Supreme Court Rules Tax On Previously Untaxed Foreign Profits Is Constitutional

A 2017 Tax Cuts and Jobs Act provision that requires companies to pay tax on previously untaxed foreign profits had the potential to shake up the tax world. But, in a closely watched case, a divided Supreme Court ruled that the mandatory repatriation tax (MRT)—which attributes the income of an American-controlled foreign corporation to the entity's American shareholders and then taxes the American shareholders on their portions of that income—does not exceed Congress's constitutional authority.

Facts

The petitioners, Charles and Kathleen Moore, own a 13% stake in an Indian corporation, KisanKraft Machine Tools Private Limited.

In 2018, the Moores learned that they were subject to a mandatory repatriation tax, or MRT, under the 2017 tax reform law (sometimes referred to as the Tax Cuts and Jobs Act, or TCJA). They had never paid tax on their earnings because previous tax law allowed income earned abroad to remain deferred until it was repatriated—they had never claimed their earnings. Under the new law, the Moores were subject to tax going back to their original investment at a 15.5% tax rate—netting them a tax bill of $14,729.

The Moores paid the tax and sued for a refund, claiming the tax was unconstitutional.

(You can read more about the facts of the case and the MRT in my previous article here.)

Question in Moore

The official question before the Court was: Whether the Sixteenth Amendment authorizes Congress to tax unrealized sums without apportionment among the states.

Mandatory Repatriation Tax

Before 1962, U.S. shareholders of foreign corporations (CFCs) were generally taxed on the earnings of those corporations only if the earnings were distributed to them as dividends. The result was an incentive to keep money offshore. The law changed to require U.S. shareholders owning 10% or more of CFCs to report and pay tax on their pro rata share of income, even if the company's earnings were not distributed. Despite this provision, the government claims that by 2015, CFCs had accumulated more than $2.6 trillion in offshore earnings that had not been subjected to U.S. tax.

To stop that practice, Congress passed the 2017 tax law, which did two things: (1) made clear that when certain foreign corporations, including CFCs, distribute their earnings as dividends to U.S. corporate shareholders, those earnings are generally no longer taxed and (2) included a one-time MRT so that the previously deferred income didn't escape from ever being taxed.

The result was a one-time tax targeting U.S. shareholders who own 10% or more of foreign corporations primarily owned or controlled by U.S. persons. Under the new law, shareholders had to account for deemed income in proportion to their ownership interest back to 1986. It was a revenue-raiser intended to partially fund the shifting of U.S. corporate taxation from a worldwide system toward a territorial one where U.S. corporations are taxed only on their domestic-source income. According to the government, in 2018, U.S. multinational enterprises distributed approximately $777 billion to U.S. shareholders—the MRT is projected to generate approximately $340 billion in tax revenue.

Oral Arguments

The petitioners were represented at oral argument by Andrew Grossman. Grossman serves as BakerHostetler's Appellate and Major Motions team co-leader, while the government was represented by Solicitor General Elizabeth Barchas Prelogar.

(You can read a deep dive into the oral arguments here.)

Decision

During oral arguments, both sides raised several arguments based on existing case law, particularly Eisner v. Macomber. The Court found that the Moores' reliance on Macomber was misplaced. There, the question was whether a distribution of additional stock to all existing shareholders was taxable income. In that case, the answer was no, with the Court finding 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 (an observation made by a judge in an opinion that is not necessary to resolve the case) that "what is called the stockholder's share in the accumulated profits of the company is capital, not income."

The Moores interpret that language to mean that a tax attributing an entity's undistributed income to its shareholders or partners is not an income tax. The Supreme Court found, however, that the "clear and definitive holdings in Burk-Waggoner Oil, Heiner, and Helvering render the Moores' reading of Eisner [Macomber] implausible."

(Notably, the opinion, concurring opinion, and dissent all focus on the case law presented.)

The Moores argued that taxes on partnerships are distinguishable from the MRT and not controlled by precedent because partnerships are not separate entities from their partners. But that assertion, the Court also found, is incorrect—writing that the federal and state treatment of partnerships as separate legal entities for tax purposes runs contrary to the Moores' theory.

The Moores also argued that taxes on S corporations are distinguishable from the MRT because shareholders of S corporations choose to be taxed directly on corporation income. But consent, the Court explained, doesn't explain Congress's authority to tax the shareholders of S corporations directly on corporate income.

