Supreme Court Upholds Mandatory Repatriation Tax on CFC Owners

(Parker Tax Publishing July 2024)

The Supreme Court affirmed a decision by the Ninth Circuit and held that the Mandatory Repatriation Tax (MRT), which attributes the realized and undistributed income of an American controlled foreign corporation (CFC) 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. The Court concluded that under longstanding precedents, when dealing with an entity's undistributed income Congress may either tax the entity or tax its shareholders or partners and, whichever method Congress chooses, the tax remains a tax on income. Moore v. U.S., 2024 PTC 220 (S. Ct. 2024).

Background

In 2005, Charles Moore and his wife, Kathleen, paid $40,000 for an 11 percent interest in KisanKraft, a controlled foreign corporation (CFC). A CFC is a foreign corporation whose ownership or voting rights are more than 50 percent owned by U.S. persons. From 2006 to 2017, KisanKraft generated a great deal of income but did not distribute that income to its U.S. shareholders.

Before 2018, U.S. taxpayers generally did not pay U.S. taxes on foreign earnings until those earnings were distributed to them. However, when certain categories of undistributed earnings were repatriated to the U.S. - through a distribution or loan to U.S. shareholders, or an investment in U.S. property - U.S. shareholders who owned at least 10 percent of a CFC could be taxed on a proportionate share of those earnings. The primary method used to tax a CFC's U.S. shareholders on foreign earnings held offshore was a provision of the Code called subpart F.

The Tax Cuts and Jobs Act (TCJA), enacted in 2017, broadened the types of CFC income subject to subpart F to include current earnings and profits from a business. Before the TCJA, current earnings and profits from a CFC's trade or business were not considered subpart F income and, therefore, were not subject to U.S. tax until distributed to a U.S. taxpayer. Under the TCJA, Code Sec. 952 taxes such income even if not distributed. The TCJA also enacted a one-time Mandatory Repatriation Tax (MRT), a "transition tax" intended to ensure that a CFC's past earnings and profits did not permanently escape U.S. tax by virtue of the TCJA's changes to subpart F. The MRT applies to the undistributed earnings and profits that a CFC earned between January 1, 1987, and December 31, 2017. The tax is levied on a U.S. shareholder's ratable share of a CFC's undistributed earnings and profits during this period and treats the entire amount as subpart F income in 2017.

At the end of the 2017 tax year, application of the new MRT resulted in a tax bill of $14,729 on the Moores' pro rata share of the KisanKraft's accumulated income from 2006 to 2017. The Moores challenged the constitutionality of the MRT, claiming, among other things, that the MRT violated the Direct Tax Clause of the Constitution because, in their view, the MRT was an unapportioned direct tax on their shares of the CFC's stock. In Moore v. U.S., 2020 PTC 409 (W.D. Wash. 2020), a district court dismissed the action for failure to state a claim and denied the Moores' cross-motion for summary judgment. The Moores appealed to the Ninth Circuit.

Observation: The Direct Tax Clause of the Constitution provides: "No Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census or Enumeration herein before directed to be taken." The Constitution does not expressly identify any tax as direct other than a "Capitation." A "capitation" (also called a "poll tax") is "[a] fixed tax levied on each person within a jurisdiction."

In Moore v. U.S., 2022 PTC 166 (9th Cir. 2022), a unanimous Ninth Circuit panel affirmed the district court's dismissal. In Moore v. U.S., 2022 PTC 369 (9th Cir. 2022), a Ninth Circuit panel subsequently denied a petition for a panel rehearing and denied a petition for a rehearing en banc. Four judges dissented from the denial of an en banc rehearing, arguing that (1) the panel erred in disregarding the realization requirement of the Sixteenth Amendment by allowing an unapportioned direct tax on unrealized income (i.e., undistributed earnings of a foreign corporation owned by a U.S. taxpayer) without offering any other limiting principle, and (2) the opinion opens the door to new federal taxes on other types of wealth and property being categorized as an "income tax" without the constitutional requirement of apportionment.

