The U.S. Supreme Court granted a married couple’s petition for certiorari challenging the constitutionality of the Sec. 965 repatriation tax (also known as the “transition tax”) enacted in 2017 by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. The petition appeals a 2022 decision by the Ninth Circuit in the government’s favor. The case is slated to be heard during the Court’s 2023–2024 term. A summary of the Ninth Circuit’s opinion follows.
Facts: In 2005, Charles and Kathleen Moore invested $40,000 in KisanKraft, a controlled foreign corporation (CFC) based in India, and received an 11% interest in the company’s common shares. The company was run by Charles’s friend and former co-worker, Ravindra “Ravi” Kumar Agrawal, to provide modern tools to small, underserved Indian farms. Agrawal owned roughly 80% of KisanKraft and managed its day-to-day operations. The Moores did not participate in the operations or management of the business, receiving only status updates and annual financial statements.
Formed to help empower rural farmers in India, KisanKraft turned a profit from inception and experienced year-over-year revenue growth. True to the company’s corporate mission, all earnings were reinvested in the company and never distributed to KisanKraft’s shareholders. By 2017, KisanKraft employed over 350 representatives in 14 regional offices serving 2,500 local dealers.
Because KisanKraft was a CFC (a foreign entity, the ownership or voting rights of which are owned more than 50% by U.S. persons), none of the company’s undistributed active business earnings were taxable to their U.S. shareholders, including the Moores, prior to the TCJA. By 2015, CFCs overall had accumulated an estimated $2.6 trillion in earnings in offshore accounts. Although undistributed active business earnings generally remained untaxed, a proportionate share of certain undistributed foreign earnings, such as dividends, interest, and earnings invested in certain U.S. property, could be taxed under Subpart F of the Code if a U.S. person owned at least 10% of the CFC’s voting stock.
The TCJA moved the U.S. corporate tax system from this “worldwide” system toward a territorial system. In doing so, it created the transition tax, under which U.S. persons owning at least 10% of a CFC are taxed on the CFC’s post-1986 profits at either 15.5% for earnings held in cash or 8% otherwise (Sec. 965(c)). The transition tax applies whether the earnings are distributed or not. Untaxed earnings repatriated as dividends to U.S. shareholders subject to the transition tax are generally not taxed (Sec. 245A(a)). The transition tax effectively eliminated other taxes on any undistributed earnings prior to 2018 by classifying post-1986 CFC earnings as taxable income in 2017. In total, the tax is forecast to generate an estimated $340 billion in additional government revenue.
After conferring with their accountant, the Moores learned the transition tax increased their tax liability by approximately $15,000. They challenged the constitutionality of the new tax by filing suit in district court. The district court granted the government’s motion to dismiss for failure to state a claim and denied the Moores’ cross-motion for summary judgment (Moore, No. C19-1539-JCC (W.D. Wash. 11/19/20)). On appeal to the Ninth Circuit, the Moores claimed the transition tax violated both the Apportionment Clause and — because the tax was applied retroactively — the Fifth Amendment’s Due Process Clause.
Issues: One of the enumerated powers granted Congress is the power to “lay and collect taxes” (U.S. Const. art. 1, §8, cl. 1). The Apportionment Clause, which traditionally applied only to capitations and land taxes, further provides that any “direct tax” must be apportioned so that each state pays in proportion to its population (U.S. Const. art. 1, §9, cl. 4; National Federation of Independent Business v. Sebelius, 567 U.S. 519 (2012)). However, the Sixteenth Amendment exempts from this apportionment requirement the expansive category of “incomes, from whatever source derived” (see U.S. Const., amend. XVI).
The concept of income is a “flexible one,” a nod to the complexity of defining everything that constitutes income (James, 333 F.2d 748 (9th Cir. 1964)). Nonetheless, the Ninth Circuit observed that income taxes similar to the transition tax have repeatedly been held constitutional (see, e.g., Estate of Whitlock, 59 T.C. 490 (1972), aff’d in part, rev’d in part, 494 F.2d 1297 (10th Cir. 1974); Garlock Inc., 489 F.2d 197 (2d Cir. 1973)). Whether a taxpayer has realized income, the court explained, does not determine whether a tax is constitutional. The rule that income is not taxable until realized is based on the principle of “administrative convenience” and is not a constitutional requirement (Helvering v. Horst, 311 U.S. 112, 116 (1940)).