Finally, the Moores attempted to distinguish Congress's history of taxing shareholders of closely held foreign corporations—including through subpart F (Controlled Foreign Corporations)—on the ground that those laws apply "the doctrine of constructive realization." That term, the Court said, noting that the Moores did not point to any use of the phrase in Supreme Court case law or the tax code, appeared to be "a one-off label created by the Moores to allow them to sidestep any existing tax that does not comport with their proposed constitutional rule."

Most tax practitioners assumed that the holding would be narrow—and it is. The Court specifically wrote that "the holding is narrow and limited to entities treated as pass-throughs." The Court added, "Nothing in this 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 realized by the entity."

And, as expected, the Court also found that the decision did not attempt to resolve the disagreement over whether realization is a constitutional requirement for an income tax. (That's clearly a nod towards the proposed wealth tax.)

With that in mind, the opinion examined the distinction between direct and indirect taxes. The Constitution requires that direct taxes be apportioned among the States imposed "in Proportion to the Census of Enumeration." In other words, direct taxes must be apportioned among the States according to each State's population. Notably, in Moore, the parties didn't include any apportioned direct taxes in the tax code, and Kavanaugh writes that it "appears that Congress has not enacted an apportioned tax since the Civil War."

In contrast, indirect taxes are imposed on activities or transactions. That includes duties, imposts, excise taxes, and income taxes. Under the Constitution, those taxes must be uniform throughout the United States.

The government argued that the MRT is an income tax and doesn't need to be apportioned. The Moores, however, argued that it is a property tax and is unconstitutional because it is not apportioned.

The Moores argue that income requires realization, which occurs when gains come into the taxpayer's coffers—for example, through wages, sales, or dividends, as distinct from appreciation in the value of a home, stock investment, or other property. And the Moores contend that the MRT does not tax any income they have realized.

The Court says the MRT does tax realized income—income realized by the corporation. The MRT attributes the income of the corporation to the shareholders, and then taxes the shareholders on the undistributed corporate income.

So, the Court found, "the precise and narrow question in Moore" is whether 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. The answer, the Court found, is yes.

As noted in the oral arguments, the Moores explicitly concede that pass-through taxes, including those on partnerships, S corporations, and subpart F, are constitutional and need not be apportioned. And, the Court found, the Moores did not ask the Court to overrule any precedents addressed in the arguments—instead, they sought to differentiate the MRT from all those taxes. The Court found "the Moores' effort to thread that needle, although inventive, is unavailing."

And, finally, the Court addressed the issue that was a real worry for tax practitioners—that the number of tax provisions that would be impacted "would deprive the U. S. Government and the American people of trillions in lost tax revenue." The Constitution, the majority wrote, "does not require that fiscal calamity."

Notably, the Court found that to decide Moore, they "need not resolve that disagreement over realization." Instead, the majority found, “[t]hose are potential issues for another day, and we do not address or resolve any of those issues here." Instead, the Court found merely that Congress has long taxed shareholders of an entity on the entity's undistributed income, and it did the same with the MRT. That, the majority declared, was permissible under the Constitution.

In her concurrence, Justice Jackson wrote separately "to emphasize that, before taking up petitioners' invitation to strike down a lawfully enacted tax, the Court would need to be persuaded of several additional arguments that we wisely do not reach." She went on to highlight two: a realization requirement and confirmation that the MRT was a direct tax before requiring apportionment.

Nodding to the existing (and potentially unresolved issues), she wrote, "I have no doubt that future Congresses will pass, and future Presidents will sign, taxes that outrage one group or another—taxes that strike some as demanding too much, others as asking too little. There may even be impositions that, as a matter of policy, all can agree are wrongheaded." However, she said, Pollock teaches us that this Court's role in such disputes should be limited.

In his dissent, Thomas argued that the text and history of the Sixteenth Amendment "make clear that it requires a distinction between 'income' and the 'source' from which that income is 'derived.'" And, he writes, "the only way to draw such a distinction is with a realization requirement." The dissent believes that the Moores never actually received any of their investment gains, and therefore, the unrealized gains could not be taxed as "income" under the Sixteenth Amendment. Seven Justices disagreed.

More Info

The case is Moore v. United States.

Justice Kavanaugh delivered the Court's opinion, which Chief Justice Roberts and Justices Sotomayor, Kagan, and Jackson joined.

Justice Jackson filed a concurring opinion, as did Justice Barrett (joined by Justice Alito).

Justice Thomas filed a dissenting opinion (joined by Justice Gorsuch).

You can read the decision in its entirety here.

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