UNITED STATES TAX COURT



   EATON CORPORATION AND SUBSIDIARIES, Petitioner v.
    COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 28040-14.                        Filed February 25, 2019.



       This case is before us on cross-motions for partial summary
judgment. The issue is whether the earnings and profits (E&P) of the
upper tier controlled foreign corporation (CFC) partners of Eaton
Worldwide LLC (EW LLC), a domestic partnership, must be
increased as a result of the partnership’s I.R.C. sec. 951(a) income
inclusions.

       P contends that EW LLC’s I.R.C. sec. 951(a) inclusions do not
affect the E&P of its upper tier CFC partners. Conversely, R
contends that the upper tier CFC partners increase their E&P to
reflect EW LLC’s I.R.C. sec. 951(a) inclusions.

      Held: The E&P of upper tier CFC partners of a domestic
partnership, such as EW LLC, must be increased as a result of the
partnership’s I.R.C. sec. 951(a) income inclusions.
                                        -2-

      Joel V. Williamson, Charles P. Hurley, John T. Hildy, Brian W. Kittle,

Geoffrey M. Collins, Christine S. Hooks, Rajiv Madan, Royce L. Tidwell,

Christopher P. Murphy, Nathan P. Wacker, Kevin R. Stults, and Christopher P.

Bowers, for petitioner.

      John M. Altman, Ronald S. Collins, Jr., Eric P. Ingala, and Laurie A. Nasky,

for respondent.



                                     OPINION


      KERRIGAN, Judge: The Internal Revenue Service (respondent)

determined deficiencies in Federal income tax and penalties for the 2007-10

calendar taxable years (years in issue) of Eaton Corp. (Eaton or petitioner). This

case is before the Court on the parties’ cross-motions for partial summary

judgment. Unless otherwise indicated, all section references are to the Internal

Revenue Code (Code) in effect for the years in issue, and all Rule references are to

the Tax Court Rules of Practice and Procedure.

      Generally speaking, a controlled foreign corporation (CFC) that is a partner

in a domestic partnership must include in gross income its distributive share of

that partnership’s gross income, including income that the partnership included
                                        -3-

under section 951(a) with respect to any lower tier CFCs. According to

respondent the upper tier CFC partners must also increase their earnings and

profits (E&P) by such an amount. Adopting that approach, respondent contends

that the correct amounts to be included in petitioner’s gross income under sections

951 and 956 are $73,030,810 and $114,065,635 for tax years 2007 and 2008,

respectively.1

       Petitioner, by contrast, contends that a domestic partnership’s section 951(a)

inclusions do not affect the E&P of its upper tier CFC partners. The primary issue

we must decide is whether the E&P of the upper tier CFC partners of Eaton

Worldwide LLC (EW LLC), a domestic partnership, must be increased as a result

of the partnership’s section 951(a) income inclusions.

                                    Background

       Some of the facts are stipulated and are so found. Eaton was a domestic

corporation with its principal place of business in Cleveland, Ohio, when it timely

filed its petition.




       1
      The parties have stipulated the amounts of the adjustments if the Court
upholds respondent’s position.
                                       -4-

I.    Corporate Structure

      During the years in issue Eaton was the parent of an affiliated group of

corporations (Eaton Group) that filed consolidated Federal income tax returns.

Members of the Eaton Group were 100% shareholders of foreign corporations that

were CFCs within the meaning of section 957. These CFCs collectively held

(directly or indirectly) 100% of the membership interests in EW LLC. The CFCs

that held membership interests in EW LLC during the years in issue were:

(1) Eaton Holding III S.a.r.l., (2) Eaton Finance N.V., and (3) Eaton B.V.

(collectively, upper tier CFC partners). Any adjustments to income under section

951(a) for the upper tier CFC partners would be made to the consolidated income

of the Eaton Group.

      During the years in issue EW LLC owned equity interests in, and was the

sole U.S. shareholder of, several CFCs within the meaning of section 957(a)

(lower tier CFCs). EW LLC included in income under section 951(a) the

subpart F income earned by the lower tier CFCs and amounts calculated under

section 956 with respect to the lower tier CFCs. Because the upper tier CFC

partners were not U.S. persons under section 957(c), they were not U.S.

