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September 21, 2023 At Court

The Supreme Court Will Determine Constitutionality of the Mandatory Repatriation Tax

Caroline Rule

In the next Supreme Court term beginning in October 2023, the Justices will hear argument on whether the Mandatory Repatriation Tax (MRT), passed as part of the Trump administration’s 2017 Tax Cuts and Jobs Act (TCJA), violates the Sixteenth Amendment. Depending on how and in what depth the Court addresses this issue, the case could be the most important tax case in decades as it requires the Court to address Congress’s power to levy taxes.

The MRT, codified in section 965 of the Internal Revenue Code, deemed the post-1986 deferred foreign income of a controlled foreign corporation (CFC)—a foreign corporation owned more than 50% by U.S. persons—to be income subject to a one-time tax in 2017 (or sometimes in 2018, depending on the taxpayer’s tax year). Both corporate and individual U.S. shareholders who owned more than 10% of a CFC were subject to a one-time income tax in 2017 on their proportional share of that income.

The case before the Court, Charles G. Moore et al. v. United States, Case No. 22-800, involves the MRT on individual taxpayers. Charles and Kathleen Moore’s argument is two-fold: 1) that Congress cannot tax undistributed and non-repatriated CFC earnings because those earnings are not “realized” income and realization is a requirement for taxation under the Sixteenth Amendment, and 2) that MRT’s taxation of over 30 years’ of unrealized income violates the Fifth Amendment’s Due Process Clause. The Ninth Circuit rejected both arguments.

The Supreme Court’s Grant of Writ of Certiorari

Even though there are no conflicting MRT appellate decisions, the Supreme Court granted the Moores’ Petition for Writ of Certiorari of the Ninth Circuit decision on June 6, 2023. Votes of only four Justices are required to grant certiorari (and those votes are not made public), but the grant without a circuit split signals that some Justices have a particular interest in the scope of the government’s taxing power and a possible willingness to invalidate the MRT. The Court will likely issue its decision by the end of the current term in late June 2024.

The Moores’ brief on the merits was filed August 30, 2023, and the government’s brief in opposition is due October 16, 2023. The issues before the Court have, however, already been briefed extensively before the Ninth Circuit, in the Moore’s Petition for Writ of Certiorari, and in the Brief of the United States in Opposition—as well as in no less than eight amicus curiae briefs in support of the petition for certiorari, filed by Americans for Tax Reform, the Buckeye Institute, the Cato Institute, the Landmark Legal Foundation, the Manhattan Institute for Policy Research, the Pacific Research Institute, the Southeastern Legal Foundation, and the United States Chamber of Commerce, all arguing for reversal of the Ninth Circuit’s decision because realization of income is a constitutional requirement.

The Sixteenth Amendment and the Mandatory Repatriation Tax

The Apportionment Clause of the U.S. Constitution, Art. I, Section 2, provides that no “direct” tax, which includes income tax, may be imposed unless it is apportioned among the states by population, meaning that each state must pay tax proportionately to the number of its residents. The Sixteenth Amendment, ratified on February 3, 1913, makes an exception for income tax. It provides that “Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States … .”

Section 965’s MRT was enacted after the TCJA moved taxation of U.S. corporations away from a global system of taxation (taxing corporations on their worldwide income, regardless of where their profits were derived), to a territorial system (taxing corporations where they do business, so U.S. corporations are taxed only on their domestic source income). Under this new system, the foreign-source portion of dividends received by a U.S. corporation from a foreign CFC subsidiary is no longer subject to U.S. tax because a U.S. corporation is taxed only on its domestic source income. The rate of U.S. taxation of corporations was also lowered to 21 percent. This territorial system significantly reduces the U.S. taxes paid by U.S. corporations.

