Mandatory repatriation tax is constitutional

Sidestepping the issue of whether realization is a constitutional requirement of an income tax, the Supreme Court held that the Sec. 965 transition tax, which attributes realized and undistributed income to the U.S. shareholders of controlled foreign corporations (CFCs) and taxes them on that income, does not violate the U.S. Constitution.

Background

In 2006, Charles and Kathleen Moore bought a 13% share of KisanKraft, a CFC based in India. The company prospered and generated a great deal of income. However, KisanKraft did not distribute that income to its American shareholders, including the Moores. Consequently, under the prevailing tax rules, the couple had not been taxed on the income.

In 2017, Sec. 965 was enacted as part of the Tax Cuts and Jobs Act, P.L. 115-97. Sec. 965 imposed a one-time tax, known as the transition tax, on accumulated income of CFCs. Under the transition tax, the accumulated and undistributed income of CFCs was attributed to their U.S. shareholders, and those shareholders were subject to tax on that income.

By the end of the 2017 tax year, the Moores’ share of KisanKraft’s income was $508,000. After taking a deduction into account, the couple had $132,512 in income from the company that was subject to the transition tax, resulting in the Moores’ owing taxes of $14,729.

Under Article I of the Constitution, Congress has the broad power to impose and collect taxes. Taxes for these purposes fall into two categories: direct taxes, which are taxes on persons and property, and indirect taxes, which are taxes on activities or transactions. Direct taxes must be apportioned among the states according to each state’s population. Indirect taxes do not have to be apportioned but are required to be uniform throughout the United States. The Sixteenth Amendment established that taxes on income, including from property, need not be apportioned.

The Moores paid the transition tax and sued for a refund in district court. They argued that because they had not received any of the income that KisanKraft had accumulated, they had not realized any income. Thus, they argued, the transition tax was an unconstitutional unapportioned direct tax on their shares of KisanKraft stock. The district court dismissed the suit (Moore, No. C19-1539-JCC (W.D. Wash. 11/19/20)), and the Ninth Circuit affirmed its decision, holding that the realization of income is not a constitutional requirement (Moore, 36 F. 4th 930 (9th Cir. 2022)).

The Moores appealed their case to the Supreme Court, asking the Court to address the question of “[w]hether the Sixteenth Amendment authorizes Congress to tax unrealized sums without apportionment among the states.” The Supreme Court agreed to hear the case, but rather than addressing the realization question, it addressed the “narrow” question of whether Congress may attribute an entity’s realized and undistributed income to the entity’s shareholders or partners and then tax the shareholders or partners on their portions of that income.

The Supreme Court’s decision

The Supreme Court, in a 7–2 decision, held that the transition tax was a valid exercise of Congress’s taxing authority. The Court based its holding on its long-standing precedents, reflected in and reinforced by Congress’s long-standing practice.

The Moores contended that the transition tax is a tax on property rather than on income, and therefore the tax is unconstitutional because it is not apportioned. They reasoned that income requires realization and, because they had not received the income from KisanKraft, they had not realized any income. Consequently, the transition tax was taxing property (their shares in KisanKraft) rather than income. The Supreme Court disagreed, finding that the transition tax, which it called the “mandatory repatriation tax” in its opinion, does tax realized income — income realized by a foreign corporation that the transition tax attributes to its shareholders, who are taxed on their share of that undistributed income.

The Supreme Court based its determination in its long-standing precedents that established that, with respect to the undistributed income of an entity, Congress may tax either the entity or its shareholders or partners, and regardless of which it chooses, a tax on the undistributed income remains a tax on income. For partnerships, the Court found that this principle was set out and reaffirmed in Burk-Waggoner Oil Ass’n v. Hopkins, 269 U.S. 110 (1925); Burnet v. Leininger, 285 U.S. 136 (1932); and Heiner v. Mellon, 304 U.S. 271 (1938), and was carried over to corporations and their shareholders in Helvering v. National Grocery Co., 304 U. S. 282 (1938). Moreover, the Court stated, the principle had been repeatedly invoked by the courts in upholding Subpart F, which treats certain foreign corporations as passthroughs by attributing the foreign corporations’ undistributed income to U.S. shareholders and then taxing those shareholders on their share of the income.