shareholders of the lower tier CFCs.
                                        -5-

      The lower tier CFCs did not make any distributions of property to EW LLC

during 2007 and 2008. On March 16, 2007, EW LLC purchased all the issued and

outstanding common stock of AT Holdings Corp. (AT Holdings) from a third

party for $387,743,528. AT Holdings was a Delaware corporation, and its sole

asset was the stock of Argo-Tech Corp., also a Delaware corporation. EW LLC

thereafter owned 100% of the issued and outstanding common stock of

AT Holdings or its successor, Eaton Industrial Corp. For the purposes of applying

sections 951(a)(1)(B) and 956, EW LLC’s interest in AT Holdings constituted

U.S. property, which was treated as held by the upper tier CFC partners. Each

upper tier CFC partner was thus treated as holding an interest in U.S. property by

virtue of EW LLC’s ownership of AT Holdings.2

II.   Tax and Financial Reporting

      During the years in issue EW LLC, as the sole U.S. shareholder of the lower

tier CFCs, was required under section 951(a) to include in gross income its pro

rata share of the subpart F income generated by the lower tier CFCs and section

956 amounts with respect to the lower tier CFCs. The lower tier CFCs treated the


      2
       The parties do not dispute that, to the extent the upper tier CFC partners
have applicable earnings, the U.S. shareholders of the upper tier CFC partners
must include in income sec. 956 amounts based on the upper tier CFC partners’
holdings of AT Holdings stock.
                                        -6-

amounts thus included by EW LLC as previously taxed E&P under section 959(c).

EW LLC timely filed Forms 1065, U.S. Return of Partnership Income, for the

years in issue on which it reported income inclusions under section 951(a) with

respect to the lower tier CFCs.

      During the years in issue EW LLC issued Schedules K-1, Partner’s Share of

Income, Deductions, Credits, etc., to the upper tier CFC partners reflecting their

distributive shares of its income inclusions under section 951(a). These

distributive shares have since been adjusted slightly following an analysis of EW

LLC’s capital accounts. The upper tier CFC partners excluded these amounts

from gross income and from the calculation of their subpart F income.

      None of the upper tier CFC partners made any adjustments to their E&P

corresponding to their distributive shares of EW LLC’s income inclusions under

section 951(a). For all other items of income, gain, loss, deduction, or credit

reflected on the Schedules K-1, the upper tier CFC partners did make adjustments

to their respective E&P. The upper tier CFC partners likewise made no

adjustments to their respective bases in their partnership interests in EW LLC

corresponding to their distributive shares of EW LLC’s income inclusions under

section 951(a). For all other items of income, gain, loss, deduction, or credit
                                          -7-

reflected on the Schedules K-1, the upper tier CFC partners did make adjustments

to their respective bases in their partnership interests.

      The consolidated financial position of Eaton Group and the consolidated

results of its operations and cashflows were reported in conformity with U.S.

generally accepted accounting principles (GAAP) for the years in issue. For

financial reporting purposes (but not for Federal income tax purposes) Eaton’s

consolidated financial statements included the results and cashflows of the upper

tier CFC partners, EW LLC, and the lower tier CFCs. Each of the upper tier CFC

partners prepared its unconsolidated financial statements and accounting records

in conformity with U.S. GAAP.

                                      Discussion

I.    Summary Judgment Standard

      Summary judgment may be granted where the pleadings and other materials

show that there is no genuine dispute as to any material fact and that a decision

may be rendered as a matter of law. Rule 121(b); Sundstrand Corp. v.

Commissioner, 

, 520 (1992), aff’d, 

(7th Cir. 1994). The

burden is on the moving party to demonstrate that there is no genuine dispute as to

any material fact and that he or she is entitled to judgment as a matter of law.

FPL Grp., Inc. & Subs. v. Commissioner, 

, 74-75 (2001). Both parties
                                         -8-

have moved for partial summary judgment, and they agree that there exist no

genuine disputes of material fact regarding the question they have asked us to

decide. After reviewing the pleadings and the stipulation of facts and attached

exhibits, we conclude that a decision may be rendered as a matter of law.

II.   Background Law

      Subpart F was enacted in response to perceived abuses by U.S. taxpayers

through the use of CFCs. See Dougherty v. Commissioner, 

, 928

(1973) (“In subpart F, Congress has singled out a particular class of taxpayers,

U.S. shareholders, whose degree of control over their foreign corporation allows

them to treat the corporation’s undistributed earnings as they see fit.” (Fn. ref.

omitted.)). The goal of subpart F is to tax currently specified earnings of CFCs

that are, in the aggregate, controlled by U.S. shareholders. Textron, Inc. v.

Commissioner, 

, 73-74 (2001).

      In the ordinary course foreign source income earned by a CFC is not subject

to U.S. taxation until it is repatriated in the form of a dividend or other distribution

to the CFC’s U.S. shareholders. Secs. 881 and 882; Dave Fischbein Mfg. Co. v.

Commissioner, 

, 353 (1972); see also S. Rept. No. 87-1881, at 78

(1962), 1962-3 C.B. 703, 784. However, under section 951(a), a U.S. shareholder

must include in gross income for the current taxable year its pro rata share of
                                         -9-

certain items attributable to the CFC, regardless of whether any distribution was

made.

