A multinational telecommunications company could not avoid recognizing gain on $2.8 billion of a $3.8 billion total gain from its sale of a Japanese controlled foreign corporation (CFC) by using a dubious argument regarding the reach of Sec. 904(f)(3)(A)(i), which requires a taxpayer to recognize some or all of its overall foreign losses on the disposition of property (including CFC stock) used predominantly outside the United States.

Background

Liberty Global is a Delaware corporation with its principal place of business in Colorado. It is the ultimate U.S. parent company, and the direct or indirect owner, of an affiliated group of U.S. and foreign corporations. The company, together with its affiliates, operated converged video, broadband, and communications businesses during 2010.

Jupiter Telecommunications Co. Ltd., a Japanese entity, was a Sec. 957 CFC of Liberty Global. In a series of transactions in February 2010, Liberty Global transferred its interests in Jupiter to an unaffiliated foreign corporation for almost $4 billion, in a transaction treated as a sale for U.S. federal income tax purposes. After the sale, Liberty Global did not own any stock in Jupiter.

Liberty Global timely filed its 2010 U.S. consolidated income tax return, reporting recognized gain of $3.256 billion from the sale of the Jupiter stock and showing a beginning balance of $474 million for its general limitation category overall foreign loss (OFL) account. The company characterized $438 million of the gain from the sale as Sec. 1248 dividend income and the remaining $2.8 billion as capital gain, which it treated as foreign-source income.

Liberty Global attached to its 2010 return a Form 1120, Schedule UTP, Uncertain Tax Position Statement, that stated:

[Liberty Global] entered into a transaction to sell its entire interest in its Japanese subsidiary, [Jupiter], during the year. [Liberty Global] recognized a gain on the sale and due to recharacterization of the gain also recognized deemed section 902 credits as part of the overall transaction. The issues are the application of the rules under section 904 to the transaction and whether the amount of the foreign tax credit taken as a result of the transaction is appropriate.

The IRS examined Liberty Global’s 2010 return and determined that the company had overstated its foreign-source income and was not entitled to any foreign tax credit for the year. The Service issued a Notice of Deficiency in which it determined a deficiency of $241,791,309. The Notice of Deficiency stated:

It is determined that no foreign tax credit is allowed due to adjustments affecting foreign source income. The amount of U.S. source gain that is recharacterized as foreign source under [Sec.] 904(f)(3) is limited to the amount necessary to recapture of the Overall Foreign Losses (“OFLs”) in the OFL account at the beginning of the year…. Your foreign tax credit allowed for the tax year ended December 31, 2010, is $0.00 rather than … $241,791,309.00.

Liberty Global petitioned the Tax Court for redetermination of the deficiency. In Tax Court, the parties stipulated that Sec. 904(f)(3) applied to Liberty Global’s sale of the Jupiter CFC stock, that Sec. 904(f)(3)(A) recaptured the company’s OFL through the recognition of gain in an amount equal to its OFL ($474 million), and that this gain amount should be recharacterized as foreign-source income. However, they disagreed regarding the implications of Sec. 904(f)(3) for Liberty Global’s gain beyond the amount needed for its OFL recapture (excess gain).

Liberty Global contended that Sec. 904(f)(3)(A), when applicable, is the only mechanism for recognizing gain from the disposition of CFC stock, overriding all other recognition provisions under Chapter 1 of the Code (Normal Taxes and Surtaxes). Thus, the company claimed that it was not required to recognize any excess gain from its disposition of its Jupiter stock. Alternatively, the company argued that Sec. 904(f)(3)(A) is ambiguous and that Regs. Sec. 1.904(f)-2(d)(1) required treating the gain from the disposition of its Jupiter stock as foreign-source income. Further in the alternative, the company elected to deduct its foreign taxes under Sec. 164(a)(3).

The IRS countered that Sec. 904(f)(3)(A) did not govern the treatment of the $2.8 billion in excess gain, which was instead subject to the rules of Secs. 865, 1001, and 1248. It argued that Sec. 904(f)(3)(A) was not ambiguous and that Regs. Sec. 1.904(f)-2(d)(1) did not require treating the gain as foreign-source income. However, the IRS did agree that Liberty Global was entitled to elect to deduct its foreign taxes under Sec. 164(a)(3).