In response to the precedents set by these cases, the Moores argued that their position was supported by an earlier case, Eisner v. Macomber, 252 U. S. 189 (1920). In that case, in dicta, the Supreme Court stated that “what is called the stockholder’s share in the accumulated profits of the company is capital, not income.” The Moores interpreted that language to mean that a tax attributing an entity’s undistributed income to its shareholders or partners is not an income tax. The Court found this reading was implausible, noting that in that case, it had not purported to address attribution. In any event, in the later cases Burk- Waggoner Oil Ass’n v. Hopkins, Heiner v. Mellon, and Helvering v. National Grocery Co., the Court addressed attribution and allowed it. Thus, the Court concluded that Eisner v. Macomber did not disallow attribution, and therefore it had no bearing on the Moores’ case.

The Supreme Court also discussed the effect of Congress’s long-standing practice of taxing the shareholders or partners of a business entity on the entity’s undistributed income, which started with the income tax law enacted in 1864 and carries on today in the passthrough regimes for partnerships, S corporations, and shareholders in CFCs under Subpart F. The Court found that a long-settled and established practice such as this can carry great weight in resolving a constitutional question and here reflected and reinforced the Court’s precedents.

The Moores, in what the Supreme Court described as an attempt to limit the collateral damage if the transition tax was held to be unconstitutional, conceded that partnership taxes, S corporation taxes, and Subpart F taxes are constitutional and sought to distinguish these taxes from the transition tax. According to the Moores: (1) Taxes on partnerships are distinguishable from the transition tax because partnerships are not separate entities from their partners; (2) taxes on S corporations are distinguishable from the transition tax because shareholders of S corporations choose to be taxed directly on corporate income; and (3) Subpart F taxes on American shareholders’ portions of undistributed foreign corporate income are distinguishable from the transition tax and not controlled by precedent because those taxes apply to what the Moores called “constructive realization.”

The Supreme Court first found that these “ad hoc” distinctions did not undermine the clear rule established by its precedents that “Congress can choose either to tax the entity on its income or to tax the entity’s shareholders or partners on their share of the entity’s undistributed income.” In addition, the Court found that the Moores’ attempts to distinguish the transition tax from the other taxes failed on their own terms. Because the Moores could not meaningfully distinguish the transition tax from the similar taxes on partnerships, S corporations, and Subpart F income, taking their argument that the transition tax was unconstitutional to its logical conclusion could render “vast swaths of the Internal Revenue Code unconstitutional.” In closing its opinion, the Court stressed that its holding was narrow and applied only to passthrough entities.

In addition, the Court stated, as it had earlier in the opinion, that the Constitution’s Due Process Clause does not allow for arbitrary attribution and that nothing in its opinion should be read to authorize a tax on both an entity and its shareholders or partners on the same undistributed income realized by the entity.

Reflections

The dissent in the case argued that the “clear rule” that Congress can choose to tax either the entity on its income or the entity’s shareholders or partners on their share of the entity’s undistributed income was an invention created by the majority by misreading the cases it cited as establishing this rule. The dissenters found that these cases, other than Heiner v. Mellon, were about tax evasion, and, at most, they showed “that Congress may attribute income to the entity or individual who actually controlled it when necessary to defeat attempts to evade tax liability” (Thomas, J., dissenting, slip op. At 30). According to the dissenters, “[t]he ‘clear rule’ that the majority relies on to sidestep the realization question is thus a mirage” (id.).

Moore, No. 22-800 (U.S. 6/20/24)

Contributor

James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser’s tax technical content manager. For more information about this column, contact thetaxadviser@aicpa.org.