        Sections 951(a)(1)(B) and 956 were intended “to prevent the repatriation of

income to the United States in a manner which does not subject it to U.S.

taxation.” H.R. Rept. No. 87-1447, at 58 (1962), 1962-3 C.B. 405, 462. The

Senate Finance Committee report noted that “[g]enerally, earnings brought back to

the United States are taxed to the shareholders on the grounds that this is

substantially the equivalent of a dividend being paid to them.” S. Rept. No. 87-

1881, supra at 88, 1962-3 C.B. at 794.

        A CFC is a foreign corporation whose stock is more than 50% (in terms of

voting power or value) owned (directly, indirectly, or constructively) by U.S.

shareholders on any day during the corporation’s taxable year. Sec. 957(a). A

U.S. shareholder is a U.S. person who owns (directly, indirectly, or constructively)

10% or more of the total combined voting power of the foreign corporation’s

stock. Sec. 951(b). All of petitioner’s foreign subsidiaries are CFCs, and

petitioner is a U.S. shareholder under section 951(b).

        Section 951(a) requires that a U.S. shareholder owning CFC stock on the

last day of the CFC’s taxable year include in gross income for the current taxable

year its pro rata share of certain items attributable to the CFC, regardless of
                                        - 10 -

whether any distribution was actually made. Generally, this includes both its

“subpart F income” and “the amount determined under section 956”. See sec.

951(a)(1). The amount determined under section 956

      is the U.S. shareholder’s pro rata share of the lesser of two amounts:
      (1) the excess of (a) the average amounts of the CFC’s investments in
      U.S. property as of the end of each quarter of the taxable year over
      (b) the CFC’s earnings and profits representing previous sec. 956
      inclusions; or (2) the amount of the CFC’s “applicable earnings”, as
      defined in sec. 956(b)(1), representing essentially the CFC’s current
      and accumulated earnings and profits that have not already been
      included in its U.S. shareholders’ gross incomes.

Rodriguez v. Commissioner, 

, 176 n.3 (2011) (citing Boris I. Bittker

& Lawrence Lokken, Federal Taxation of Income, Estates and Gifts, para. 69.11.1,

at 69-72 through 69-74 (rev. 3d ed. 2005)), aff’d, 

(5th Cir. 2013).

U.S. property includes, among other things, stock and debt of U.S. corporations.

See sec. 956(c)(1)(B) and (C). Generally, the amount taken into account with

respect to any property that is U.S. property under section 956(a) is its adjusted

basis, reduced by any liability to which the property is subject.

      When the CFC eventually distributes the amounts previously included in the

U.S. shareholder’s gross income pursuant to section 951, the distribution then

reduces the CFC’s E&P. See sec. 959(d). To avoid double taxation to the
                                        - 11 -

shareholder, the actual distribution is excluded from the shareholder’s gross

income. See sec. 959(a).

III.   Analysis

       To determine whether the upper tier CFC partners are required to increase

their E&P to reflect their distributive shares of EW LLC’s section 951(a)

inclusions, we need to analyze the interaction between sections 312 and 964.

Section 312, a provision of subchapter C, is captioned “Effect on Earnings and

Profits.” That section and the regulations interpreting it provide elaborate,

technical rules governing the calculation of E&P. See sec. 1.312-6, Income Tax

Regs. Section 964(a), a provision of subpart F captioned “Earnings and Profits”,

concerns the calculation of “the earnings and profits of any foreign corporation”.

       Section 964(a) provides that, “[e]xcept as provided in section 312(k)(4),

* * * the earnings and profits of any foreign corporation * * * shall be determined

according to rules substantially similar to those applicable to domestic

corporations, under regulations prescribed by the Secretary.” The “rules

* * * applicable to domestic corporations” are set forth in section 312 and the

regulations interpreting it. Section 312(k)(4), captioned “Certain Foreign

Corporations”, provides that special depreciation rules apply to computation of a
                                        - 12 -

foreign corporation’s E&P if “less than 20 percent of * * * [its] gross income * * *

is derived from sources within the United States.”

      We must first decide the universe of regulations to which the phrase “under

regulations prescribed by the Secretary”, as used in section 964(a), refers. That

phrase, as enacted in 1969, is naturally read to refer to any regulations that the

Secretary might later promulgate under section 964(a). But given the statutory

text, we believe that this phrase also refers to regulations that the Secretary had

previously promulgated, or might in the future promulgate, under section 312.3

      The phrase “under regulations prescribed by the Secretary” immediately

follows the phrase “rules substantially similar to those applicable to domestic

corporations”. Section 964(a) provides that the same general rules apply to E&P

computations for domestic and foreign corporations. Since those rules are set

forth both in section 312 and in the regulations interpreting it, the reference to

