Supreme Court upholds Section 965 in narrow Moore ruling

The Supreme Court upheld the one-time Mandatory Repatriation Tax (MRT) under Section 965 in a 7-2 decision released on June 20. The landmark ruling in Moore v. United States allows the MRT from the 2017 Tax Cuts and Jobs Act (TCJA) to stand, but sidesteps other tax questions, such as whether realization is a constitutional requirement of an income tax.

Justice Brett Kavanagh wrote the majority opinion of the Court, with Justices Clarence Thomas and Neil Gorsuch dissenting. Justices Amy Coney Barrett and Samuel Alito wrote a concurring opinion in judgment that goes farther on the question of taxing unrealized income. Justice Ketanji Brown Jackson wrote a concurring opinion, joining the majority opinion in full.

The decision was highly anticipated both because of its potential effect on proposals such as a “wealth tax,” and also because of the potential impact on other existing taxes on undistributed income, such as Subpart F, partnership tax, S corporation tax, and estate and trust taxes.

The majority opinion answered the specific question at hand relating to the MRT (and by implication several other existing taxes on undistributed income of pass-through entities), but left several open questions, including on proposed wealth taxes. It did so by focusing on the attribution of realized and undistributed income of a controlled foreign corporation (CFC) to the entity’s U.S. shareholders providing such income can be taxed at the shareholders’ level. The Court specifically emphasized that its holding was narrow and limited to:

“… (i) taxation of the shareholders of an entity, (ii) on the undistributed income realized by the entity, (iii) which has been attributed to the shareholders, (iv) when the entity itself has not been taxed on that income. In other words, our holding applies when Congress treats the entity as a pass-through.”

Background on Section 965

Prior to the TCJA, U.S. taxpayers could generally defer tax on income earned abroad through foreign corporations until it was repatriated, with an exception for certain highly mobile income which is taxed, since 1962, through the Subpart F rules of the Internal Revenue Code. These rules apply to certain U.S. shareholders who own 10% or more by vote or value (“U.S. Shareholders”) of a CFC, which is a foreign corporation owned 50% or more by U.S. Shareholders. Subpart F taxes these U.S. Shareholders currently on their pro rata share of Subpart F income earned by a CFC, regardless of whether the CFC actually distributes the income.

The TCJA created a dividend received deduction that effectively offsets CFC dividends from U.S. tax. As part of the transition to this new system, the TCJA amended Section 965 to impose a one-time transition tax on previously untaxed post-1986 foreign earnings and profits (E&P) of certain foreign corporations owned by a U.S. Shareholder. Section 965 deems those earnings to be repatriated, resulting in an income inclusion at reduced tax rates for the U.S. Shareholder of the foreign corporation. Foreign earnings considered held in the form of cash and cash equivalents were taxed at a 15.5% rate, and the remaining earnings were taxed at an 8% rate. The transition tax is applicable to U.S. Shareholders in specified foreign corporations (SFC). SFCs are defined to include all CFCs and all other foreign corporations (which are not passive foreign investment corporations) with at least one U.S. corporation that is a U.S. Shareholder.

The transition tax was imposed by using the Subpart F rules to require applicable U.S. Shareholders to include their pro rata share of post-1986 earnings and profits (E&P) in income to the extent such E&P has not been previously subject to U.S. tax. The E&P was measured as the greater amount at either Nov. 2, 2017, or Dec. 31, 2017. The inclusion in income was for the foreign subsidiary’s last taxable year beginning before 2018 and was determined without regard to certain dividends paid during the taxable year.

Relevant facts and procedural history

The constitutional challenge to the MRT in Moore was brought by Charles and Kathleen Moore, who in 2006 invested $40,000 into KisanKraft Machine Tools Pvt. Ltd. (KisanKraft), a CFC organized under the laws of India. For purposes of determining the MRT, the Moores were considered U.S. Shareholders of the CFC and computed an income inclusion amount under the Transition Tax of about $132,512, with a tax liability of $14,729 determined under Section 965.

Subsequent to paying the MRT, the Moores sued for a refund in the District Court, arguing that the MRT violated the Direct Tax Clause under Article I of the Constitution and the Due Process Clause of the Fifth Amendment. The District Court dismissed the case for failure to state a claim and the Ninth Circuit for the U.S. Court of Appeals affirmed this. The Ninth Circuit held that the pro rata share of the MRT allocated to the Moores for the earnings of KisanKraft was a constitutional tax on income, and the Ninth Circuit rejected the Due Process Clause claim.

On Feb. 21, 2023, a petition for a writ of certiorari was filed by the Moores. On June 26, 2023, the petition was granted. Read out about our prior coverage, here.

Analysis

The Court granted certiorari on the question of whether the 16th Amendment authorizes Congress to tax unrealized sums without apportionment among the states. Article I of the Constitution grants Congress the power to “lay and collect taxes” but provides that “direct Taxes shall be apportioned among the several States.” The 16th Amendment grants Congress the power to collect taxes “on incomes, from whatever sources derived” without apportionment among the states. If the Court had concluded that the MRT was considered a tax on unrealized gains, and such a tax was not allowed under the 16th Amendment, it could have been ruled unconstitutional because it was not apportioned among the states. Such finding could have had implications beyond Section 965 on many other longstanding tax regimes using similar frameworks, such as partnership taxation, S corporation taxation, and Subpart F. 

The Moores attempted to distinguish between the MRT and other taxes that have long been imposed by Congress, and upheld by the courts, based on the fact that they did not have control to distribute earnings, a doctrine they termed “constructive realization.” Justice Kavanaugh wrote in the majority opinion that “the term seems to be a one-off label woven out of whole cloth by the Moores to allow them to sidestep any existing tax, especially Subpart F, that does not accord with their proposed constitutional rule.” The Court commented that the Moores’ effort to “thread that needle, although inventive, is unavailing.” In connecting the MRT and subpart F, the majority opinion notes that “the MRT is integrated into Subpart F’s framework, and it has the same essential features as Subpart F. If Subpart F is not unconstitutional under the ‘constructive realization’ theory — and the Moores explicitly concede that it is not … then the MRT is likewise not unconstitutional on that theory.”

Ultimately, the Court ruled that the MRT is not a tax on unrealized income, but is instead a tax on undistributed income. The majority opinion explained that both the Court’s longstanding precedents and Congress’ longstanding practices confirm that Congress may tax either the entity or its shareholders or partners on the entity’s undistributed income. The Court has held that such tax remains a tax on income, which, as an indirect tax, does not need to be apportioned under the 16th Amendment. 

Importantly, the majority opinion does not address the question of whether realization is required for an income tax. Justices Barrett and Alito wrote a concurring opinion arguing that income must be realized to be taxed. They found that while the Moores did not realize income as shareholders, KisanKraft had realized income as a corporation. They pointed out that the Court’s precedent suggests that Congress’ power to attribute a corporation’s income to its shareholders for tax purposes is limited. Given the similarity between Subpart F and the MRT in attributing corporate income to shareholders and the Moores’ concession that Subpart F is constitutional, the concurring opinion concluded the Moores had not met their burden to show they were entitled to a refund. Justice Thomas’ dissenting opinion took a stronger stance on the realization requirement, stating that because the Moores never actually received any of their investment gains, those unrealized gains could not be taxed as “income” under the 16th Amendment.

Potential implications

While the Supreme Court’s decision in Moore confirms that the MRT enacted under the TCJA is a constitutional tax, the Court reiterated that its holding is narrow and limited to entities treated as pass-throughs. The majority opinion explicitly expressed the following limitations: