On June 26, 2023, the US Supreme Court granted a petition for a writ of certiorari in Moore v. United States to determine whether section 965, the transition tax, is constitutional under the Sixteenth Amendment to the US Constitution. Specifically, the Court will determine whether the realization of income is a constitutional requirement for Congress to impose a tax. The US Court of Appeals for the Ninth Circuit held that there is no such requirement.
The taxpayers, Mr. and Mrs. Moore, made an investment in 2006 in an India-based corporation formed to assist rural farmers. Through this investment, the Moores received about 13 percent of the company’s common shares, but never received a distribution, dividends, or any other payment from the company. The company had reinvested all its earnings to grow the business in India.
Under section 965, the Moores were taxed for the portion of the company’s reinvested 2006-2017 earnings proportional to their 13% ownership, even though the company had never distributed any earnings to its shareholders. The Moores paid an additional $14,729 in tax for 2017.
The Moores filed a refund action in the Western District of Washington, arguing that section 965 violated the Sixteenth Amendment because it imposed an unapportioned direct tax, rather than an income tax. The Moores also argued, in the alternative, that section 965 violated the Fifth Amendment’s Due Process Clause because it was a retroactive application of a new tax. The district court ruled against the Moores. The Ninth Circuit affirmed the district court. The Ninth Circuit noted that courts have held other provisions of Subpart F to be constitutional over the years. The Moores argued that under the Supreme Court’s decisions in Eisner v. Macomber, 252 U.S. 189 (1920) and Commissioner v. Glenshaw Glass, 348 U.S. 426 (1955), income has to be realized to be taxed. The Ninth Circuit held that these decisions did not provide a “universal definition of income.” The Ninth Circuit also rejected the Moores’ Due Process Clause arguments. The Moores subsequently petitioned the US Supreme Court to review the Ninth Circuit’s decision, relying solely on the Sixteenth Amendment argument.
What Happens Next
Now that the Supreme Court has granted review, the parties will provide the Court additional briefs on the issue, followed by oral argument before the Court later this year. We would expect the Supreme Court to issue its opinion by June 2024.
If the Court holds section 965 unconstitutional, it is possible that the decision would be limited to individual US shareholders. Individual shareholders were treated worse than corporate US shareholders under section 965 (no foreign tax credits) and related provisions of the 2017 Tax Cuts and Jobs Act such as GILTI (higher tax rate, no foreign tax credits) and the 100% dividends received deduction under section 245A (only available to corporate shareholders). However, some of the bite to individuals in respect of foreign tax credits and GILTI could be somewhat ameliorated by, for example, having the individual make a section 962 election to be subject to tax at corporate tax rates. A broadly-worded decision in favor of the Moores could conceivably apply to US corporate shareholders, as well as to individual shareholders.
There also has been speculation that an opinion striking down section 965 could put other US income tax provisions at risk for similar arguments, including, for example, Subpart F income, GILTI, sections 817A and 1256 (mark-to-market), section 877A (expatriation tax), and section 884 (branch profits tax).
What Taxpayers Can Do Now
While we wait for the Supreme Court to decide the issue, taxpayers should review their statute of limitations for years in which they paid the section 965 tax to determine if they need to file a protective refund claim, and consider whether to repatriate any remaining earnings and profits (E&P) that have been “previously taxed” under section 965.
Protective Refund Claims
Although section 965(k) provides the IRS an additional six years to assess any taxes owed, section 6511 governs related refund claims. Section 6511(a) provides that refund claims must be filed within three years of filing the tax return, or two years of paying the tax, whichever is later. Where a taxpayer has extended the statute of limitations under section 6501(c)(4), section 6511(c) provides for additional time upon which to file a refund claim. Specifically, section 6511(c)(1) provides for an additional six months after the expiration of the extended statute of limitations for a taxpayer to file a refund claim.
Taxpayers should review when their statutes of limitation closes for years 2017 through 2022 to assess whether they need to file a protective refund claim for each year the section 965 tax was paid. Protective claims are filed as placeholders to protect the statute of limitations when the refund is contingent on outcome of a pending case, which is not likely to be resolved until after the statute expires. If the statute of limitations will remain open through June 2024, a protective claim does not need to be filed before the Supreme Court decides Moore, although taxpayers may still want to consider doing so. If the statute of limitations has already closed, taxpayers should determine whether they are still in the window to file a protective claim. If the statute of limitations may close before June 2024, taxpayers should determine whether they should file a protective claim in order to protect their interests.
Potential Traps and Opportunities
If the Supreme Court were to find section 965 to be unconstitutional, individuals—and possibly corporations—would be entitled to refunds of section 965 taxes. However, there are potential traps here, as well as possible opportunities.
Individual taxpayers face potential traps if section 965 is overturned. Individuals may have paid dividends out of section 965 earnings and treated them as tax-free previously taxed E&P under section 959. At least theoretically, such dividends could have instead been subject to a 37% tax, instead of the lower section 965 tax rates. Presumably, Congress, IRS, or Department of the Treasury would grant appropriate relief in such circumstances.
Corporate taxpayers, on the other hand, may have an opportunity to receive dividends of post-1986, pre-2018 earnings and be entitled to the section 245A 100% dividends received deduction in respect thereof. However, any such potentially tax-free repatriations would likely need to take place before any Moore decision, as Congress, IRS, or Treasury would likely move quickly to end the opportunity should section 965 be found unconstitutional with respect to corporations. Corporate taxpayers who have not repatriated any remaining E&P that was taxed under section 965 may want to consider doing so before Moore is decided, and perhaps do so yet this calendar year.