge Kerrigan concluded: "Petitioner's chosen structure does not trigger section 960." A major problem indeed, self-engineered in the pursuit of savings.