Executive summary:
On June 26, 2023 the U.S. Supreme Court agreed to hear an appeal from a decision of the 9th Circuit in Moore v. U.S., 36 F.4th 930 (2022) regarding a constitutional challenge to the section 965 mandatory repatriation tax ('MRT' or 'transition tax'). The Supreme Court’s opinion in this case may reach beyond section 965 to address the continuing relevance of the realization requirement in light of the widespread use of deemed income inclusions in the Code.
Supreme Court agrees to hear a challenge to section 965
Background on section 965
Section 965 applies to deferred foreign income corporations (DFICs). A DFIC is defined in section 965(d) as any specified foreign corporation (SFC) of a U.S. shareholder which has accumulated post-1986 deferred foreign income greater than zero. A SFC is:
- a controlled foreign corporation (CFC), or
- a foreign corporation that is not a CFC or a passive foreign investment corporation (PFIC) with respect to which one or more domestic corporations is a U.S. shareholder.
Section 965 was enacted as part of the Tax Cuts and Jobs Act of 2017 (TCJA) to facilitate the change from a system where the earnings of a SFC were generally not subject to U.S. tax until distributed (except to the extent narrow pre-TCJA Subpart F anti-deferral rules applied), to a territorial system where U.S. corporate shareholders generally are not taxed on earnings of a foreign affiliate (unless the foreign affiliate is not subject to tax in the foreign jurisdiction above a certain threshold).
Section 965 treats the undistributed earnings of a SFC accumulated after 1986 and before 2018 as a deemed Subpart F dividend to U.S. shareholders that own 10% or more in the SFC. The section 965 deemed dividend is an extension of the original subpart F tax regime enacted in 1962, which essentially requires 10% or greater U.S. shareholders in a SFC to include in income a pro rata share of certain types of income earned by the SFC, such as passive income and related party sales, regardless of whether any amount has been distributed to the shareholder. In enacting subpart F Congress chose not to directly tax a SFC on its earnings and instead tax the U.S. shareholder on the SFC’s income presumably due to jurisdictional nexus concerns where international taxing norms have historically limited a country’s right to tax income that either arises in the country or is earned by a resident of the country.
With the exception of related party sales or services income, the original subpart F tax regime generally did not tax a U.S. shareholder on the active business earnings of the SFC until it was distributed. The section 965 MRT is essentially a current tax on the remaining deferred earnings of a SFC (primarily active unrelated business income) realized by the SFC after enactment of the original Subpart F regime.
Background on taxpayers
The taxpayers in Moore are U.S. resident individuals who invested in a foreign corporation, KisanKraft, that supplied agricultural tools to small farmers in India. The Moores held shares representing just over 10% of the foreign corporation. Other U.S. persons also held shares in KisanKraft and it was classified as a SFC. KisanKraft regularly realized a profit but never distributed its earnings out to shareholders. With the enactment of the TCJA, the Moores were taxed in 2017 under section 965 on their proportionate share of the post-1986 undistributed earnings of KisanKraft.
The constitutional challenge
The Moores challenged the section 965 MRT primarily on the grounds that the tax is not an income tax within the meaning of the Sixteenth Amendment to the U.S. Constitution because it is levied on a deemed distribution of earnings from the SFC, not a realization event. The taxpayers then claim that the MRT is a direct tax that must be apportioned among the states based on population pursuant to the apportionment clause in article 1, section 9, of the U.S. Constitution. And since the tax is not apportioned among the states, it violates the U.S. Constitution.
The Sixteenth Amendment allows Congress to tax income from ’whatever source derived without apportionment among the states.’ The Sixteenth Amendment was designed specifically to allow Congress to tax income without regard to the apportionment clause given the impracticality of apportioning income taxes among the states.
There is no comprehensive definition of gross income under U.S. tax law. Section 61 of the Code mirrors the language of the Sixteenth Amendment and defines gross income as 'all income from whatever source derived' and includes specific enumerated examples of income. However, U.S. courts have developed certain concepts of gross income, including a realization requirement established in Eisner v. Macomber, 252 U.S. 189 (1920) (suggesting that realization is a constitutional prerequisite to earning gross income and concluding that a pro rata stock dividend was not income), and refined in Glenshaw Glass, 348 U.S. 426 (1955) (defining gross income as accessions to wealth, clearly realized, and over which the taxpayer has complete dominion). Realization is made on a case-by-case basis. However, realization generally occurs when there is a transaction where the taxpayer’s economic gain materializes, such as through the actual or constructive receipt of money or property in exchange for other appreciated property, the right to use property or capital, or for services.