The Moores appealed to the Supreme Court raising the Direct Tax Clause argument and the Court granted certiorari. The Moores argued that the MRT is a tax on property and is therefore unconstitutional because it is not apportioned. Income, the Moores contended, requires realization, and the MRT was not taxing any income that they had realized. In making their argument, the Moores invoked the decision in Eisner v. Macomber, 252 U.S. 189 (S. Ct. 1920), in which the Supreme Court held that a distribution by a corporation of additional stock to all existing shareholders was not taxable income because 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."

The government, on the other hand, cited longstanding precedents such as Burk-Waggoner Oil Assn v. Hopkins, 269 U.S 110 (S. Ct. 1925), Heiner v Mellon, 304 U.S. 271 (S. Ct. 1938), and Helvering v. National Grocery Co., 304 U.S. 282 (S. Ct. 1938) for the proposition that the MRT is a tax on income and therefore need not be apportioned.

Analysis

In a 7-2 decision, delivered by Justice Kavanaugh, the Supreme Court held that Congress did not exceed its constitutional authority when it enacted the MRT.

Observation: Justices Roberts, Sotomayor, Kagan, and Jackson joined in Kavanaugh's decision. Justice Jackson filed a concurring opinion and Justice Barrett filed an opinion concurring in the judgment, in which Justice Alito joined. Justice Thomas filed a dissenting opinion in which Justice Gorsuch joined.

The MRT, the Court said, attributes the undistributed income of American CFCs to their American shareholders, and then taxes the American shareholders on that income. By doing so, the court observed, the MRT operates in the same basic way as Congress's longstanding taxation of partnerships, S corporations, and subpart F income. Thus, the MRT is consistent with the principles that the Court has previously articulated in upholding those kinds of taxes and the MRT therefore falls squarely within Congress's constitutional authority to tax.

The Court rejected the Moores' argument that the MRT is an unconstitutional tax on property. The Court observed that the MRT does in fact tax realized income - namely, the income realized by the CFC, which the MRT attributes to the CFC shareholders. Longstanding precedents, the court stated, confirm that 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.

In the Court's view, the Moores' reliance on the Eisner decision was misplaced as that decision predated its decisions in cases such as Burk-Waggoner, Heiner, and Helvering. In Burk-Waggoner, the Court held that the status of a business entity under state law could not limit Congress's power to tax a partnership's income as it chose, taxing either the partnership or the partners. In Heiner, the Court reaffirmed that Congress may choose to tax either the partnership or the partners on a partnership's undistributed income, even where state law did not allow the partners to personally receive the income. In Helvering, the Court concluded that Heiner also applied to corporations. This line of precedents, the Court said, remains good law and establishes the clear principle that Congress can attribute the undistributed income of an entity to the entity's shareholders or partners and tax the shareholders or partners on their pro rata share of the entity's undistributed income.

In his dissenting opinion, Justice Thomas wrote that the Ninth Circuit wrongly rejected the Moores' challenge on the grounds that realization of income is not a constitutional requirement. According to Justice Thomas, the majority upheld the MRT by relying on unrelated precedent to derive a clear rule that Congress can attribute the undistributed income of an entity to the entity's shareholders or partners. The Ninth Circuit, he said, erred by concluding that realization is not a constitutional requirement for income taxes and said the majority's "attribution" doctrine is an unsupported invention.

Observation: Addressing the dissenting opinion, the majority said the dissent and the opinion concurring in the judgment were focusing primarily on the realization issue - namely, whether realization is required for an income tax. The majority noted that it was not deciding that question. The majority emphasized that its holding is limited to: (1) taxation of the shareholders of an entity, (2) on the undistributed income realized by the entity, (3) which has been attributed to the shareholders, (4) when the entity itself has not been taxed on that income. In other words, its holding applies when Congress treats the entity as a pass-through. Further, the majority noted that its decision does not address the distinct issues that would be raised by (1) an attempt by Congress to tax both the entity and the shareholders or partners on the entity's undistributed income; (2) taxes on holdings, wealth, or net worth; or (3) taxes on appreciation.

For a discussion of the taxation of U.S. shareholders in controlled foreign corporations, see Parker Tax ¶201,510.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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