“regulations” in section 964(a) is reasonably read to include regulations

promulgated under section 312 as well as under section 964(a). There is nothing




      3
     The Secretary promulgated the initial regulations under sec. 312 in
December 1955. See T.D. 6152, 1955-2 C.B. 61, 99-117.
                                        - 13 -

in the text of section 964(a) that limits the scope of “regulations” to regulations

that might later be promulgated under that specific provision.4

      The Code “does not comprehensively define ‘earnings and profits,’” but

“[p]rovisions of the Code and regulations relating to earnings and profits

ordinarily take taxable income as the point of departure.” Boris I. Bittker &

Lawrence Lokken, Federal Taxation of Income, Estates and Gifts, para. 92.1.3, at

*4-*5 (Westlaw 2018). Among the items entering into the computation of E&P

are “all items includible in gross income under section 61 or corresponding

provisions of prior revenue acts.” Sec. 1.312-6(b), Income Tax Regs. Thus, a

corporation’s E&P are calculated by making certain adjustments to its taxable

income. See DiLeo v. Commissioner, 

, 888 (1991), aff’d, 

(2d Cir. 1992); Henry C. Beck Co. v. Commissioner, 

, 6 (1969) (defining

E&P as a measure “to approximate a corporation’s power to make distributions

which are more than just a return of investment” (quoting Arthur R. Albrecht,

“‘Dividends’ and ‘Earnings or Profits’”, 7 Tax L. Rev. 157, 183 (1952))), aff’d per

curiam, 

(5th Cir. 1970).




      4
      Cf., e.g., sec. 964(d)(3) (“The Secretary shall prescribe such regulations as
may be necessary or appropriate to carry out the purposes of this subsection.”
(Emphasis added.)).
                                        - 14 -

      Section 312 and its accompanying regulations specify how the E&P

computation is affected by various corporate transactions and events.

Transactions and events that may require adjustments in computing E&P include

distributions of property, distributions of appreciated property, distributions of

property subject to indebtedness, distributions of stock and securities, tax-free

distributions, redemptions, corporate separations and reorganizations, discharge of

indebtedness income, depreciation, installment sales, and last-in, first-out (LIFO)

inventory adjustments. See sec. 312.

      The rules applicable to domestic corporations, as set forth in section 312

and its accompanying regulations, assume that the corporation will have

determined its taxable income using U.S. tax accounting principles. Because that

assumption will often be invalid for a foreign corporation, the regulations under

section 964 require that preliminary adjustments be made to the profit and loss

(P&L) statement of a foreign corporation to enable the rules of section 312 to be

applied correctly.

             Section 1.964-1(a)(1), Income Tax Regs., provides as follows:

      [E]xcept as otherwise provided in the Code and regulations, the
      earnings and profits * * * of a foreign corporation for its taxable year
      shall be computed for all federal income tax purposes substantially as
      if such corporation were a domestic corporation by--
                                          - 15 -

             (i) Preparing a profit and loss statement with respect to such
      year from the books of account regularly maintained by the
      corporation for the purpose of accounting to its shareholders;

             (ii) Making the adjustments necessary to conform such
      statement to the accounting principles described in paragraph (b) of
      this section; and

             (iii) Making the further adjustments necessary to conform such
      statement to the tax accounting standards described in paragraph (c)
      of this section.

      Paragraph (b) of the regulation, captioned “Accounting adjustments”, states

that “[t]he accounting principles to be applied in making the adjustments required

by paragraph (a)(1)(ii) * * * shall be those accounting principles generally

accepted in the United States for purposes of reflecting in the financial statements

of a domestic corporation the operations of its foreign affiliates”. 

These principles include (for example) “clear reflection * * * of income” and rules

governing “translation of foreign currency amounts into United States dollars.”

(v). Paragraph (c) of the regulation, captioned “Tax adjustments”,

specifies various “tax accounting standards to be applied in making the

adjustments required by paragraph (a)(1)(iii)”. These include (for example)

adjustments to inventories to conform to “the provisions of sections 471 and 472”

and adjustments required by U.S. rules governing changes in accounting method.

See 

and (ii); see also 

(providing that a foreign
                                       - 16 -

corporation’s P&L must be adjusted to reflect the nondeductibility of “bribe[s]”

and “kickback[s]” under section 162(c)).

      The regulations issued under section 964, described above, do not provide

comprehensive guidance for calculating the E&P of a foreign corporation. Rather,

they specify a preliminary process by which a foreign corporation’s P&L

statement is conformed to, or made to resemble, that of a domestic corporation by

making a series of tax accounting adjustments. Section 964(a) then incorporates

the rules of section 312--other than the depreciation rule of section 312(k)(4)--by

requiring that the foreign corporation’s E&P shall be computed “according to rules

substantially similar to those applicable to domestic corporations”. See sec.