What constitutes taxable gain, according to the Ninth Circuit, is also broadly interpreted. For example, an increase in wealth on the cancellation of indebtedness is taxable gain where the taxpayer received something of value in exchange for the indebtedness (Vukasovich, Inc., 790 F.2d 1409 (9th Cir. 1986)). Moreover, the court found no blanket constitutional ban against attributing a corporation’s income pro rata to its shareholders (Dougherty, 60 T.C. 917 (1973)).
Citing Eisner v. Macomber, 252 U.S. 189 (1920), and Glenshaw Glass Co., 348 U.S. 426 (1955), the Moores argued that the transition tax is an unapportioned direct tax and not a tax on income because income must be realized before it can be taxable. They urged the court to apply the definition of income used in Glenshaw Glass: (1) an undeniable accession to wealth, (2) clearly realized, (3) over which taxpayers have complete dominion.
However, the Ninth Circuit found the Moores’ argument unpersuasive. The definition of income offered in Macomber is not universal, as it provides only what “income may be defined as” (emphasis added). The Ninth Circuit noted that the Supreme Court in Glenshaw Glass emphasized the narrow scope of this definition, stating it was not intended to be a “touchstone to all future gross income questions.” It also found that the Supreme Court in Glenshaw Glass had qualified its own definition by suggesting it was focused on the specific facts before it and noting that realization was not even at issue in that case, explaining why the Court referred to it only in passing (Glenshaw Glass Co., 348 U.S. at 428–29). Furthermore, the Ninth Circuit stated that it has not adopted the definition favored by the Moores (see James, 333 F.2d at 752; see also Fender Sales, Inc., 338 F.2d 924 (9th Cir. 1964)).
The Ninth Circuit also pointed out that the constitutionality of many other provisions of the Code would be called into question if it determined that Subpart F was unconstitutional under the Apportionment Clause (see, generally, Ackerman, “Taxation and the Constitution,” 99 Colum. L. Rev. 1, 52 (1999)).
As for the transition tax’s purported violation of the Fifth Amendment’s Due Process Clause, the Ninth Circuit noted that, despite a presumption against retroactive laws, retroactive tax legislation is often constitutional (see, e.g., Carlton, 512 U.S. 26 (1994)). To pass constitutional muster, the retroactive application must serve “a legitimate purpose by rational means” (Quarty, 170 F.3d 961 (9th Cir. 1999)).
Applying the Carlton test, the Ninth Circuit stated that if the transition tax did not tax undistributed foreign earnings, then CFC shareholders would have received a windfall, as the tax eliminated other taxes on a CFC’s undistributed earnings before 2018. By creating a single date of repatriation, the law creates a rational administrative remedy. Also, though it was long in this instance, the length of a tax’s retroactive period is often only one of several nondispositive considerations (see, e.g., GPX International Tire Corp., 780 F.3d 1136 (Fed. Cir. 2015)). Though the Moores expected the tax to remain deferred, the court, citing Carlton, 512 U.S. at 33, stated that their “reliance alone is insufficient to establish a constitutional violation. Tax legislation is not a promise, and a taxpayer has no vested right in the Internal Revenue Code.”
Moreover, the court also found the transition tax is not a “wholly new tax” (a label applied to unconstitutional retroactive taxes in early cases) because, prior to enactment of the TCJA, U.S. shareholders were generally taxed on CFC earnings once distributed. Therefore, the Moores, as 11% shareholders, had reason to believe their pro rata share of the corporation’s income would eventually be taxed, especially since their earnings were already subject to certain taxes under pre-transition tax rules that applied to shareholders who owned at least 10% of a CFC, regardless of whether earnings were distributed.
Holding: The Ninth Circuit, in affirming the district court’s decision, held that the transition tax does not offend the Apportionment Clause because it is not an unapportioned direct tax; rather, it is a tax on income allowable by the Sixteenth Amendment. Furthermore, because the tax’s retroactive application served a legitimate purpose by rational means, it did not violate the Fifth Amendment’s Due Process Clause.
The Ninth Circuit denied a petition for rehearing on Nov. 22, 2022. The Supreme Court granted the Moores’ petition for a writ of certiorari in June 2023.
■ Moore, U.S. No. 22-800 (6/26/23) (cert. granted); Moore, 36 F.4th 930 (9th Cir. 2022)
— John McKinley is a professor of the practice in accounting and taxation in the SC Johnson College of Business at Cornell University in Ithaca, N.Y.; Adam Vars is a recent graduate of the SC Johnson College of Business at Cornell University; and Luke Richardson is an associate professor of instruction and Kerkering Barberio fellow in accounting and taxation in the Muma College of Business at the University of South Florida in Tampa, Fla. To comment on this column, contact Paul Bonner, the JofA’s tax editor.