Tax

On June 20, 2024, the Supreme Court issued its opinion in Moore v. United States, ruling 7-2 that the Tax Cuts and Jobs Act’s (the “TCJA”) mandatory repatriation tax (“MRT”) under Section 965 of the Internal Revenue Code¹ does not violate the Direct Tax Clause of the Constitution. Congress enacted the MRT as part of the TCJA’s shift to a more territorial tax system. The MRT required U.S. shareholders owning 10 percent (by vote or value) of a “controlled foreign corporation” as defined under Section 951 of the Code (a “CFC”), to pay a one-time transition tax in a deemed repatriation of realized but undistributed income of the CFC. Such income had, until the enactment of the MRT, enjoyed deferred taxation in the hands of the CFC’s U.S. shareholders.

Key Takeaways:

• In plain terms, the decision reaffirms the principle that Congress can attribute a foreign corporation’s income to its U.S. shareholders and tax them accordingly (even if the earnings relating to the income have not been distributed).
• In the ruling, the Justices found that the MRT operates in a way that does not require the Supreme Court to weigh whether the Constitution’s Sixteenth Amendment prohibits Congress from taxing unrealized income. In doing so, the Supreme Court sidestepped the contentious issue as to whether “realization is required for an income tax.” Specifically, the Court ruled that the MRT taxes income that was realized by foreign corporations with U.S. shareholders, and Congress has the authority to attribute certain realized but undistributed income of certain companies to its shareholders for taxation.
• The Court’s ruling, however, is narrow and is limited to entities treated as “pass-throughs.” In this respect, the Court notes that nothing in their opinion should be read to authorize any hypothetical congressional effort to tax both an entity and its shareholders (or partners) on the same undistributed income of the entity, nor does the decision attempt to resolve the parties’ disagreement over whether realization is a constitutional requirement for an income tax.

Ruling Breakdown:

Background

The Moores challenged the MRT after they were assessed with a nearly $15,000 tax bill for 2017 as a result of the law, which required them to pay the MRT based on the undistributed earnings allocable to them from an India-based CFC called KisanKraft. The Moores paid the tax and then sued for a refund, claiming, among other things, that the MRT violated the Direct Tax Clause of the Constitution² because the MRT was an unapportioned direct tax on their shares of KisanKraft stock. The District Court dismissed the suit, and the Ninth Circuit affirmed.

(1) Taxes on Income v. Taxes on Property

Ruling: The MRT does tax realized income – income realized by the corporation, KisanKraft.

The Moores claimed the MRT is a direct tax on property — in this case, shares in a foreign corporation — that violates the Constitution’s apportionment clause, which requires direct taxes to be apportioned in proportion to each state’s population. While the Sixteenth Amendment exempts income taxes from this apportionment requirement, the Moores claimed that their unrealized gains shouldn’t be classified as income. Income, the Moores argued, requires realization, and the MRT does not tax any income that they have realized. The Government argued that the MRT is a tax on income and, therefore, needs not be apportioned and that the MRT does tax realized income—namely, the income realized by KisanKraft, which the MRT attributes to its shareholders.

• Weil Tax Observation: Notably, the Supreme Court notes in its analysis that the ruling does not address the distinct issues that would be raised by (i) an attempt by Congress to tax both the entity and the shareholders or partners on the entity’s undistributed income; (ii) taxes on holdings, wealth, or net worth; or (iii) taxes on appreciation. The Supreme Court makes a concerted effort to cite the Government’s brief, which explains that a hypothetical unapportioned wealth tax “could of course raise different issues” (emphasis added). The Government’s brief also distinguishes an income tax from a tax on wealth or net worth because an income tax targets economic gain ‘between two points of time”. The Supreme Court notes that the constitutionality of a hypothetical unapportioned tax on appreciation may depend on, among other things, whether realization is a constitutional requirement for an income tax.

In its opinion, the Court notes that its longstanding precedents plainly establish that, when dealing with an entity’s undistributed income, Congress may either tax the entity or tax its shareholders or partners. Whichever method Congress chooses, the Supreme Court has held that the tax remains a tax on income. Citing Burk-Waggoner Oil Assn. v. Hopkins, 269 U. S. 110, Burnet v. Leininger, 285 U. S. 136, Heiner v. Mellon, 304 U. S. 271, and Helvering v. National Grocery Co., 304 U. S. 282, the Court notes that the aforementioned line of precedents remain good law and establish the clear principle that Congress can attribute the undistributed income of an entity to such entity’s shareholders or partners and tax the shareholders or partners on their pro rata share of the entity’s undistributed income and notes that the principle has repeatedly been invoked by the lower courts in upholding subpart F.