The Moores rely on Eisner v. Macomber and Glenshaw Glass for their claim that the MRT is not an income tax, asserting that this authority requires that the taxpayer realize an accession to wealth before that wealth can be taxed as income. The Moores have essentially asserted that a shareholder, unlike a partner, cannot be taxed on the earnings that the corporation earns unless there is a realization event that severs the earnings from the corporation and allows them to be utilized by the shareholder (i.e., a distribution of earnings or a sale of the shares).
The Ninth Circuit rejected the Moore’s claim on the grounds that 'realization of income is not a constitutional requirement' and concluded that 'there is no constitutional prohibition against Congress attributing a corporation’s income pro-rata to its shareholders and then taxing them on it.' The Court also cited Helvering v. Horst, 311 U.S. 112 (1940) for the principle that the Supreme Court has previously ruled that the concept of realization is 'founded on administrative convenience and does not mean that a taxpayer can escape taxation because he did not actually receive the money.’
In opposition to the Moore’s petition for certiorari, the U.S. Department of Justice (the DOJ) argued that the realization requirement is not a component of the definition of income. The DOJ conceded that the realization requirement remains relevant when interpreting the statutory concept of realization in section 1001, which informs when appreciation on property should be reported. However, the DOJ argues that it should not be viewed as defining the nature of income itself, which is more properly understood as the net accretion to one’s economic power between two points in time. Although not precedential at the level of the Supreme Court, the DOJ also points out that the 2nd Circuit upheld the constitutionality of the original Subpart F deemed dividend tax regime in Garlock, Inc. v. Comm’r., 489 F.2d 197 (1973) and found that Eisner v. Macomber had 'no validity' for purposes of challenging the Subpart F deemed distribution following Heiner v. Mellon, 304 U.S. 271 (1938) where the Supreme Court concluded that partners may be taxed on their pro rata shares of partnership income even when those shares are not distributed.
Potential impact of case
In many ways this case is not so much about whether there has been a realization event. The parties do not dispute that the SFC in this case actually realized income that gave rise to the deemed income inclusion at the level of the U.S. shareholders. Rather, the issue is whether Congress has the power to disregard the corporate form and tax shareholders on income earned by the corporation much the same way partners in a partnership are taxed on the earnings of the partnership. While U.S. courts have also developed doctrines that tax a shareholder on income earned by the corporation (e.g., substance over form, economic substance, conduits, agency) those doctrines are generally limited to potentially abusive situations where the corporation is not functioning as the beneficial owner of the income. In contrast, the MRT and the subpart F tax regime more generally taxes U.S. shareholders on income earned by the corporation even though the corporation is not functioning as an agent or conduit and would clearly be considered the beneficial owner of the income.
If a strict realization requirement is applied as the Moores have argued, many deemed income inclusion regimes in the Code beyond Subpart F would also be subject to challenge, such as the section 951A global intangible low-taxed income (GILTI) regime which also taxes a U.S. shareholder on income earned in a SFC, the section 884 branch profits tax which deems a foreign corporation to have received a dividend from a U.S. branch, the section 475 and section 1256 mark-to-market regimes that deem a taxpayer to have sold securities at the end of each tax year, and section 877A which deems an expatriating U.S. citizen to have sold its assets on the date of expatriation.
A multitude of pro-taxpayer organizations have gotten behind the Moore’s case (including the U.S. Chamber of Commerce, the Cato Institute, the Southeastern Legal Foundation, and Americans for Tax Reform) and filed amicus curiae briefs in support of the Moore’s position. This case has garnered a great deal of support in part due to concerns that the Ninth Circuit’s dismissal of the relevance of the realization requirement could open the door to allowing Congress to impose a wealth tax on property holdings (e.g., Senator Wyden’s Billionaires ‘Income’ Tax).
The Moore’s case was initially heard by the Ninth Circuit, which some practitioners view as a liberal leaning court centered in California (although many justices were appointed during the Trump administration). In contrast, the U.S. Supreme Court may be more conservative following an ideological shift to the right in recent years. Thus, it is far from clear whether the U.S. Supreme Court will agree with the reasoning of the Ninth Circuit.