Subpart F is the primary method used to tax U.S. shareholders of a CFC on foreign earnings held offshore. Before the MRT, U.S. shareholders who owned at least 10% of the voting stock of a CFC could be taxed on a proportionate share of limited categories of the CFC’s undistributed earnings such as dividends, interest, and earnings invested in certain U.S. property. The CFC’s active business income from the CFC’s operations outside the U.S was only taxable, however, if and when it was repatriated to the U.S. through a distribution to U.S. shareholders, a loan to U.S. shareholders, or an investment in U.S. property. This Subpart F regime created a strong incentive for CFCs to separately incorporate their foreign operations and keep those earnings offshore as undistributed retained earnings. The government estimated that, by 2015, CFCs had parked $2.6 trillion offshore in undistributed retained earnings that were not presently subject to U.S. taxation.

The TCJA countered the future loss of corporate taxes under the new territorial system with section 965’s one-time tax on those massive previously untaxed earnings for the years 1986 to 2017. The Ninth Circuit considered this appropriate since otherwise those earnings, supposedly only deferred under the prior worldwide taxation regime, would escape taxation completely under the new territorial regime. The government estimated that the MRT would raise $339 billion in taxes.

The effect of the MRT’s one-time tax is mitigated by section 965(c), providing for favorable tax rates of 15.5 percent for earnings held in cash and 8 percent on illiquid earnings, and by section 965(h), allowing shareholders to pay the tax in interest-free installments over eight years.

Facts of the Moores’ Case

The Moores owned 11 percent of Kisankraft, an Indian CFC that provides affordable equipment to small-scale farmers, and took no part in Kisankraft’s day-to-day operations or management. During the ten years that the Moores owned Kisankraft stock, the company made no dividend distributions of its profits. In 2017, Kisandraft had $508,000 of retained earnings, and the Moores were subject to the MRT tax on their proportionate share of this sum, resulting in an increase to their U.S. income tax liability of approximately $15,000. The Moores paid the MRT on their share of the CFC’s reinvested profits and sued for a refund, arguing that they had not “realized” the income and that unrealized income was not included in the understanding of “income” when the Sixteenth Amendment was adopted.

The Ninth Circuit Opinion Upholding the MRT

The Ninth Circuit affirmed the U.S. District Court for the Western District of Washington’s grant of the government’s motion to dismiss the taxpayers’ complaint, basing its decision on three principles. First, it noted that “the Supreme Court has made clear that realization of income is not a constitutional requirement,” citing, inter alia, the Court’s 1940 holding in Helvering v. Horst that “the rule that income is not taxable until realized .... [is] founded on administrative convenience,” and “does not mean that a taxpayer can ‘escape taxation because he did not actually receive the money.’” Consequently, “[w]hether the taxpayer has realized income does not determine whether a tax is constitutional.” Second, it confirmed that “[w]hat constitutes taxable gain is also broadly construed.” For this proposition, the court relied on cases from the 1970s upholding the constitutionality of a precursor to the current Subpart F that taxed “a corporation’s undistributed current income to the corporation’s controlling stockholders.” Third, it held that “there is no blanket constitutional ban on Congress disregarding the corporate form to facilitate taxation of shareholders’ income” so Congress may “attribut[e] a corporation’s income pro-rata to its shareholders.”

The Ninth Circuit rejected the Moores’ reliance on realization arguments from Eisner v. McComber, a 1920 Supreme Court decision, and Comm’r v. Glenshaw Glass, a 1955 Supreme Court decision. The Ninth Circuit held that the McComber Court only provided a definition of what “‘[i]ncome may be defined as,’ not a universal definition.” Likewise, “Glenshaw Glass reiterated the limited scope of Macomber’s definition of income by emphasizing that, while the definition served a useful purpose ..., it was not meant to provide a touchstone to all future gross income questions.” The Ninth Circuit noted that “[t]he Court in Glenshaw Glass never stated or suggested that the definition it used was a universal (or even broadly applicable) test.”

The Ninth Circuit also rejected the Moores’ argument that the MRT violated the Due Process Clause, noting that “retroactive tax legislation is often constitutional.” The Ninth Circuit found that the MRT serves a legitimate purpose by preventing CFC shareholders from obtaining a windfall by never having to pay taxes on their undistributed offshore earnings.