The Court found that Moores’ reliance on Eisner v. Macomber, 252 U. S. 189, which predates the Heiner and Helvering line of cases, was misplaced. In Macomber, the question was whether a prorata distribution of additional common stock to all existing common shareholders was taxable income. The Court said such a distribution is not taxable income because income requires realization.  The Court further explained that there was no change in the value of the shareholders’ total stock holdings in the corporation before and after the stock distribution. The Court said separately in dicta that “what is called the stockholder’s share in the accumulated profits of the company is capital, not income.” 252 U. S., at 219. The Moores interpreted that language to mean that a tax attributing an entity’s undistributed income to its shareholders or partners is not an income tax. The Court in its opinion noted that the clear and definitive holdings in Burk-Waggoner Oil, Heiner, and Helvering render the Moores’ reading of Macomber implausible. The Supreme Court noted that those cases squarely addressed and allowed attribution, whereas Macomber did not address attribution.

• Weil Tax Observation: Justice Jackson in her concurrence notes that Macomber’s assertion that income requires realization has been so thoroughly caveated and criticized by subsequent case law that this assertion is all but relegated to the issue of stock dividends, and the case is not fundamental to the meaning of what is income for the purposes of the 16th Amendment. Though the Court opinion does not go as far as Justice Jackson in her concurrence, the Court’s approach of distinguishing the case only serves to further limit the reach on the greater body of income tax law. For purposes of substantiating the constitutionality of a hypothetical wealth tax, some commentators have proposed viewing Macomber as a case turning on the absence of economic gain as opposed to realization. That is, under Macomber, Congress can tax—and can only tax—an object or transaction that is constitutive of an actual accretion to wealth (Compare, Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 429 (1955); Helvering v. Bruun, 309 U.S. 461, 464 (1940)).

(2) Attribution

Ruling: Congress may attribute an entity’s realized and undistributed income to the entity’s shareholders or partners and then tax the shareholders or partners on their portions of that income.

Instead of arguing that partnership taxes, S-corporation taxes, and subpart F taxes are all unconstitutional (and that all of the Supreme Court’s precedent regarding such taxes should be overruled), the Moores tried to distinguish the MRT from the other taxes and argued that that only the MRT is unconstitutional, conceding that partnership taxes, S-corporation taxes, and subpart F taxes are income taxes that are constitutional and need not be apportioned. The Moores sought to differentiate the MRT from the other taxes by noting that (1) taxes on partnerships are distinguishable from the MRT and not controlled by precedent because partnerships are not separate entities from their partners, (2) taxes on S-corporations are distinguishable from the MRT because shareholders choose to be taxed directly on the corporation’s income, and (3) the pre-TCJA aspects of subpart F are distinguishable from the MRT because subpart F applies the “doctrine of constructive realization” –  which, by targeting specific events, like a foreign corporation’s earning of investment income while being controlled by a small number of domestic shareholders – allows the pre-TCJA portion of subpart F to satisfy the constructive realization requirement.

The Court found that the Moores failed to sufficiently distinguish the MRT from the other taxing regimes. Specifically, in response to the Moores’ attempt to distinguish:

