Ninth Circuit Rejects En Banc Rehearing of Mandatory Repatriation Tax Case

(Parker Tax Publishing December 2022)

A Ninth Circuit panel denied a petition for a rehearing, as well as a petition for an en banc rehearing, in a case in which a unanimous Ninth Circuit panel affirmed a district court's dismissal of an action seeking to invalidate the Mandatory Repatriation Tax. Four Circuit Court judges dissented, arguing that the Ninth Circuit's opinion disregards the realization requirement of the Sixteenth Amendment by allowing an unapportioned direct tax on unrealized income without offering any other limiting principle and positing that the decision 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. Moore v. U.S., 2022 PTC 369 (9th Cir. 2022).

Background

In 2005, Charles Moore and his wife, Kathleen, invested $40,000 for an 11 percent interest in 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. Traditionally, U.S. taxpayers generally did not pay U.S. taxes on foreign earnings until those earnings were distributed to them. However, when particular 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.

In 2017, Congress passed, and the President signed into law, the Tax Cuts and Jobs Act (TCJA). TCJA broadened the types of CFC income subject to subpart F to include current earnings and profits from a business. Prior to the TCJA, current earnings and profits from a CFC's trade or business were not considered subpart F income and, therefore, not subject to U.S. tax until distributed to a U.S. taxpayer. Under the TCJA, beginning on January 1, 2018, 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 by treating the entire amount as subpart F income in 2017.

The Moores challenged the constitutionality of subpart F's ability to permit taxation of a CFC's income after 1986 through the MRT. 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.

In Moore v. U.S., 2022 PTC 166 (9th Cir. 2022), a unanimous Ninth Circuit panel affirmed the district court's dismissal. The panel first held that, given the background of the government's power to lay and collect taxes, the MRT is consistent with the Apportionment Clause. That clause requires that a direct tax must be apportioned so that each state pays in proportion to its population. The panel acknowledged that the Sixteenth Amendment exempts from the apportionment requirement the category of "incomes, from whatever source derived." The panel observed that (1) courts have consistently upheld the constitutionality of taxes similar to the MRT notwithstanding any difficulty in defining income, (2) the realization of income does not determine the tax's constitutionality, and (3) there is no constitutional ban on Congress disregarding the corporate form to facilitate taxation of shareholders' income. The panel explained that subpart F only applies to U.S. persons owning at least 10 percent of a CFC and the MRT builds upon a preexisting liability attributing a CFC's income to its shareholders and taxpayers continue to be treated as individuals who have some ability to control distributions.

The panel also held that, assuming without deciding that the MRT is retroactive, the MRT does not violate the Fifth Amendment's Due Process Clause. The panel explained that the MRT serves the legitimate purpose of preventing CFC shareholders who have not yet received distributions from obtaining a windfall by never having to pay taxes on their offshore earnings that have not yet been distributed. According to the panel, the MRT accomplishes this legitimate purpose by rational means: by accelerating the effective repatriation date of undistributed CFC earnings to a date following passage of the TCJA.

The full Ninth Circuit was subsequently advised that the Moores had filed a Petition for Rehearing En Banc. A judge requested a vote on whether to rehear the matter en banc, and the matter failed to receive a majority of the votes of the nonrecused active judges. Thus, the Moores' Petition for Rehearing En Banc was denied.

Dissenting Opinions

Four Ninth Circuit judges (Judges Bumatay, Ikuta, Callahan, and Vandyke) dissented from the denial of an en banc rehearing for the Moores. The judges noted that under the original constitutional design, Congress could only levy direct taxes if such taxes were apportioned among the states in proportion to the Census. Thus, at the Founding, for a direct tax to be constitutional, the federal government had to collect the proceeds proportionally (i.e., if one state had twice the population of another, it also had to contribute twice as much). However, this system was changed in 1913 when the Sixteenth Amendment was ratified, providing a limited exception to the apportionment requirement, and giving Congress the limited authority to "lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States." As a result, the judges said, Congress may enact a direct tax on "incomes" - and only on "incomes" - without apportioning the tax. The Sixteenth Amendment, the judges observed, thus struck a delicate balance for federal taxing power - freeing Congress from the unwieldy requirement of apportionment, but only for taxes on "incomes." Nothing in the Sixteenth Amendment, the judges argued, relieved Congress of its duty to apportion other forms of direct taxation, such as a tax on property interests.

According to the dissenting judges, the Ninth Circuit is upsetting the balance reached by the people by becoming the first court in the country to state that an "income tax" doesn't require that a "taxpayer has realized income" under the Sixteenth Amendment. Instead, the judges said, the Ninth Circuit's decision concludes that the Sixteenth Amendment authorizes an unapportioned tax on unrealized gains because, as it says in the opinion, the "realization of income is not a constitutional requirement." As a result, the dissenting judges argued, the court is affirming the constitutionality of a federal tax on the share of undistributed earnings of a foreign corporation owned by a U.S. taxpayer - despite (in this case) the U.S. taxpayer being a minority shareholder of the foreign corporation. In other words, the judges said, the court is allowing a direct tax on the ownership interest of a taxpayer - even when the taxpayer has yet to receive any economic gain from the interest and has no ability to direct distribution of gain from the interest.

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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