The Moores’ Petition for Writ of Certiorari and the Solicitor General’s Brief for the United States in Opposition

In their Petition for Writ of Certiorari, the Moores relied on the Macomber statement that profits must be “received or drawn by the recipient (the taxpayer) for his separate use, benefit and disposal” in order to be “income derived from property,” claiming that the Ninth Circuit’s opinion “shatters” a “judicial consensus” limiting the Sixteenth Amendment’s apportionment exemption to realized gains. The Moores also relied again on Glenshaw Glass as a decision that, they argued, “requir[ed] that gains be ‘clearly realized’ by taxpayers and reduced to their ‘complete dominion’” before being taxable as income under the Sixteenth Amendment. The Moores characterized the Ninth Circuit’s “treatment of Glenshaw Glass” as “outright defiance.”

In the Brief for the United States in Opposition, the solicitor general argued that the Sixteenth Amendment allows congress to tax income both on a realization basis and on an accrual basis, noting this as a longstanding consensus among tax scholars. The Sixteenth Amendment, by its terms, applies to “taxes on incomes, from whatever source derived,” and “says nothing about this being limited to realized gains.” The government generally agreed with the Ninth Circuit’s reasoning about why Glenshaw Glass and Macomber are not controlling, characterizing the former case as “simply list[ing] elements that were sufficient to create income on the facts of that case—not necessary elements of income in every case,” and the latter case as “interpreting the statutory ‘concept of realization,’” which “does not suggest that realization is a constitutional mandate.” The government also pointed out a potential windfall problem: under the TCJA, when CFC’s distribute their earnings as dividends to U.S. shareholders, those earnings are generally no longer taxed, so the TCJA “eliminates, on an ongoing basis, the prior taxes that would have applied to dividends distributed by a CFC to a U.S. corporate shareholder.” The one-time MRT was therefore necessary to avoid the potential windfall on deferred income and “[t]he TCJA appears to be working largely as Congress envisioned,” with “U.S. multinational enterprises distribut[ing] approximately $777 billion to U.S. shareholders in 2018.”

Finally, the government argued that it was unnecessary for the Court to review the case “because the MRT is a one-time tax applicable only to pre-2018 income, [so] the case lacks pressing prospective importance.”

Commentary From the Moores’ Counsel

The Moore’s lead counsel, Baker Hostetler’s Andrew M. Grossman, stated that “[i]ncome means the same thing now that it did when the Sixteenth Amendment was ratified: gains that have been realized by the taxpayer. We are confident that the Supreme Court will vindicate that fundamental principle and confirm that Congress’s power to tax is not unlimited.”

Dan Greenberg, general counsel of the Competitive Enterprise Institute that also represents the Moores, agreed with the four judges who dissented from the Ninth Circuit’s denial of rehearing en banc when they wrote: “Divorcing income from realization opens the door to new federal taxes on all sorts of wealth and property without the constitutional requirement of apportionment.” Those four judges argued that: “We [wrongly] become the first court in the country to state that an ‘income tax’ doesn’t require that a ‘taxpayer has realized income’ under the Sixteenth Amendment.” (While the Ninth Circuit may have been the first court to state this proposition outright, numerous provisions of the Internal Revenue Code impose income tax on unrealized gains, as discussed later in this article.)

What the Case is Really About

The Moores’ challenge to the MRT, brought by Baker Hostetler and the Competitive Enterprise Institute, is not really about the insignificant $15,000 MRT that the Moores’ paid, nor even about the projected $339 billion to be raised by the MRT. Instead, the case is a vehicle seeking a Supreme Court decision against the constitutionality of a wealth tax based on the market value of a person’s assets, even when there are no realized gains. The Moores’ Petition argued specifically that the case offers an opportunity for the Court to proclaim realization as a constitutional requirement for taxable income, stating that this would “provide certainty to families and businesses arranging their financial futures” and “head off a major constitutional clash when Congress accepts the Ninth Circuit’s invitation to enact an unapportioned tax on property or wealth.”

