The U.S. Supreme Court will consider the constitutionality of Internal Revenue Code Section 965, which mandated the repatriation tax on previously untaxed income from controlled foreign corporations (CFC).
Section 965 Background
Section 965 is a relatively new addition to the Internal Revenue Code and was enacted as part of the 2017 Tax Cuts and Jobs Act. This section requires United States shareholders to bring into income and pay a one-time transition tax on the untaxed foreign earnings of certain specified foreign corporations as if those earnings had been repatriated to the United States.
The 8% and/or 15.5% effective tax rates applicable to the income inclusions are the result of an applicable participation deduction. Furthermore, a reduced foreign tax credit applies to the inclusion under Section 965(g) and taxpayers could have elected to pay the transition tax in installments over an eight-year period. The Section 965 repatriation tax was projected to generate approximately $340 billion in tax revenue.
Before the enactment of Section 965, U.S. shareholders were generally taxed on the earnings and profits of CFC in two scenarios: if the earnings qualified as Subpart F income OR the earnings were distributed as dividends. Essentially, these were very rare circumstances since shareholders could plan around Subpart F earnings and avoid distributions. The U.S. government claimed that more than $2.6 trillion of offshore earnings had escaped U.S. tax.
The Case
Charles and Kathleen Moore, the petitioners, own a 13% stake in an India corporation, KisanKraft Machine Tools Private Limited. This corporation supplies affordable equipment to farmers in impoverished regions of India and their initial investment made in 2005 was $40,000.
KisanKraft earned profits each year and reinvested all earnings to grow the business, while no funds or other payments/dividends were made to the petitioners. The Moores learned that under Section 965 they would be subject to tax on their share of the reinvested earnings at a 15.5% tax rate, resulting in a tax bill of $14,729. The Moores paid the tax due and then sued for a refund.
In its simplest form, the Moores’ basis for the refund suit is that the Section 965 repatriation tax is unconstitutional. Specifically, the Moores argue that the Sixteenth Amendment does not authorize Congress to tax unrealized sums without apportionment among the states. So, the question at issue is: does income have to be realized to be taxed?
The District Court disagreed with the petitioners’ assertion and granted the government’s motion to dismiss holding that the Section 965 transition tax falls within Congress’ power under the Sixteenth Amendment. On appeal, the U.S. Court of Appeals for the Nineth Circuit affirmed, noting that “realization of income is NOT a constitutional requirement” (with emphasis added).
A Bit of History: The Sixteenth Amendment
The official text of the Sixteenth Amendment states, “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”
This amendment was significant when it was ratified as it reversed the 1895 Supreme Court decision of Pollock that made a nationwide income tax effectively impossible by invoking a distinction between direct and indirect taxes. At the time, the Sixteenth Amendment was considered a new income tax law and set in motion the federal tax statutes we live by (and sometimes love) today.
Where Do Things Stand?
The Moores’ petition was filed in February and the government’s response was followed in May. Numerous amicus briefs were filed in the intervening months supporting both sides of the argument. The Supreme Court Granted cert on June 26th and arguments have not yet been scheduled. The ruling in this case will be impactful and far-reaching as there are already numerous provisions of the IRC that apply to unrealized gains that haven’t been challenged: Subpart F, global intangible low-taxed income, passive foreign investment company mark-to-market elections, just to name a few!
Is this a slippery slope that would see numerous IRC sections topple and proposed taxes, namely Biden’s Green Book proposal for a tax on unrealized capital gains, fizzle before even taking off? We’ll have to wait and see.
The International Tax Team at Wolf & Company will continue to monitor the news releases in this space, and will provide updates as arguments are heard and this case progresses. Do you think that you may have missed complying with the Section 965 transition tax and want to discuss your options to come into compliance? Wolf’s International Tax Team is here to assist you.
