Why Supreme Court Should Allow Repatriation Tax To Stand

April 8, 2024Law360 Expert Analysis

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A tax case currently before the U.S. Supreme Court has generated not only discussion, but also a good deal of nervousness among tax practitioners. Charles G. Moore v. U.S. involves the mandatory repatriation tax, enacted in 2017, which requires all taxpayers with undistributed profits from a controlled foreign corporation to pay a one-time tax on the undistributed profits.

Taxpayers Charles and Kathleen Moore paid about $15,000 in additional tax on undistributed profits of such a corporation. They brought suit against the U.S. for a refund of the tax, claiming the tax was unconstitutional as a violation of both the apportionment clause of Article 1 and the due process clause of the 15th Amendment to the U.S. Constitution.

Their suit was soundly rejected by the U.S. District Court for the Western District of Washington and the U.S. Court of Appeals for the Ninth Circuit, from which they appealed. The briefs have all been filed, and oral argument was held before the Supreme Court last December. A decision is expected in late spring or early summer.

If the court accepts the Moores' arguments, it could wreak havoc on our system of taxation and result in a catastrophic loss of revenue for the government.

The basic facts are as follows: In 2006, the Moores invested $40,000 in KisanKraft, an Indian company that supplies tools to small farmers. The company was run by Charles' friend and former co-worker, Ravindra "Ravi" Kumar Agrawal, who managed its day-to-day operations. Over time, KisanKraft reinvested its profits back into the company, meaning the Moores never received a distribution.

The Moores claim that they did not participate in the management of the business, although KisanKraft's corporate filings in India show that Charles Moore was listed as a director of KisanKraft from April 2012 through March 2017. The corporate records showed that Charles Moore also made several other contributions to the company, in addition to the Moores' initial $40,000 investment, and sold shares in 2019 for almost $300,000.

Under the Internal Revenue Code, KisanKraft is a controlled foreign corporation, meaning it is a foreign corporation in which U.S. shareholders own at least 50% of the stock. Until passage of the mandatory repatriation tax, a controlled foreign corporation's income was largely untaxed unless and until it came into the U.S., typically by a distribution to its shareholders — although 10% of the shareholders of controlled foreign corporations have always been subject to tax on their pro rata share of corporate income as computed under Subpart F of the IRC.

Since the Moores never received a distribution, they argue that their share of KisanKraft's income should not be subject to U.S. tax.

In 2017, Congress enacted the Tax Cuts and Jobs Act, which created the one-time mandatory repatriation tax, imposed on U.S. shareholders who own 10% or more of a foreign corporation. The tax was imposed on a taxpayer's accumulated post-1986 income, regardless of whether the taxpayer received a distribution. Essentially, this was a tax on the unrealized gain of an appreciated asset.

In effect, due to the Moores' 13% shareholder interest in KisanKraft, they were taxed as if KisanKraft had paid them a 2017 dividend worth 13% of KisanKraft's earnings retroactively to 2006. Even though that 2017 dividend was fictional, their tax bill was real — at approximately $15,000. The Moores paid the tax and subsequently challenged the law.

Under Article 1 of the Constitution, Congress can impose direct taxes, provided they are apportioned among the states in proportion to their populations. However, this became nearly impossible, particularly if the government wished to impose a progressive tax scheme. In 1909, Congress ratified the 16th Amendment to exempt "incomes, from whatever source derived" from the apportionment requirement.

The courts have struggled to define what constitutes income, ultimately confounding what can be subjected to income tax. The Supreme Court further refined the 16th Amendment in cases such as Eisner v. Macomber, which in 1920 implied, but did not hold, that for income to be taxed it must be "realized."

Questions over what defines "realized income" have not been resolved, but the U.S. tax system has predominately adapted to the realization principle that says income is taxed upon the taxpayer's receipt of a payment, or the proceeds of an asset sale or other disposition.

The Moores' claims should be rejected. As an income tax, the U.S. already taxes the Subpart F income attributable to U.S. taxpayers who hold at least 10% of a controlled foreign corporation; but income is narrowly defined in Subpart F.

As Justice Elena Kagan pointed out during oral arguments, the U.S. has a long history of taxing American shareholders on their income and gains from foreign corporations to prevent such shareholders from stashing money overseas tax-free, which serves a significant public purpose.[1]

The Moores' position that realization of income is required is misguided. In fact, realization is not necessarily required. Partners in partnerships, S corporation shareholders and members of limited liability companies frequently pay tax on income they have not received. No one argues that receipt by the entity is insufficient to income tax liability.

Indeed, Justice John Roberts, like the Ninth Circuit,[2] noted during oral arguments that the income was in fact received by KisanKraft. Congress' decision to attribute the income to U.S. controlling shareholders who would have been in a good position to force a distribution is not unconstitutional.

The Moores posit that, because they realized nothing from the corporation, the mandatory repatriation tax is actually a wealth tax on property, not an income tax. Even if true, this does not help their argument.

A one-time wealth tax is not an unusual phenomenon in U.S. tax law, although it is rarely described as such. For example, the imposition of the federal estate tax predates the income tax and is, in essence, a one-time tax on the wealth of certain individuals over and above whatever exemption is in place at the time of death.

The federal estate tax is not challenged here, and has its constitutional basis as an excise tax on the privilege of transferring property to one's heirs. Similarly, the federal gift tax is an excise tax on the transfer of property by gift. Arguably, even if it were a so-called wealth tax, the mandatory repatriation tax could easily be recharacterized as an excise tax on the privilege of doing business overseas.

The Moores have also attacked the mandatory repatriation tax as a retroactive tax in violation of due process. This assumes, however, that the Moores never anticipated that their income or gains from KisanKraft would be subject to tax, even though they would eventually be subject to tax if the corporation made a distribution or a loan to them. The mandatory repatriation tax merely accelerates the tax, which in and of itself is not fatal.

From an estate planning perspective, if the Moores do not prevail and the one-time repatriation tax is made permanent and recurring, practitioners will have to reconsider how they plan for assets with significant unrealized capital gains. Currently, a taxpayer can defer a tax on capital gains until the asset is realized or sold.

If held until the owner's death, the asset gets an automatic step-up in basis equal to the value of the asset on the decedent's date of death. The decedent's estate is then potentially subject to estate tax, but the underlying capital gains are never actually subject to tax. One tax is traded for the other. This benefit is often considered when crafting an estate plan for a person with low-basis assets.

But each time the mandatory repatriation tax is imposed — so far only once — the shareholders pay tax on any gain and get a step-up in basis. With the repatriation tax, the Moores are paying the equivalent of a capital gains tax, but if the Moores still hold the asset on their deaths, their heirs will also have to account for the asset for estate tax purposes and pay any estate tax due. Both taxes will have been due and payable.

The decision in the Moores' case has implications for the national tax regime If the Supreme Court requires receipt of the income to necessitate the tax, the taxation of pass-through entities will be in disarray.

In addition, the government's ability to prevent U.S. taxpayers from stashing money overseas will be compromised, severely damaging its ability to tax such interests. It appears that the court may be looking for a narrow ruling, based, for example, on the fact that KisanKraft really did receive the income taxed, thus satisfying any alleged realization requirement.

[1] Howe, Amy, "Oral argument suggests narrow ruling to uphold disputed tax", SCOTUSblog (Dec. 6, 2023).

[2] Ibid. Moore v. U.S., 36 F.4th 930 (9th Cir. 2022).