The Tax Court’s decision

The Tax Court ruled against Liberty Global on its most important arguments, holding that Sec. 904(f)(3)(A) speaks only to the gain necessary to recapture the OFL and no more; that Sec. 904(f)(3)(A) does not override any recognition provisions under Code Chapter 1; that Sec. 904(f)(3)(A) is not ambiguous and did not recharacterize gain in excess of that necessary to recapture the OFL as foreign-source gain; and that Regs. Sec. 1.904(f)-2(d)(1) did not recharacterize gain in excess of that necessary to recapture the OFL as foreign-source gain. Finally, the court held that, for 2010, Liberty Global could deduct its foreign taxes under Sec. 164(a)(3).

Sec. 904(f)(3)(A)’s background: The Tax Court explained that Sec. 904(f)(1) recaptures the prior benefit of permitting a U.S. taxpayer to offset its U.S. income with foreign-source loss, so that viewing the year(s) of excess loss and the year(s) of recharacterization together, the U.S. taxpayer’s U.S.-source income will bear its full tax share. Congress recognized, though, that a taxpayer might dispose of the assets used in its foreign operations before an OFL had been fully recaptured. The disposition of those assets would leave the mechanism reflected in Sec. 904(f)(1) ineffectual because the taxpayer would no longer have any foreign-source income that might be recharacterized as U.S.-source income.

Thus, Congress added rules on the disposition of assets used in foreign operations in Sec. 904(f)(3). The provision, according to the Tax Court in Hershey Foods Corp., 76 T.C. 312, 322—23 (1981) “accelerates the recapture process upon such disposition by requiring recognition at the time of disposition of an amount of income equal to the lesser of the gain realized or the amount of any previously unrecaptured excess foreign loss.”

In 2010, Sec. 904(f)(3)(A)(i) provided that upon disposition of property used predominantly outside the United States in a trade or business (which, under a 2004 amendment to Sec. 904(f)(3), included stock in a CFC):

[T]he taxpayer, notwithstanding any other provision of this chapter (other than paragraph (1)), shall be deemed to have received and recognized taxable income from sources without the United States in the taxable year of the disposition, by reason of such disposition, in an amount equal to the lesser of the excess of the fair market value of such property over the taxpayer’s adjusted basis in such property or the remaining amount of the overall foreign losses which were not used under paragraph (1) for such taxable year or any prior taxable year.

Stated differently, notwithstanding any other provision of Chapter 1, when a taxpayer disposes of the right kind of property, the taxpayer is deemed to recognize foreign-source income in an amount sufficient to offset its remaining OFLs at the time of the disposition, but only to the extent of the taxpayer’s actual gain from the transaction.

Treatment of excess gain: Sec. 904(f)(3)(A) does not prescribe a specific treatment for the gain beyond the amount necessary to offset a taxpayer’s remaining OFLs (excess gain). The IRS and Liberty Global, however, claimed that this silence on the issue in Sec. 904(f)(3)(A) resulted in very different outcomes in practice.

The IRS argued that the statute should be taken at its word, and, if its text does not speak to the excess gain in a disposition, then the statute does not control the treatment of excess gain, i.e., silence is insufficient to create a new exclusion. Therefore, the IRS reasoned that the statute’s silence leaves other applicable Code sections — here, Secs. 865, 1001, and 1248 — to operate as they normally would. Operating normally in this case, Sec. 1001 requires the gain from a disposition to be fully recognized; Sec. 1248 requires that the recognized gain, to some extent, to be recharacterized; and Sec. 865 requires the recognized gain to be treated as U.S.-source income.

Liberty Global, on the other hand, argued that Sec. 904(f)(3)(A) supplants all other Code sections, precluding the taxation of any gain from a disposition beyond the amount it requires to be recognized. The company presented two competing interpretations of what Sec. 904(f)(3) does in the disposition of a CFC.

