Author: Anna K. Derewenda
The Ruling
On June 20, the U.S. Supreme Court released its opinion in the closely watched case of Moore v. United States. In a 7-2 decision, the court upheld the constitutionality of the mandatory repatriation tax (MRT), also referred to as the “transition tax,” imposed under Section 965 of the Internal Revenue Code.
The Moores argued that the MRT is an unconstitutional tax on unrealized gains. Under Article I of the Constitution, Congress can only levy taxes on property (“direct taxes”) if they are apportioned among the states in proportion to their populations. Conversely, taxes on income are “indirect taxes” and the Sixteenth Amendment confirms the ability of Congress to enact a federal income tax without apportionment. The Moores argued that the Sixteenth Amendment requires a “realization” event and, without such an event, the MRT is a property tax rather than an income tax and therefore unconstitutional because it is not apportioned.
Avoiding this core question, the court intentionally deferred resolution on whether a realization event is a constitutional requirement for an income tax. Instead, the court stated that the MRT does tax realized income – the income realized by foreign corporations. As a result, the court narrowly ruled on the question of whether an entity’s realized and undistributed income may be attributed to an entity’s shareholders or partners and whether those shareholders or partners may then be taxed on their portions of that income. Citing long-standing precedents and the mechanics behind the taxation of partnerships, Subchapter S corporations, and Subpart F, the court found the answer to be “yes.”
Acknowledging the potential implications of its ruling on potential future legislation as well as existing law, the court further narrowed its ruling to entities treated as pass-throughs and indicated nothing in the opinion should be read to authorize taxation of an entity and its shareholders or partners on the same undistributed income realized by the entity. In addition, the analysis specifically does not address taxes on holdings, wealth, net worth, or appreciation.
The Background
The Tax Cuts and Jobs Act of 2017 (TCJA) introduced a one-time MRT on certain undistributed foreign profits of U.S. taxpayers. Prior to the TCJA, subject to anti-deferral regimes such as Subpart F, U.S. shareholders of controlled foreign corporations (CFCs) – i.e., foreign corporations more than 50% owned by U.S. shareholders – could defer paying taxes in the U.S. on their share of the CFC’s earnings until such earnings were distributed to them. The MRT required U.S. shareholders who own 10% or more of a CFC to pay a one-time tax on the CFC’s accumulated earnings from the past 30 years, which had previously benefited from deferral. Essentially, the MRT applied to the CFC’s retained foreign earnings even though that income was not actually distributed to its U.S. shareholders.
The Moores are individual shareholders with a more than 10% interest in a CFC that became subject to the MRT. They invested $40,000 in KisanKraft Machine Tools Private Limited (KisanKraft) in 2005 in exchange for 13% of the common shares of the Company. Under Section 965, the Moores’ share of the accumulated earnings of KisanKraft was about $133,000. As a result, the Moores were required to pay a tax of approximately $15,000 and sued for a refund.
The Moores argued that (i) the MRT is an unconstitutional unapportioned direct tax on their shares of KisanKraft stock and (ii) the MRT violates the Due Process Clause of the Fifth Amendment because it applies retroactively to past income. Based on the Government’s argument that “realization” was not a constitutional requirement and that retroactive tax laws are not fatal if they serve a legitimate purpose by rational means, the District Court upheld the MRT and the Ninth Circuit affirmed. The Supreme Court was requested and granted certiorari only on the first question of direct tax.
The Stakes
Concerns were raised as to whether a realization requirement could also affect other provisions of the tax code, such as e.g., the Subpart F rules and the taxation of partnerships and S corporations, which impose a tax on income that is not received in cash. The court worried that such regimes, and many others, would be within the “blast radius of the [Mooores] legal theory.” Stating that suddenly eliminating these provisions would “deprive the U.S. government and the American people of trillions in lost tax revenue” and that the “Constitution does not require that fiscal calamity,” the court was unconvinced by arguments attempting to distinguish the MRT from these long-standing regimes.
One core debate surrounding the Moore ruling considered whether the court’s opinion could impact the viability of future legislative action relating to a wealth tax or a tax on unrealized capital gains. Although the majority decision left the question of realization to another day, four justices – Justice Thomas, filing a dissenting opinion joined by Justice Gorsuch, and Justice Barrett, filing a concurrence joined by Justice Alito - supported a constitutional realization requirement for an income tax. Commentators have suggested that these opinions could provide guidelines for future cases on issues raised by these taxes.