1.964-1(a)(1), Income Tax Regs. (providing that the E&P of a foreign corporation

“shall be computed * * * substantially as if such corporation were a domestic

corporation”). In other words the foreign corporation’s E&P are “determined

according to rules substantially similar to those applicable to domestic

corporations” in that its P&L statements, as adjusted through the “regulations

prescribed by the Secretary”, are then further adjusted through most of the rules
                                        - 17 -

under section 312 that would apply to a similarly situated domestic corporation’s

computation of its E&P. See sec. 964(a); sec. 1.964-1(a)(1), Income Tax Regs.5

      This Court and the Commissioner have consistently applied the principles

of section 312 to compute a foreign corporation’s E&P. See H.H. Robertson Co.

v. Commissioner, 

, 70-74 (1972) (concluding section 312(a)(3) applies

to determine the effect of an earlier distribution), aff’d without published opinion,

(3d Cir. 1974); Juha v. Commissioner, T.C. Memo. 2012-68, slip

op. at 12-15 (discussing the application of section 312 and its regulations in

determining a foreign corporation’s E&P). In Rev. Rul. 86-131, 1986-2 C.B. 135,

the Commissioner analyzed the effect of a distribution of property on the E&P of a

foreign corporation. For a domestic corporation, section 312(a) sets forth the

general rule governing that subject. The Commissioner concluded that “[t]he rules

of section 312(a) apply to distributions by a foreign corporation as well as a

domestic corporation.” Rev. Rul. 86-131, 1986-2 C.B. at 136 (citing H.H.

Robertson Co. v. Commissioner, 

).6


      5
       The Secretary issued Notice 2009-7, 2009-3 I.R.B. 312, and Notice 2010-
41, 2010-22 I.R.B. 715, which address transactions similar to the transaction at
issue. However, neither notice addresses the calculation of the E&P of a foreign
corporation.
      6
          We are not bound by revenue rulings, and the weight we afford them
                                                                      (continued...)
                                         - 18 -

      For these reasons and looking at the plain meaning of the relevant

provisions, we conclude that the rules set forth in section 312 and its regulations

must be applied in determining the E&P of the upper tier CFC partners of EW

LLC. See Huntsberry v. Commissioner, 

, 747-748 (1984). The next

step is to determine what should be included in their E&P. There is no explicit

rule in section 312, section 964, or their accompanying regulations specifying how

a CFC’s distributive share of partnership income generally--or its distributive

share of a partnership’s income inclusion under section 951(a) specifically--should

be treated for purposes of computing its E&P. We accordingly consult the general

rules set forth in subpart F and section 312.

      Subpart F requires that the upper tier CFC partners compute their gross

income as if they were domestic corporations. See sec. 1.952-2(a)(1), (c)(1),

Income Tax Regs. The upper tier CFC partners are partners of a domestic

partnership. Section 701 provides that a partnership is not liable for Federal

income tax; instead, its partners are liable in their individual capacities for the

income tax arising from the partnership’s operations. In determining its income


      6
       (...continued)
depends upon their persuasiveness and the consistency of the Commissioner’s
position over time. See Skidmore v. Swift & Co., 

, 140 (1944);
PSB Holdings, Inc. v. Commissioner, 

, 142 (2007).
                                        - 19 -

tax, a partner must take into account its “distributive share” of each item of

partnership income, gain, loss, deduction, and credit. Sec. 702. Each partner is

taxed on its distributive share of partnership income without regard to whether the

income is actually distributed. Sec. 1.702-1(a), Income Tax Regs.

      Under these rules the upper tier CFC partners must include in their gross

income their distributive shares of EW LLC’s income. Under section 951(a) EW

LLC’s income includes subpart F income and section 956(a) inclusions from the

lower tier CFCs, regardless of whether the lower tier CFCs made actual

distributions. The gross income of the upper tier CFC partners thus includes their

distributive share of EW LLC’s gross income, whether or not distributed, pursuant

to sections 61(a)(13) and 702(c). The fact that the upper tier partners are CFCs

makes no difference. For the purposes of computing gross and taxable income

under subpart F, a foreign corporation is treated as a domestic corporation and the

principles of sections 61 and 63 apply. Sec. 1.952-2(a) and (b), Income Tax Regs.

      Since there are no Code provisions or regulations that have special rules for

E&P with respect to distributive shares of partnership income pursuant to section

951(a), the general rules of section 312 apply. Section 1.312-6(b), Income Tax

Regs., explicitly states that E&P shall be determined by taking into account “all

items includible in gross income under section 61”. Because the upper tier CFC
                                        - 20 -

partners’ distributive shares of EW LLC’s section 951(a) inclusions are

“includible in [their] gross income”, their E&P must be increased by those

amounts.

      Therefore, each upper tier CFC partner is required to include in gross

income, and make a correlative increase to its E&P to reflect, its distributive share

of EW LLC’s partnership income, including EW LLC’s section 951(a) inclusions

with respect to the lower tier CFCs. If the upper tier CFC partners did not increase

their E&P on this account, there is no other mechanism to ensure that their E&P

would ever be increased. That would produce an irrational result because (as

noted supra pp. 5-6) the lower tier CFCs treated the amounts included by EW LLC

as “previously taxed E&P” under section 959(c).