First, Liberty Global contended that when Sec. 904(f)(3) applies, it is the only mechanism for recognizing gain from a transaction, overriding Sec. 1001 and any other Chapter 1 gain-recognition provision. As a result, in its case, it was not required to recognize any gain on its sale of Jupiter stock beyond the $475 million needed to recapture its OFL. In other words, the company argued that Sec. 904(f)(3) completely exempted the remaining $2.8 billion of gain from the Jupiter stock disposition from U.S. federal income tax.

Second, if the Tax Court disagreed with that interpretation, Liberty Global argued that Sec. 904(f)(3) is by necessity ambiguous and that Regs. Sec. 1.904(f)-2(d)(1) required the company to treat all gain on a disposition of property used predominantly outside the United States as foreign-source income. Under the formula set out for determining the limitation on a taxpayer’s foreign tax credit, treating all the gain as foreign-source income would mean Liberty would be allowed foreign tax credits totaling more than $240 million for 2010, permitting it to offset U.S. tax on gain that, absent the proposed recharacterization, would have been U.S.-source.

Before addressing these arguments specifically, the Tax Court observed that, “notably,” Liberty Global made no attempt to explain why, in a rule that the company agreed was adopted to prevent a taxpayer from offsetting U.S.-source income in one year and then claiming foreign tax credits on positive foreign-source income in a subsequent year, Congress “would have provided for either one of these rather remarkable results.” The court further remarked that in its briefing, Liberty Global seemed “to acknowledge the absence of any potential rationale.”

Sec. 904(f)(3) as a cap on recognized gain: After reviewing the statute, the Tax Court agreed with the IRS that it did not affect the treatment of the excess gain and did not exempt it from recognition. Consequently, the statute did not act as a cap on the amount of gain the company recognized from disposition of a CFC.

The Tax Court found that the IRS’s interpretation “adheres to the text” of Sec. 904(f)(3)(A)(i), which it stated provided “no instruction at all regarding amounts in excess of the gain necessary to recapture an OFL balance” and did not state that such gain was exempt from recognition. Thus, the Tax Court, taking the statute at its word, determined that because the text did not speak to the excess gain, it did not control it and did nothing with respect to it. This, the court concluded, left the other applicable statutes — Secs. 865, 1001, and 1248 — to operate unimpeded with respect to the excess gain.

In the Tax Court’s view, adopting Liberty Global’s opposing interpretation would require the court to infer a limiting principle not present in the statute’s text. Specifically, the court found that it would have to read Sec. 904(f)(3) as requiring gain recognition that is limited to the amount specified therein. But neither those words nor similar ones appear in Sec. 904(f)(3), so the court declined Liberty Global’s invitation to add them.

Moreover, the court determined that, importantly, its interpretation is far more consistent with the broader statutory scheme. The court explained that, generally, to apply Sec. 904, a taxpayer must first claim the foreign tax credit (see Sec. 901(a)). Also, even when applying Sec. 904, a taxpayer would turn to subsection (f) only if it has an outstanding OFL balance, and to paragraph (f)(3) only if, in addition to having an outstanding OFL balance, the taxpayer also disposes of qualifying foreign property.

Based on the statute’s placement, the court reasoned it would not be expected that such a narrow rule, titled “Recapture of Overall Foreign Loss” and adopted to limit a taxpayer’s foreign tax credit, would also serve to exempt billions of dollars of gain from U.S. taxation. The court quoted the Supreme Court’s admonition that “Congress does not ‘hide elephants in mouseholes’ by ‘alter[ing] the fundamental details of a regulatory scheme in vague terms or ancillary provisions’ “(Sackett v. EPA, 143 S. Ct. 1322, 1340 (2023) (quoting Whitman v. American Trucking Assns., 531 U.S. 457, 468 (2001)).

The Tax Court also considered Liberty Global’s argument that Sec. 904(f)(3)(A)(i)’s prefatory language, which states that the subsection applies “notwithstanding any other provision of this chapter,” signaled that Sec. 904(f)(3) turns off all other recognition provisions. The court concluded that Liberty Global had overread the text.