The Moores argued that the Court should resolve this wealth tax question as a way of “inform[ing] lawmakers.” Amici also suggest that the Court should refuse to uphold section 965 to avoid creating a precedent supporting a future wealth tax proposal.

On the other hand, the government’s brief opposing granting certiorari argued that the possibility of a future wealth tax did not justify Supreme Court review, emphasized that the potential “wealth tax” is only a “specter” since Congress has not yet taken action to impose such a tax. The government emphasized the long-held proposition that the Court does not decide whether a tax is constitutional until Congress actually imposes the tax, nor does the Court “‘exercise general oversight of the Legislative and Executive Branches’ or ‘issue advisory opinions’ on matters not before it.”

It is, of course, unclear if the Court intents to reach the issue of a potential future wealth tax, but Senate Finance Committee Chair Ron Wyden, D-Ore, issued a statement that a judgment in favor of the Moores would be “all for the benefit of the ultra-wealthy.” He stated: “If the Republicans on the Supreme Court take the petitioners’ side, they’dbe handing a massive windfall to multinational corporations and could potentially lock in a right for billionaires to opt out of paying anything remotely close to a fair share in taxes.”

Possible Ramifications of the Court’s Ruling

There are a number of possible outcomes of this case, with repercussions beyond a potential MRT refund.

  • Even if the Moores win on their individual MRT refund suit, the MRT on corporate shareholders could survive—and that tax on mega-companies that have retained billions in overseas affiliates forms the most significant part of the expected MRT tax.
  • The Court could agree that the Sixteenth Amendment includes a realization requirement but hold that the MRT satisfies that requirement.
  • Even if the Court agrees that the Sixteenth Amendment authorizes accrual-based taxation, making an annual mark-to-market accrual income tax such as that under section 475 constitutional, the Court could possibly conclude that the MRT look-back period is an unreasonably long period for taxation under the accrual method.
  • The Court could possibly conclude that taxing up to thirty-one years of deferred earnings is not a tax on income but an improperly apportioned unconstitutional tax on wealth.
  • Similarly, the Supreme Court could possibly find that the MRT’s look-back period violates the Due Process Clause, even though the Moores’ petition abandoned that argument to focus on the “realization” issue.

If the Court decides that realization is required for a tax to pass constitutional muster under the Sixteenth Amendment, this holding will call into question a significant number of other Internal Revenue Code sections. For example, the subpart F regime for CFCs under sections 951 through 965 and the TCJA’s global intangible low-taxed income (GILTI) regime are both based on deemed dividends and so would be unconstitutional. The same is true for imputed interest under section 7872. Under section 1256, futures contracts are treated as sold for their fair market value on the last business day of a taxable year; section 817 has a similar provision for a segregated asset of an insurance company; and the section 877A exit tax includes a mark-to-market provision under which all property of a covered expatriate is subject to tax as though sold for its fair market value on the day before the expatriation date: none of these provisions would be constitutional. There are numerous “deemed” transactions throughout the code used to ensure the proper treatment of complex transactions that would also be called into question. These are just a few examples that would be presumptively unconstitutional under a holding that the Sixteenth Amendment includes a realization requirement. The chaos that would result from overturning the longstanding consensus that realization is not required should be considered by the Court. For the sake of stability, perhaps we should hope that the Court holds that the Sixteenth Amendment allows for both accrual-based and realization-based taxation.

Finally, taxpayers subject to the MRT should determine whether they should file a protective refund claim if the state of limitations for a refund under section 6511(a) has not yet run—i.e. less than three years since they filed a tax return involving the MRT or less than two years since they paid the tax, whichever is later. A protective claim is filed to protect the statute of limitations when a refund is contingent on the outcome of a pending case that is not likely to be decided until after the statute expires. Since taxpayers were allowed eight years in which to pay the MRT, the statute of limitations for refunds of some of their payments may well still be open, and filing a protective claim may be advisable.

    Caroline Rule

    Kostelanetz LLP, New York, NY

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