      The fact that the upper tier CFC partners did not reflect their distributive

shares of EW LLC’s section 951(a) inclusions on their unconsolidated financial

statements has no bearing on the requirement that such amounts be included in

their E&P. The P&L statement to which the regulations refer is not produced by

copying local financial records but by preparing from such records a financial

statement conforming to U.S. tax standards. See sec. 1.964-1(a)(1), Income Tax

Regs. The required preparation includes ensuring that the P&L statement

conforms to U.S. Federal income tax principles applicable to the computation of
                                        - 21 -

E&P by including all items of income under U.S. tax principles. Petitioner cannot

follow local accounting or GAAP to the exclusion of U.S. tax principles. E&P are

increased upon a corporate partner’s inclusion in income of a distributive share of

partnership income, even if the partner does not receive a distribution of cash from

the partnership. See Henry C. Beck Co. v. Commissioner, 

, 10

(concluding that a corporation’s E&P are increased even if the profit that resulted

in that increase is not taxable); sec. 1.312-6, Income Tax Regs.; Rev. Rul. 79-20,

1979-1 C.B. 137.

IV.    Petitioner’s Arguments

      Petitioner’s primary argument, reduced to its essentials, is that the section

964 regulations supply a freestanding, self-contained, and comprehensive system

for determining the E&P of a foreign corporation, without any need to refer to or

incorporate the rules set forth in section 312 and the regulations thereunder. As

discussed earlier section 1.964-1(a)(1), Income Tax Regs., states that a foreign

corporation’s E&P shall be computed “substantially as if such corporation were a

domestic corporation by” doing three things: taking the foreign corporation’s

P&L statement and making U.S. accounting and tax adjustments to it. Petitioner

interprets the preposition “by” in an extremely narrow sense, to mean “by doing

these three things and nothing else.”
                                       - 22 -

      Petitioner contends that the upper tier CFC partners did the three required

things by making the adjustments specified in paragraphs (b) and (c) of the

regulation. That having been done, petitioner says, the E&P computation was

complete. Petitioner’s view of section 1.964-1(a), Income Tax Regs., forecloses

resort to the general rules of section 312 for determining the E&P of a foreign

corporation--in particular, to the requirement that E&P shall be determined by

taking into account “all items includible in gross income under section 61”. Sec.

1.312-6(b), Income Tax Regs.

      Petitioner’s argument is unpersuasive. The section 964 regulations set forth

preliminary steps that must be taken to conform a foreign corporation’s P&L

statement to that of a domestic corporation. By its terms, section 1.964-1(a)(1),

Income Tax Regs., refers only to the “profit and loss statement” and “the

adjustments necessary to conform such statement” to U.S. accounting and tax

principles. The section 964 regulations do not tell the taxpayer how to compute

E&P. They simply require that the foreign corporation’s P&L statement first be

adjusted to U.S. standards before the E&P rules of section 312 can be applied.

      Section 964(a) explicitly incorporates the rules of section 312. It provides

that the E&P of a foreign corporation shall be determined according to rules

substantially similar to those applicable to domestic corporations “[e]xcept as
                                        - 23 -

provided in section 312(k)(4).” If section 964 did not incorporate the general rules

of section 312, Congress would have had no reason to carve out an exception for

the specific depreciation rules of section 312(k)(4).

      Section 1.964-1(a)(1), Income Tax Regs., reiterates the incorporation of

section 312 by stating that, “except as otherwise provided in the Code and

regulations, the earnings and profits * * * of a foreign corporation for its taxable

year shall be computed for all federal income tax purposes substantially as if such

corporation were a domestic corporation”. The phrase “except as otherwise

provided in the Code and regulations” clarifies that all of the E&P rules applicable

to domestic corporations also apply to a foreign corporation, unless there is a

provision explicitly prohibiting application. For example, section 312(m)

provides a special rule for taking into account interest paid on a bearer bond for

foreign corporations other than CFCs. If section 312 did not apply to foreign

corporations, there would be no need for section 312(m).

      Without reference to the detailed rules of section 312 and the regulations

interpreting it, it would be without meaning--employing the section 964

regulations alone--to perform an E&P computation for a foreign corporation. As

noted earlier section 312 and the regulations thereunder explain how numerous

corporate transactions and events affect E&P. These include distributions of
                                        - 24 -

property, distributions of appreciated property, distributions of property subject to

indebtedness, distributions of stock and securities, tax-free distributions,

redemptions, corporate separations and reorganizations, discharge of indebtedness

income, depreciation, installment sales, and LIFO inventory adjustments. See sec.