• (1) partnership tax from the MRT, the Court noted that when the Sixteenth Amendment was ratified, the courts, Congress, and state legislatures treated partnerships as separate entities in many contexts, and numerous states imposed taxes directly on partnerships for partnership income, so the federal and state treatment of partnerships as separate legal entities for tax purposes contravenes the Moores’ theory,
• (2) S-corporation tax from the MRT, the Court noted that consent cannot explain Congress’s authority to tax the shareholders of S-corporations directly on corporate income. Rather, S-corporations are another example of Congress’s authority to either tax the corporation itself on corporate income or attribute the undistributed income to the shareholders and tax the shareholders, and
• (3) the pre-TCJA aspects of subpart F tax from the MRT, the Court noted that the level of control with the MRT (at least 10 percent) is the same as under the longstanding subpart F tax principles (and, thus, if the Moores concede that subpart F is not unconstitutional under the “constructive realization” theory, then the MRT is likewise not unconstitutional on that theory).
• Weil Tax Observation: According to the Moores, although the “constructive realization” doctrine will support a wide range of congressional impositions of income tax without a “sale of other disposition of property,” it will not do so when the effect of a provision is to tax a person on income the economic accrual “of which occurred before that person owned the income-producing property.” There are, however, two problems with that position:
  • (I) Not so distinguished from Section 951. According to the Moores, the MRT is invalid because the MRT simply attributes a foreign corporation’s retained earnings going back to whoever owned its shares in 2017, irrespective of any realization event, whereas the older provisions (in particular, Section 951) attribute to current shareholders only current-year earnings. However, under Section 951, U.S. shareholders of a CFC must include in their gross income their pro rata share of the CFC’s current-year subpart F income, if they owned stock of the CFC on the last day of the CFC’s tax year. That inclusion is required even if the shareholder did not acquire the stock until December 31, in which case 364/365 of the inclusion is of income earned by the CFC before that U.S. shareholder became a shareholder (subject to a reduction for any actual dividend from a CFC to the prior shareholder during the year under Section 951(a)(2)(B)). Thus, subpart F routinely taxes an end-of-year shareholder on the stock’s pro rata share for the entire year, regardless of how small of fraction of the year the shareholder actually owned the shares, which is precisely the feature of the MRT that the Moores sought to distinguish from the general subpart F regime (which the Moores conceded was constitutional). The Moores’ attempted distinction thus fails; had the Court considered the issue described above, it would have likely concluded that the difference between taxing several decades’ worth of pre-ownership CFC income (MRT) and taxing 364 days’ worth of pre-ownership CFC income under Section 951 would not be one constitutional significance.
  •  (II) Phellis. According to the Moores, the MRT is unconstitutional because it taxes U.S. shareholders of a CFC on CFC income predating their ownership. That is inconsistent with the Supreme Court’s holding in United States v. Phellis, 257 U.S. 156, 171-172 (1921). It is not surprising that the Supreme Court did not cite Phellis, given the narrow scope of the ruling, although the Moores did not attempt to distinguish their facts from those of Phellis. In Phellis, the Supreme Court refuted Phellis’ argument that the dividend Phellis received was not taxable as income to him, noting that Phellis acquired, as a part of the valuable rights purchased, the prospect of a dividend from the accumulations, which he necessarily took subject to the burden of the income tax proper to be assessed against him by reason of the dividend if and when made. The Court noted that “[Phellis] simply stepped into the shoes, in this as in other respects, of the shareholder whose shares he acquired.”  Thus, the Phellis ‘step-in-the-shoes’ logic – as described by some commentators – could similarly be applied to justify the MRT in Moore. Indeed, under longstanding income tax principles, a distribution made to a shareholder out of a corporation’s accumulated earnings and profits may be treated as a taxable dividend, even if the distribution did not constitute economic income to a specific shareholder because the shareholder had purchased the stock after the E&P had been generated, so that in an economic sense for that shareholder, the distribution was a return of capital rather than income. Had the Court considered the issue of realization, and agreed with the Moores , it would call into question as to whether the longstanding subchapter C regime for the taxation of corporate distributions would be rendered unconstitutional in significant part.

The Court noted that the upshot is that the Moores’ argument, taken to its logical conclusion, could render vast swaths of the Internal Revenue Code unconstitutional. And those tax provisions, if suddenly eliminated, would deprive the U. S. Government and the American people of trillions in lost tax revenue. The logical implications of the Moores’ theory would therefore require Congress to either drastically cut critical national programs or significantly increase taxes on the remaining sources available to it— including, of course, on ordinary Americans. The Constitution, the Court notes, does not require that fiscal calamity.

Concurrences and Dissent

Jackson Concurrence. Justice Jackson wrote a solo concurring opinion. She rejects the notion that the Sixteenth Amendment allows taxation only of realized gains but cautions that the Supreme Court should take limited roles in such cases.

• Weil Tax Observation: That said, the logical extension of the position taken in Justice Jackson’s concurrence (rejecting the notion that the Sixteenth Amendment allows taxation only of realized gains) could, in her view, open the door to a federal tax on wealth.

Barrett Concurrence. Justice Barrett, joined by Justice Alito, concurred in the judgment. Despite her agreement with the Court’s bottom line, Barrett’s opinion has much more in common with Thomas’s dissent. Unlike Justice Jackson, Barrett concludes that it is “straightforward” that the Sixteenth Amendment does not authorize Congress to tax unrealized sums. She disagrees with the Court’s reasons for saying that the income realized by a foreign corporation can be attributed to its shareholders, but she finds that the Moores, having “barely addressed” the attribution question, “have not met their burden” of showing that the income at issue here cannot be attributed to them.

Thomas Dissent. Justice Thomas, joined by Justice Gorsuch, in his dissent, stresses that realization is a constitutional requirement for income taxes, and he calls the Court’s “clear rule” on attribution an “invention” and a “mirage.” He concludes that the MRT does not operate as a tax on income.

Moore to Come and a (Potentially) Not so Bright Future

With Moore providing stability, Loper Bright Enterprises v. Raimondo looms in the Supreme Court, which poses a significantly broader challenge to the stability of administrative law writ large—by no means excluding tax regulations. The pending Loper Bright case challenges the scope and validity of so-called Chevron Deference—a principle of administrative law first articulated in Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., which holds that courts should defer to an administrative agency’s reasonable interpretation of an ambiguous statute. A Supreme Court overruling or limiting Chevron Deference could have massive implications for tax law—with some portions of tax law, such as transfer pricing, potentially being entirely gutted. The Internal Revenue Service and Treasury, like all other agencies, rely on assumed deference to interpret complex and ambiguous tax statutes. If the challenge to Chevron Deference were successful, courts may no longer defer to IRS interpretations, and we may see a major uptick in challenges to tax regulations.