On June 26, 2023, the Supreme Court of the United States granted certiorari in Charles G. Moore, et ux., v. United States, a challenge to the constitutionality of Internal Revenue Code (“Code”) section 965 and the repatriation tax imposed under the Tax Cuts and Jobs Act of 2017 (the “TCJA”). If the Supreme Court holds that the tax is unconstitutional, this case could affect many other Code provisions, especially in the international tax arena.

Background

In general, a U.S. shareholder of a foreign corporation does not pay U.S. tax on the foreign corporation’s income. Rather, the shareholder pays tax when the shareholder receives a distribution from the foreign corporation. However, where a shareholder owns in an interest in a controlled foreign corporation (“CFC”),¹ that shareholder may be subject to U.S. tax on certain types of the CFC’s income (so-called “Subpart F” income), even when the CFC makes no distribution. In general, the subpart F rules operate by treating a U.S. shareholder of a CFC as if the U.S. shareholder actually received her share of certain categories of the corporation’s earnings and profits.² This income is generally not taxed again when it is distributed to the shareholder.³ In enacting section 965, Congress recognized that billions of dollars of income not falling within the definitions of Subpart F income was being accumulated in foreign countries by U.S. shareholders. The transition tax under section 965 was an addition to subpart F of the Internal Revenue Code and intended to reach types of income not covered by Subpart F.

Under the TCJA, section 965 required a U.S. shareholder who held more than 10% of a controlled foreign corporations (“CFC”) to pay a one-time transition tax on the shareholder’s pro rata share of the CFC’s accumulated earnings as if those earnings had been repatriated to the United States. In general, shareholders paid tax on the share of CFC profits at either 15.5% (for earnings held in cash) or 8% otherwise for the 2018 tax year.⁴ A shareholder could elect to pay this tax in eight annual installments.⁵ The income is not taxed again when it is distributed to the shareholder.⁶

Case

The facts of the case are as follows. In 2005, Charles and Kathleen Moore bought 11% of outstanding common shares in KisanKraft, an India company which supplies modern tools to small farmers. KisanKraft is a CFC under the applicable Code sections.⁷ While KisanKraft has accumulated profits, it never distributed any earnings to its shareholders; instead it has reinvested all of its earnings in its business. Before 2017, the Moores would not pay U.S. taxes on KisanKraft’s earnings.⁸ Rather, they would pay U.S. income tax on distributions received from KisanKraft. The Moores’ tax liability for 2017 increased by $15,000 because of the transition tax under section 965.

The Moores paid the tax and sued for a refund. The district court dismissed the case, and the Moores appealed. The Ninth Circuit Court of Appeals affirmed the district court’s order.

The Moores raise two constitutional challenges to the transition tax. First, they contend that it violates the Apportionment Clause of Article I.⁹ They argue that a taxpayer has to realize income before the income can be taxed. Because the taxpayers personally incurred no "realization event", the Moores allege that they cannot be subject to tax.¹⁰ The Court of Appeals held that the tax did not violate the Apportionment Clause.¹¹ It further held that income realization does not determine the constitutionality of a tax, pointing to various Supreme Court decisions.

Second, the Moores contend that section 965 violates the Fifth Amendment’s Due Process Clause because it is a retroactive tax on income accumulated between 1987 and 2017. The Court cited United States v. Carlton¹² to show that the Supreme Court “repeatedly has upheld retroactive tax legislation against a due process challenge.” Retroactive tax legislation may overcome a due process challenge if “the retroactive application itself serves a legitimate purpose by rational means.” Further, the Court of Appeals held that the retroactive tax was constitutional because it served a legitimate purpose (preventing CFC shareholders from obtaining a windfall by never having to pay taxes on yet undistributed earnings) by rational means (accelerating the effective repatriation date to a single date of repatriation).

In their petition for a writ of certiorari, the Moores contend that the Ninth Circuit’s decision misinterpreted the Sixteenth Amendment.

Tax Implications

Previous attacks on Subpart F on constitutional grounds in 1973¹³ and 1974¹⁴ were rejected by the Second and Tenth Circuits and the Supreme Court denied certiorari in both instances. The Second Circuit found the argument against the constitutionality of Subpart F “borders on the frivolous”,¹⁵ while the Tenth Circuit found no merit in the argument given the provisions of Article I of the Constitution, the Sixteenth Amendment, and various case law including Glenshaw Glass.¹⁶ Given the similarity of application of the Subpart F rules and section 965, if the Supreme Court holds that section 965 is unconstitutional, such a decision may have far-reaching and serious implications for certain fundamentals of current tax law, including Subpart F and the global intangible low-taxed income provision enacted in the TCJA. In addition, a ruling that income must be realized before it is taxed may also spur challenges to the tax regime of “pass-through” entities, such as partnerships and S corporations. Income of a “pass-through” entity is deemed to flow directly to the interest holder for tax purposes and is taxed at the interest holder’s level, even if the entity does not immediately distribute it to the interest holder.¹⁷ A requirement that a taxpayer actually realize the income before the income is taxed would be at odds with this regime.

At the more practical level for taxpayers affected by section 965, this one-time tax was assessed in 2018. Although taxpayers had the option to pay the tax over a period of 8 years, not all taxpayers took advantage of that option. To the extent that payments were made in 2018 or 2019, claims for refunds of those tax payments may be time-barred by the statute of limitations unless the Court holds that the statute of limitations does not apply to payments of a tax found to be unconstitutional. During the pendency of the Moore case, taxpayers who have been assessed tax liability under section 965 may wish to consult with their tax advisers as to whether to file protective claims for refunds of section 965 taxes for years that are still not barred by the statute of limitations.

We will continue to monitor this case closely. Taxpayers with questions about IRC section 965 or other international tax provisions can contact the authors (below) or the Hanson Bridgett Tax Group.

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¹ Under Code section 957, a foreign corporation is a CFC if more than 50% of it is held by U.S. shareholders who hold more than 10% of it.

² Code sections 951, 951A.

³ Code section 959; see Code section 951A(f).

⁴ Code section 957(c).

⁵ Code section 957(h).

⁶ Code section 957(d)(2)(B).

⁷ More than 50% of KisanKraft is owned by U.S. shareholders.

⁸ KisanKraft did not generate subpart F income under Code section 951.

⁹ U.S. Const. art. I, section 9, cl. 4.

¹⁰ In the Ninth Circuit, the Moores contended that income required "[1] undeniable accessions to wealth, [2] clearly realized, and [3] over which the taxpayer have complete dominion" under Glenshaw Glass, 348 U.S. 426, 431 (1955).

¹¹ The Court of Appeals applied the Sixteenth Amendment to hold that the Apportionment Clause had a "narrow reach" and that "incomes, from whatever source derived," were exempted from the apportionment requirement.

¹² 512 U.S. 26, 30 (1994).

¹³ Garlock Inc. v. C.I.R., 489 F.2d 197 (2d Cir. 1973).

¹⁴ Whitlock’s Estate v. C.I.R., 494 F.2d 1297 (10th Cir.1974).

¹⁵ Garlock, at 202.

¹⁶ Whitlock, at 1301.

¹⁷ See Code sections 702(b), 1366(b), requiring interest holders to determine items of income "as if such item were realized directly from the source from which realized by [the partnership or corporation]."