312. The section 964 regulations do not address or even mention any of these

things. This makes it clear that the E&P of a foreign corporation must be

determined by applying the general rules of section 312 that govern E&P

computations for a domestic corporation.

      Finally, petitioner contends that section 951(a) inclusions do not increase

the dividend paying capacity of the upper tier CFC partners. Petitioner refers to a

section 951(a) inclusion as “phantom income” and not a transfer of value. It

argues that E&P increase only where a corporation receives tangible, economic

value that enhances its dividend paying capacity.

      There are many instances in which E&P are increased when amounts are

included in income but no cash is received. For example, taxpayers that are

subject to the rules governing original issue discount (OID) on a debt instrument

are generally required to include the OID in gross income, and thus E&P, even

though no cash is received until a later period. See sec. 1272(a)(1); sec. 1.312-

6(b), Income Tax Regs. Another instance in which this occurs is with an accrual
                                       - 25 -

method taxpayer. Similarly, an accrual method taxpayer may include income

before the receipt of cash. An accrual method taxpayer’s E&P increase when the

taxpayer accrues income, not in a later period when cash is received. See sec.

1.312-6, Income Tax Regs.

      Section 882(b) is irrelevant in determining the gross income, and hence the

E&P, of the upper tier CFC partners. Section 882 provides for direct U.S. taxation

of a foreign corporation’s U.S.-source income and income effectively connected

with a U.S. trade or business. Secs. 881 and 882. The section 951(a) income

inclusions at issue here are not U.S. source income or income effectively

connected with a U.S. trade or business. Accordingly, sections 881 and 882(b) are

inapplicable in this case. The gross income of the upper tier CFC partners is

calculated pursuant to section 61. Their distributive shares of EW LLC’s income

are thus included in their gross income and (correspondingly) in their E&P.

V.    Conclusion

      Eaton’s upper tier CFC partners must include their distributive shares of

EW LLC’s income, including their distributive shares of EW LLC’s section 951(a)

income inclusions, in their gross income and their E&P. CFCs compute E&P in

the same manner as a domestic corporation, except as otherwise provided in the

Code or the regulations. See sec. 964(a). There are no special E&P rules in the
                                          - 26 -

Code or regulations concerning a CFC partner’s distributive share of partnership

income. Domestic corporations increase E&P by amounts included in gross

income under section 61, and a partner’s gross income includes its distributive

share of all items of the partnership’s income. See secs. 61(a)(13), 702(c); see also

sec. 1.312-6(b), Income Tax Regs. Eaton is thus required to include in its

consolidated income, under sections 951 and 956, $73,030,810 and $114,065,635

for tax years 2007 and 2008, respectively.

         Accordingly, we will grant respondent’s motion for partial summary

judgment and deny petitioner’s cross-motion for partial summary judgment. We

have considered all of the arguments made by the parties, and to the extent we did

not mention them above, we conclude that they are moot, irrelevant, or without

merit.

         To reflect the foregoing,


                                                   An appropriate order will be issued.

Reviewed by the Court.

    THORNTON, MARVEL, PARIS, BUCH, LAUBER, NEGA, ASHFORD,
URDA, and COPELAND, JJ., agree with this opinion of the Court.

         PUGH, J., did not participate in the consideration of this opinion.
                                        - 27 -

      MORRISON, J., concurring: In my view, the opinion of the Court is

unsatisfactory to the extent it suggests that one of the rules in section 1.312-6(b),

Income Tax Regs. (the rule that E&P shall be determined by taking into account

“all items includible in gross income under section 61”), governs the computation

of the E&P of a foreign corporation solely by operation of section 964(a) without

the intervening operation of section 1.964-1(a)(1), Income Tax Regs. It is section

1.964-1(a)(1), Income Tax Regs., by requiring the E&P of a foreign corporation to

be computed “substantially as if such corporation were a domestic corporation”,

that incorporates that particular rule for the purpose of computing the E&P of a

foreign corporation.
                                          - 28 -

         FOLEY, C.J., dissenting: Eschewing a plain language interpretation, the

opinion of the Court imprudently stretches the explicit terms of section 964(a) and

its accompanying regulation. Section 964(a) provides:

         Except as provided in section 312(k)(4), for purposes of this subpart,
         the earnings and profits of any foreign corporation, and the deficit in
         earnings and profits of any foreign corporation, for any taxable year
         shall be determined according to rules substantially similar to those
         applicable to domestic corporations, under regulations prescribed by
         the Secretary. * * *

         Thus, the Secretary has wide latitude to prescribe these earnings and profits

(E&P) calculations but, pursuant to section 312(k)(4), cannot require a foreign

corporation that earns less than 20% of its gross income from U.S. sources to use

straight line depreciation. Yet the opinion of the Court concludes that “[s]ection

964(a) * * * incorporates the rules of section 312--other than the depreciation rule

of section 312(k)(4)”. See op. Ct. p. 16. To the contrary, section 964(a) explicitly

incorporates section 312(k)(4) but makes no other reference to section 312.

