Will IRC Section 965, the Repatriation of Foreign Earnings, Be Overturned?

On December 5, 2023, oral arguments were heard in the Moore¹ case considering the constitutionality of the mandatory repatriation tax (MRT) imposed by Internal Revenue Code Section 965. Enacted under the Tax Cuts and Jobs Act in 2017, Section 965 requires a one-time tax on U.S shareholders owning 10% or more of a controlled foreign corporation (CFC). All accumulated post-1986 deferred foreign income of the CFC was classified as taxable income in 2017, requiring shareholders to include their pro-rata share as taxable income in 2017.

The taxpayers were small stakeholders in an Indian CFC. (See Ryan’s previously released article.) They never received a distribution from the CFC and are claiming that Section 965 acts as a wealth tax on unrealized income. The Moore’s are challenging the law, contending that the tax violates the Sixteenth Amendment of the Constitution. The Constitution only permits the federal government to tax income. The Sixteenth Amendment states that “Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.” The plaintiffs argue that Section 965 should be seen as a tax on property, not income. The position depends on what the term “realization of income” means under the Sixteenth Amendment. The petitioner argues that “derived” implies a level of realization, under a common meaning interpretation despite the fact that the Sixteenth Amendment does not specifically require it.

Once the petitioner had presented its case, the first question asked (by Justice Thomas) involved the definition of “realization.” The petitioner had argued that the taxpayers should not be taxed on income they had not realized, but acknowledged that the corporation had realized the income, not the shareholders. Upon further questioning, plaintiffs’ counsel differentiated the MRT from the tax on Subpart F income (a tax on the current earnings of a CFC) by the fact that tax on Subpart F income does not look backwards, as the MRT does. The MRT is taxing shareholders on income earned at a time they may not have been shareholders.

The concept of realization was repeatedly addressed, citing treatment in Eisner v. Macomber², which held that income is not realized unless it “is available for actual distribution.” The court made clear in Eisner that a taxpayer does not receive income simply because his property or investments increase in value, whereas the MRT taxes property that shareholders own in 2017, rather than income. The petitioner discusses constructive realization, which the government says is a fabricated term.

The petitioner is seeking an affirmation of the implied definition in the Sixteenth Amendment, requiring realization of income to allow taxation. The government proposes that the MRT is constitutional because the corporation realized the income, and this is analogous to other passthrough applications.

Petitioners stake their case on Macomber, but the government position is “that the Court has limited Macomber to taxes on particular stock dividends that are not at issue here. If the Court now extended Macomber’s discussion to invalidate all taxes on undistributed business earnings, it would cause a sea change in the operation of the Tax Code and cost several trillions of dollars in lost tax revenue.” A floodgate of challenges to other applications and valuation methods, including passthrough taxation of entities, mark-to-market valuation, and accrual accounting methods would be opened.

The outcome of this case will be particularly interesting to watch, as Senator Ron Wyden (D-OR) has introduced a bill entitled “The Billionaires Income Tax Act.” The Act had been introduced in earlier Congresses and did not pass. The Act would apply to taxpayers with $1 billion in assets or more than $100 million in income for three consecutive years. The Act would impose a tax on annual gains and losses in the taxpayer’s stock portfolio—a deferred recapture charge on the sale or transfer of other appreciable assets, which would be similar to an interest charge on deferred gains.

Much of the questioning by both the liberal and conservative justices centered around the term “realization” of income. It would appear the Court is hesitant in defining this term. The Court seems to be leaning towards a narrow interpretation of whether Section 965 violates the Sixteenth Amendment so as not to “open the door to taxation of practically everything.”

Regardless of the outcome, many states taxed the Section 965 income, and continue to tax foreign source income without proper factor representation. Ryan’s experts have developed many unique statutory positions to relieve taxpayers of this unwarranted burden. Please contact the individuals listed below for assistance in reducing the state income tax impact of the taxation of foreign income.

¹ Moore v. U.S., No. 22-800.

² 40 S. Ct. 189.

TECHNICAL INFORMATION CONTACTS:

Greg Rottjakob
Principal
Ryan
314.721.1300
greg.rottjakob@ryan.com

Violet Goodheart
Director
Ryan
972.934.0022
violet.goodheart@ryan.com

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