The court noted that the Supreme Court has stated, “In statutes, the word [‘notwithstanding’] ‘shows which provision prevails in the event of a clash.’ “(National Labor Relations Bd. v. SW Gen., Inc., 580 U.S. 288, 301 (2017)). The Tax Court found that, based on the facts of the present case, there was no conflict between Sec. 904(f)(3) and Sec. 1001 or any other provision requiring recognition. Rather, Sec. 904(f)(3) operates to ensure the minimum amount of recognition necessary to recapture a taxpayer’s OFLs and does not prevent recognition beyond the minimum amount. Consequently, it does not conflict with provisions that require additional recognition.

However, Sec. 904(f)(3) sometimes conflicts with nonrecognition provisions, such as Sec. 351, as well as with sourcing rules, such as Sec. 865, as in this case. In those circumstances, the rule of Sec. 904(f)(3) prevails over the conflicting rule elsewhere in the Code. Therefore, the Tax Court found that, although the inclusion of “notwithstanding” in the statute makes perfect sense, it did not support Liberty Global’s interpretation of the statute.

Liberty Global had also argued that the IRS’s interpretation of the statute impermissibly creates different rules for recognition and nonrecognition transactions. The Tax Court noted that this was true but added, “Nothing about this result is impermissible; rather, it reflects the statute operating as drafted. And this result is fully consistent with [the Tax Court’s] interpretation of Sec. 904(f)(3) shortly after it was adopted” (citing Hershey Foods Corp., 76 T.C. at 323). The court found, on the other hand, that Liberty Global’s interpretation of the statute would result in different recognition rules being applied to taxpayers with OFL balances and those without them, giving the taxpayers with OFL balances much more beneficial tax treatment. Moreover, as the IRS pointed out, Liberty Global’s interpretation is internally inconsistent when it comes to recognition and nonrecognition transactions, the court stated.

Regs. Sec. 1.904(f)-2(d)(1)’s effect on sale gain’s treatment as foreign-source income: Alternatively, Liberty Global argued that Sec. 904(f)(3) is ambiguous and, because of that, Regs. Sec. 1.904(f)-2(d)(1) applied to treat all gain on the Jupiter stock sale as foreign-source income. If this were correct, the court stated, then any gain in excess of its remaining OFL balance (which would otherwise be Sec. 865 U.S.-source income) would become foreign-source income. The ultimate result of this would be that Liberty Global would be allowed to use more than $240 million in additional foreign tax credits.

The Tax Court rejected this argument because, as it had already determined, Sec. 904(f)(3)(A)(i) is not ambiguous. By its plain terms, the statute directs a taxpayer to deem amounts necessary to recapture an OFL as recognized foreign-source taxable income. It does not speak to gain beyond that amount because it has no reason to. The court found that silence in this instance, where other Code provisions address the salient points, is not ambiguity; rather, Sec. 904(f)(3)(A)(i) leaves those other provisions to do their work. Even assuming for the sake of argument that the statute were ambiguous, the court determined that Regs. Sec. 1.904(f)-2(d)(1) did not support Liberty Global’s position.

Election to deduct foreign taxes: Because Liberty Global lost with respect to its Sec. 904(f)(3) arguments, it alternatively argued it could deduct its foreign taxes under Sec. 164(a)(3), which it claimed would also cause the reversal of income recognized for its 2010 tax year under Sec. 78. The IRS had already conceded that the company could deduct its foreign taxes instead of taking a foreign tax credit. Therefore, the Tax Court did not discuss the issue.

Reflections

If Congress had intended that Sec. 904(f)(3) would exempt a taxpayer in Liberty Global’s position from tax on excess gain on the dispositions subject to it, the statute would have to be considered a poorly drafted section of the Code, as it does not mention explicitly the taxation of the excess gain.

Because there is no rational reason for exempting excess gain from a transaction subject to Sec. 904(f)(3) from tax, doing so would also represent a poor tax policy decision, because, as this case demonstrates, under the right circumstances, a huge amount of excess gain could be exempted if this rule were followed.