         Undaunted by the plain language, the opinion of the Court continues,

misquotes the statute, and proceeds to interpret language that Congress did not

write:

         Section 964(a) provides that the same general rules apply to E&P
         computations for domestic and foreign corporations. Since those
         rules are set forth both in section 312 and in the regulations
         interpreting it, the reference to “regulations” in section 964(a) is
                                        - 29 -

      reasonably read to include regulations promulgated under section 312
      as well as under section 964(a). There is nothing in the text of section
      964(a) that limits the scope of “regulations” to regulations that might
      later be promulgated under that specific provision. [Fn. ref. omitted.]

See op. Ct. p. 12-13 (emphasis added). Section 964(a) does not, however, provide

that the “same general rules apply” to E&P computations for domestic and foreign

corporations. The statute provides that the E&P of a foreign corporation “shall be

determined according to rules substantially similar to those applicable to domestic

corporations, under regulations prescribed by the Secretary.” See sec. 964(a)

(emphasis added). Without citing any precedent, the opinion of the Court goes on

to state that the phrase “under regulations prescribed by the Secretary” also refers

“to regulations that the Secretary had previously promulgated, or might in the

future promulgate, under section 312.” See op. Ct. p. 12 (emphasis added). This

analysis sets bad precedent and is a rickety analytical construct.

      Section 964(a) delegates broad regulatory authority to the Secretary, and he

exercised that authority by promulgating section 1.964-1(a)(1), Income Tax Regs.,

which states: “[E]xcept as otherwise provided in the Code and regulations, the

earnings and profits * * * of a foreign corporation for its taxable year shall be

computed for all federal income tax purposes substantially as if such corporation

were a domestic corporation by” following a specific three-step process. The
                                        - 30 -

opinion of the Court states that “[p]etitioner interprets the preposition ‘by’ in an

extremely narrow sense, to mean ‘by doing these three things and nothing else.’”

See op. Ct. p. 21. Yet that is precisely what the regulation dictates. Indeed, the

prior version of section 1.964-1, Income Tax Regs., provided that a foreign

corporation’s E&P shall be computed according to a five-step process. See T.D.

6764, 1964-3 C.B. 260, 260-261. The regulation’s first three steps were identical

to the three steps in the current regulation. The last two steps, made obsolete by

the enactment of section 985, provided rules for converting a foreign corporation’s

E&P calculation to U.S. dollars. The first three steps of the prior regulation were

not preliminary or subject to additional revision under section 312. The

calculation was complete upon the conversion to U.S. dollars and, like the current

version of section 1.964-1(a), Income Tax Regs., section 312 played no part in that

calculation. See T.D. 6764, 1964-3 C.B. 260. Similarly, the E&P calculation

process in the current regulation is self-contained and complete. The Secretary

certainly had, and still has, the authority to promulgate regulations incorporating

the rules of, or similar to, section 312. He has not.1

      1
       In 2009 the Secretary identified transactions similar to the transaction at
issue as a “Transaction of Interest” that had the “potential for tax avoidance.” See
Notice 2009-7, 2009-3 I.R.B. 312. In 2010 the Secretary stated he would
promulgate regulations to address these purported “tax avoidance” transactions.
                                                                         (continued...)
                                        - 31 -

       We need not opine on whether the Secretary’s inaction is the result of

bureaucratic indolence or inertia, but we know this: The Secretary has not

promulgated the rule respondent espouses and is now imploring us to do his

bidding. The opinion of the Court acquiesces. We should decline. Our role is to

review and construe, not adjust and reconstruct, the statute and the regulations.

See Dodd v. United States, 

, 359 (2005) (stating that courts “are not

free to rewrite the statute that Congress has enacted”). The Secretary is bound by

the terms of the rules he created. Similarly, taxpayers are bound by the applicable

rules, but they are not required to employ their imagination to divine them.

Petitioner may have found a hole in the dike, but the closing of the hole “calls for

the application of the * * * [Secretary’s] thumb, not the court’s.” Fabreeka Prods.

Co. v. Commissioner, 

, 879 (1st Cir. 1961), vacating and remanding

(1960), Friedman v. Commissioner, 

(1960), and Sherman

v. Commissioner, 

(1960). In short, we must interpret, not make, the

law.

       GUSTAFSON, J., agrees with this dissent.

       1
       (...continued)
See Notice 2010-41, 2010-22 I.R.B. 715. He has not. Curiously, respondent now
asks the Court, rather than his Office of Tax Policy scriveners, to interpret sec.
1.964-1, Income Tax Regs., to halt a transaction similar to those he has for a
decade deemed problematic.