Although it was passed into law in 2017, the Tax Cuts and Jobs Act (TCJA) will soon be put to a new test. That is, the U.S. Supreme Court will hear the case of Moore v. United States. It involves a married couple who owned shares in a controlled foreign corporation (CFC) and are suing the federal government for a tax refund on the grounds a tax created by the TCJA is unconstitutional under the 16th Amendment of the U.S. Constitution.

Pro Rata Share

Dubbed the mandatory repatriation tax (MRT), also referred to as “the transition tax,” Internal Revenue Code Section 965 was established under the TCJA. It applies to U.S. taxpayers with 10% or more shares of a CFCs as of Dec. 31, 2017. The one-time tax was designed to make such taxpayers pay their pro rata share of the CFC’s retained earnings (15.5% on cash and other liquid assets and 8% on nonliquid assets). This was supposed to be the cost of transitioning to a new, more territoriality tax system for U.S. corporations that owned CFCs. It has not really changed the system of taxation for individuals who own CFCs, as they are only very much aware.

In the case in question, the taxpayers owned a 13% stake in a foreign company, KisanKraft Machine Tools Private Limited, which provides equipment to rural Indian farmers. Thus, they were subject to the MRT.

The taxpayers initially invested in the company in 2006. KisanKraft thereafter reinvested profits into its business operations rather than distributing dividends to shareholders. However, because the MRT targets “the untaxed foreign earnings of certain specified foreign corporations as if those earnings had been repatriated to the United States,” as described by the IRS, the taxpayers paid an additional $15,000 on top of their 2017 tax liability. This amount was based on their pro rata share of KisanKraft’s retained earnings of $508,000. They then sued for a refund.

Appellate Court Decision

The question before the Supreme Court is whether the MRT violates the 16th Amendment as a tax on unrealized income. The taxpayers suffered losses in the U.S. District Court for the Western District of Washington and the U.S. Court of Appeals for the Ninth Circuit. The latter held that the MRT does not violate the Apportionment Clause of the U.S. Constitution, nor the Fifth Amendment’s Due Process Clause.

“Whether the taxpayer has realized income does not determine whether a tax is constitutional. Further, there is no blanket constitutional ban on Congress disregarding the corporate form to facilitate taxation of shareholders’ income. In other words, there is no constitutional prohibition against Congress attributing a corporation’s income pro-rata to its shareholders,” said the Ninth Circuit in its June 7, 2022, majority opinion authored by Judge Ronald Gould.

Ninth Circuit Judge Patrick Bumatay dissented from the court’s denial of the taxpayers’ request for rehearing. He wrote, “Without the guardrails of a realization component, the federal government has unfettered latitude to redefine ‘income’ and redraw the boundaries of its power to tax without apportionment.”

Two Sides to the Story

In a petition filed on Feb. 21, 2023, the taxpayers sought review before the Supreme Court. They argued neither lower court explained how KisanKraft’s retained earnings were the couple’s income, calling the decisions broadly declared. The petition, penned by the taxpayers’ legal representatives, went on to say the Ninth Circuit’s opinion:

• Creates a rift with past decisions of other circuits.
• Eviscerates the 16th Amendment’s apportionment requirement.
• Raises an exceptionally important question about Congress’ power to tax unrealized income without apportionment.

In the government’s response, which was filed on May 16, Solicitor General Elizabeth Prelogar, Deputy Assistant Attorney General David Hubbert and three U.S. attorneys countered “no other court of appeals has even considered the MRT’s constitutionality. And because the MRT is a one-time tax applicable only to pre-2018 income, the case lacks pressing prospective importance.”

The government added the MRT shares common features with several other income taxes, such as those relating to Sec. 877A, Sec. 1256, Sec. 475 and other areas of the tax code.

Support for the Petitioners

Eight amicus briefs were filed on March 27, 2023, by various policy and trade organizations, all in support of the petitioners. One filing by the U.S. Chamber of Commerce contended the Ninth Circuit’s holding harms businesses and the economy by introducing uncertainty into tax planning.

“First, uncertainty simply costs businesses money, as they are forced to hire lawyers and accountants to navigate the uncertainty, a deadweight loss to the nation’s economy,” reads the Chamber’s brief. “Businesses’ necessary and predictable responses to tax uncertainty benefit no one in the long run. Consumers are affirmatively harmed, as they have to pay twice — suffering the generalized depressive effect of deadweight loss on the economy while also paying more for goods and services.”

Action Required?

As of this writing, the Supreme Court’s decision in the case is pending. However, it could have a marked impact on the federal government’s ability to tax unrealized gains as income.

Due to the fact actual transition tax is being paid over an eight-year period, there is also an issue about when the statute of limitation applies. Many taxpayers started paying this liability with the filing of their 2017 tax returns. How does the normal three-year statute of limitations apply in this case? When should a possible protective claim be filed, and on what basis? These are all issues that should be explored.

If you would like to undertake an exploration trip with a Moore Doeren Mayhew advisor on these issues, contact us today.