U.S. Supreme Court Upholds Section 965 Transition Tax

In a 7-2 decision, the U.S. Supreme Court on June 20 upheld as constitutional the Internal Revenue Code Section 965 transition tax, also known as the mandatory repatriation tax (MRT) enacted as part of the Tax Cuts and Jobs Act of 2017 (TCJA), while leaving open the question of the constitutionality of wealth taxes, which have been a Biden administration tax policy focus.

Justice Brett Kavanaugh, writing for the majority in Moore v. United States, rejected the challenge to the MRT on narrow grounds, holding that the Court did not need to decide the broader question of whether Congress has the constitutional authority to tax unrealized gains, because the Moores’ share in the undistributed earnings of the foreign company of which they were shareholders should be treated as realized income of the corporation.

Justice Kavanaugh was joined by Chief Justice John Roberts, Justice Sonia Sotomayor, Justice Elena Kagan, and Justice Ketanji Brown Jackson. Justice Jackson wrote an opinion concurring in full, while Justice Amy Coney Barrett wrote an opinion concurring in judgment, with Justice Samuel Alito joining in Barrett’s opinion. Justice Clarence Thomas wrote a dissenting opinion, in which Justice Neil Gorsuch joined.

Background

In 2005, Charles and Kathleen Moore invested $40,000 in an Indian 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 those profits in the business.

In 2017, the TCJA introduced Section 965¹, which requires 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 transition 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 may elect to pay the one-time tax over eight years.

As a result of the new tax provision, the Moores -- U.S. shareholders given their 11% stake in the Indian company -- incurred a nearly $15,000 tax liability on their pro rata share of the CFC’s $508,000 in undistributed earnings.

Court Challenges

The Moores challenged the repatriation tax, arguing that it did not meet the requirements of the 16th Amendment to the U.S. Constitution, which states that “Congress shall have the power to lay and collect taxes on incomes, from whatever sourced derived, without apportionment among the several States, and without regard to any census or enumeration.” Specifically, the Moores argued that long-standing jurisprudence requires that income be “realized” before it can be taxed.

The U.S. District Court for the Western District of Washington disagreed and granted the government’s motion to dismiss. The Ninth Circuit affirmed the district court’s decision, stating that “Whether a taxpayer has realized income does not determine whether a tax is constitutional,” and held that the tax constituted “income, from whatever source derived” under the 16th Amendment.

The Court granted certiorari on June 26, 2023, and oral arguments took place on December 5, 2023. 

Supreme Court Ruling

The question in Moore is whether the MRT of Section 965 exceeds Congress’s constitutional authority. After a review of Congress’s taxing power under the Constitution, Kavanaugh and the concurring justices concluded that it does not.

Article I of the Constitution grants Congress broad “power to lay and collect taxes, duties, imposts and excises.” That power is exercised by imposing two categories of taxes—direct taxes and indirect taxes. Direct taxes are those taxes imposed on persons or property. As a practical matter, Congress has rarely enacted direct taxes because the Constitution requires that direct taxes be apportioned equally among the states. In fact, Kavanaugh pointed out, the parties cited no apportioned direct taxes in the current Internal Revenue Code.

By contrast, indirect taxes are imposed on activities or transactions, and include duties, imposts, and excise taxes, as well as income taxes. Because income taxes are indirect taxes, they are permitted under Article I, §8 of the Constitution without apportionment. The 16th Amendment, ratified in 1913, expressly confirmed that taxes on income—including taxes on income from property—are indirect taxes that need not be apportioned.

The government argued that the MRT is a tax on income and therefore need not be apportioned. Conversely, the Moores contended that the MRT is a tax on property, rather than a tax on income, and that the tax is therefore unconstitutional because it is not apportioned. The Moores further argued that income requires realization, and that the MRT did not tax any income that they had realized.

Kavanaugh dismissed this line of argument, stating “Critically, however, the [repatriation tax] does tax realized income—namely, income realized by the corporation. . .. The [repatriation tax] attributes the income of the corporation to the shareholders, and then taxes the shareholders (including the Moores) on their share of that undistributed corporate income.”

To support his conclusion, Kavanaugh reviewed Court decisions going back to 1925, including Helvering v. National Grocery, in which the Court held that Congress may tax shareholders of a corporation on the corporation’s undistributed income. Thus, Kavanaugh writes, “by 1938, this Court’s precedents had established a clear rule that directly contradicts the Moores’ argument in this case. That line of precedent remains good law to this day.”

Kavanaugh drew an analogy between the MRT and Subpart F, which has been repeatedly upheld by the courts. Similarly, he said, the taxation of partnerships and S corporations has long been accepted by the courts.

The Moores conceded that partnership and S corporation taxation, as well as Subpart F, are constitutional income taxes that do not need to be apportioned. However, they argued, the MRT is different from those provisions, because:

• Partners can be taxed on a partnership’s income only because, at the time the 16th Amendment was ratified, partnerships were not seen as legal entities separate from the partners. 
• In the case of S corporations, shareholders’ choice to become an S corporation necessarily means that the S corporation’s income is truly the shareholders’ income.
• The doctrine of “constructive realization.”
   

The Court readily dismissed all three arguments, noting that the Moores’ position that the repatriation tax could be distinguished from taxes on partnerships, S corporations, and Subpart F income, taken to its logical conclusion, “could render vast swaths of the Internal Revenue Code unconstitutional.” However, Kavanaugh concluded, “the Constitution does not require that fiscal calamity.”

Implications

The Moore case had attracted attention because of its potential implications for the introduction of a U.S. wealth tax, a possibility that has been floated by some officials. While the Moore decision rejects the notion that the MRT is unconstitutional because it taxes unrealized income, it also leaves the question of whether wealth taxes are constitutional unresolved. In fact, the opinion includes a footnote stating that “our analysis today does not address … taxes on holdings, wealth, or net worth.”

In affirming the judgment of the U. S. Court of Appeals for the Ninth Circuit, Kavanaugh concluded: “The Moores argue that realization is a constitutional requirement; the Government argues that it is not. To decide this case, we need not resolve that disagreement over realization.”

Justice Thomas, dissenting from the majority, wrote that “income” in the context of the 16th Amendment includes only income realized by the taxpayer. “Because the Moores never actually received any of their investment gains, those unrealized gains could not be taxed as ‘income’ under the Sixteenth Amendment,” he wrote.

¹ The original Section 965 was a one-time provision with special tax rates on specified repatriation from CFCs enacted with the American Jobs Creation Act of 2004. Congress utilized Section 965 again with the MRT enactment as part of the TCJA.