The Challenge to the Section 965 Transition Tax: What a Supreme Court Ruling Could Mean for Taxpayers

The Supreme Court of the United States has agreed to review a challenge to the constitutionality of the Section 965 repatriation tax — a one-time mandatory “transition tax” on accumulated untaxed earnings of certain foreign corporations enacted by the 2017 Tax Cuts and Jobs Act (TCJA) and imposed on U.S. shareholders. The Court’s decision in Moore v. United States is not expected until sometime in 2024. However, taxpayers should take steps now to consider their Section 965 positions and assess whether pre-emptive actions should be taken in anticipation of a possible taxpayer-favorable Court ruling. Such actions could include filing protective claims for refund of the transition tax paid under Section 965. 

In 2005, Charles and Kathleen Moore invested in a controlled foreign corporation (CFC) — a foreign corporation whose ownership or voting rights are more than 50% owned by U.S. persons who each own at least 10%. In exchange, the Moores received 11% of the company’s equity. The company was profitable, but instead of distributing its earnings to shareholders, it reinvested the profits in the business. 

In 2017, the TCJA introduced new Internal Revenue Code Section 965, which required “U.S. shareholders” (broadly defined as U.S. persons who own 10% or more of the total combined voting power of a foreign corporation) to pay a one-time tax on the accumulated post-1986 untaxed foreign earnings of specified foreign corporations as if those earnings had been repatriated to the U.S. Taxpayers could pay the tax all in one year or elect to pay the over eight years. As a result of Section 965, the Moores — U.S. shareholders given their 11% stake in the CFC — incurred a transition tax liability on their pro rata share of the CFC’s undistributed earnings. The Moores paid the entire amount of their transition tax liability on their 2017 amended income tax return.

Implications of a Supreme Court Ruling

The question presented to the Court in Moore is whether the Section 965 mandatory transition tax is constitutional. The Moores argue that the tax is imposed on unrealized income, which is unconstitutional because income realization is a requirement under the 16th Amendment to the U.S. Constitution, and because long-standing jurisprudence requires that income be realized before it can be taxed. 

If the Moores prevail in Court, Section 965 will be invalidated, which could result in a variety of complex procedural considerations related to the ability of taxpayers to seek refunds of transition taxes they have paid (whether in a one-time payment or in installments if elected). For most calendar-year individual and corporate taxpayers, the year of the CFC income inclusion required by Section 965 was 2017 (2018 if the CFC had a fiscal year end). The statutes of limitations for filing refund claims for these years are closed for most taxpayers unless otherwise open due to audit or other procedural matters. The procedural considerations relate to the ability for taxpayers to rightfully make a claim of refund for tax that has already been remitted and collected.   

Under the general statute of limitations for refund claims — the later of three years of filing a tax return or two years from the date the tax was paid — taxpayers who paid the repatriation tax in 2017 (or 2018 in certain cases) when the tax would have been due normally would be precluded from filing a refund claim in 2024, when the Court’s decision is expected. However, certain exceptions to the general statute of limitations may potentially apply to some taxpayers – for example, taxpayers who elected to pay the tax in installments, taxpayers under examination who extended the statute of limitations, or where the tax was offset by net operating losses or foreign tax credits. It is unclear how the Court may address these procedural matters if they find in favor of the taxpayer.

Protective Refund Claims

In anticipation of a possible taxpayer-favorable ruling from the Court, taxpayers that reported a Section 965 income inclusion and have remitted transition tax payments should consider filing protective refund claims (whether the statute of limitations is currently open or not) for the income inclusion year as well as each subsequent year in which payments have been made. Careful consideration should be given to the disclosures made with respect to the claims.  

Filing such claims does not guarantee that the Internal Revenue Service will process a refund, even if the Court rules in favor of the taxpayer. However, due to the uncertainty surrounding how the Court may rule and any procedural aspects that the Court may address, taxpayers should consider this course of action. BDO can assist taxpayers with protective refund claims as well as determining their statute of limitations periods.

Additional Refund or Tax Attribute Situations

Taxpayers may have utilized tax attributes such as net operating losses and/or tax credits or carryovers (e.g., foreign tax credits and general business credits) to reduce their transition tax liability in whole or in part. If the Court rules in favor of the Moores, the potential exists for taxpayers to either: 

• File refund claims for carryover years in which such losses or credits could have been used but for the transition tax; or 
• Adjust the amount of the carryover prospectively if such attributes have not yet been utilized in a carryover period.  

As with any refund claim related to the Section 965 transition tax, these types of protective refund claims should be carefully considered.

Other Impacts of a Court Decision

If the Court rules in favor of the Moores and impacted taxpayers are able to obtain refunds of transition tax in whole or in part, a variety of complex tax issues could arise. For instance, tax attributes such as previously taxed earnings and profits (PTEP), tax basis, and characterization of earnings and profits could be impacted, thereby altering the tax treatment or characterization of transactions — including repatriation, restructuring, and M&A transactions — undertaken by taxpayers during the year of the Section 965 income inclusion and subsequent years. A discussion of the potential complexities is beyond the scope of this article but issues will continue to be assessed by BDO as this case is considered by the Court.  

Because of the potentially sweeping consequences of a taxpayer win, follow BDO’s coverage of the case for additional details and insights, and contact BDO for assistance.