The Court of Appeals for the Federal Circuit agreed with a film production company that it was entitled to transitional relief afforded by the American Jobs Creation Act (AJCA) for extraterritorial income (ETI). The ETI was received from transactions in 2005 and 2006, including income recognized after those years.

The ruling reversed and remanded for further proceedings a ruling by the U.S. Court of Federal Claims.

Distribution Agreements

The film production company produces animated motion pictures and relies on third parties to distribute the films. The company signed a distribution agreement in 2005 granting Paramount Pictures Corp. exclusive, worldwide rights to distribute certain of the production company’s existing and future feature films.

In 2006, following Paramount’s acquisition of DreamWorks LLC (of which the plaintiff was originally a division), the parties signed a new distribution agreement, adding a Paramount affiliate as a party. The new accord is nearly identical in all material respects to the 2005 agreement, except that the affiliate replaced Paramount as the distributor of the licensed material outside of the U.S. and Canada.

After the 2006 agreement, the production company recognized qualifying ETI for the 2006 tax year and, following a provision in the AJCA, excluded from gross income 60% of the ETI that constituted qualifying foreign trade income attributable to the 2006 agreement. At the same time, the company included, in gross income, 40% of its ETI attributable to the 2006 agreement.

The IRS agreed that the company’s claimed ETI exclusion was allowable. The company then continued to receive income from the 2006 agreement during 2007, 2008 and 2009. However, it didn’t claim any exclusion for ETI recognized in those years.

Seeking Refunds

The production company subsequently realized during a routine IRS examination that it hadn’t claimed those exclusions and filed income tax refund claims totaling more than $4.4 million.

The IRS disallowed the refund claims and the company paid the disputed amount.

The company later sued the federal government in the claims court to recover the money it maintained was a refund. The parties filed cross-motions for summary judgment on the legal question of whether the AJCA provision in question:

  • Provides for transitional relief for all ETI received from transactions entered into in 2005 and 2006, including income from such transactions recognized after 2006, or
  • Is instead limited to extraterritorial income recognized during those years.

The Claims Court sided with the government, holding that the tax benefits provided in the law’s transition rule were limited to income recognized in 2005 or 2006, citing DreamWorks Animation SKG, Inc. v. United States (Ct. Fed. Cl. 2016).

The production company appealed.

Unambiguous Language

The Court of Appeals for the Federal Circuit, reversing and remanding the claims court, found that the plain language of the AJCA unambiguously provides tax benefits for transactions entered into in 2005 and 2006, with no limitation on the calendar year in which the income was earned.

The appeals court rejected the government’s argument that the AJCA provision, which sets out the applicable percentages for 2005 and 2006, functions as a standalone provision limiting the scope of transitional relief available. Rather, the appeals court found that the provision in question merely explains how to make the calculations described in another provision of the law that refers to “transactions during 2005 or 2006” in describing the circumstances in which transitional relief is available.

The appeals court also noted that this interpretation was consistent with the “last antecedent” canon of statutory construction, which construes a limiting clause or phrase as modifying only the noun or phrase that immediately follows — such that “during 2005 or 2006” refers to transactions, and not income. In addition, the transaction-based approach was supported by other AJCA provisions, which showed that Congress knew how to adopt an income-recognition-based approach and didn’t do so here.

Finally, while the appeals court wasn’t required to look at legislative history because the provision in question was unambiguous, it nonetheless found, contrary to the claims court, that legislative history supported the production company’s interpretation of the provision. (DWA Holdings LLC v. U.S., CA Fed. Cir., 5/9/2018

For a no-obligation discussion on the possible impact and steps you should take now, contact Lien Le, the head of our International Tax practice.

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