Over the past several years, a number of articles have been written declaring, or at least arguing, that section 965 of the Code, informally known as the transition tax, is unconstitutional. Some tax advisors have promoted this idea to market their practice. The first case directly addressing this claim was recently decided, on November 19, 2020. Moore v. United States, Case No. C19-1539-JCC (W.D. WA, Nov. 19, 2020). The Federal District Court in Moore granted the Government’s motion to dismiss the taxpayers’ refund suit, with prejudice.
The transition tax was enacted near the end of 2017 as part of the Tax Cuts and Jobs Act’s (TCJA) transition to a (partial) territorial tax, under which, beginning in 2018, current income of a controlled foreign corporation (CFC) would be taxable only in a limited manner. Since a CFC shareholder could generally defer tax on the CFC’s income since the beginning of the subpart F regime in 1962, some new rules were put into effect that would impose tax on CFCs’ historic earnings and profits accumulated from 1986 through the end of 2017. Section 965 treated this income as subpart F income, taxed to the CFC’s shareholders at one of two concessionary rates, 8% or 15.5%, depending on the amount of earnings represented by cash (or near cash(). As the court pointed out, this was Congress’ attempt to incentivize U.S. taxpayers to repatriate foreign earnings back into the United States. Moore, at 2.
In this case, the shareholders, Charles and Kathleen Moore, paid the transition tax and sued in Federal District Court for a refund, on the grounds that (1) the transition tax violates the Apportionment Clause of Article I, Section 9 of the U.S. Constitution because it is an unapportioned direct tax, rather than an income tax; and (2) the tax was imposed retroactively, violating the Fifth Amendment’s Due Process clause.
The Apportionment Clause provides that amounts of a “direct tax” must be apportioned to each state (“No Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census or enumeration herein before directed to be taken”). Direct taxes are considered to be those imposed on property, on the basis of headcount (capitation), or on income. However, this clause was significantly modified over 100 years ago by Amendment XVI, which permits a tax on income without apportionment (“The 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 taxpayers argued that by taxing accumulated income rather than current income, the transition tax is a direct tax on property, rather than an income tax. Moore, at 4. The taxpayers apparently asserted that there was no realization event and, consequently, the transition tax could not be a valid income tax, citing Eisner v. Macomber, a stock dividend case in which the Supreme Court determined there was no realization of income. Eisner v. Macomber, 252 U.S. 189, 211 (1920).
The District Court found that numerous subsequent cases had specifically and routinely departed from the realization standard as expressed in Eisner, most compellingly citing a Tax Court case addressing subpart F taxation of accumulated earnings. Dougherty v. Comm’r, 60 T.C. 917 (1973). The court also appeared to confine Eisner to its facts relating to stock dividends, relying on Comm’r v. Glenshaw Glass Co, 348 U.S. 426 (1955). In addition, the court found numerous statutory regimes – mark-to-market rules – that require the taxation of unrealized income. See 26 U.S.C. secs. 475 (dealer inventory), 1256 (futures contracts), and 877A (assets held by expatriates).
Comment on this issue: Another way to look at this is that the accumulated income was realized by the taxpayers in the sense that their wealth had been increased by the amounts of income accumulated. The tax was simply deferred. Congress never granted foreign accumulated income a full exemption from U.S. income tax and clearly has the power to grant or to withhold such exemption.
The taxpayers also argued that the transition tax (1) is retroactive, and (2) also deprived them of property without due process of law. The court found that the tax is, retroactive “by its very nature,” despite the Government’s arguments to the contrary, because it was levied tax upon the accumulation of earnings and profits before adoption of the statute. Moore, at 6-8.
Notwithstanding the taxpayers’ victory on the retroactivity issue, however, the District Court found that not all retroactive taxes violate the Due Process Clause. The key case in this area is United States v. Carlton, 512 U.S. 26 (1994). In Carlton, the Supreme Court rejected a notice and reliance standard for retroactive tax legislation and instead required only (1) a legitimate legislative purpose, and (2) furtherance of that purpose by rational means. That leaves Congress lots of room to legislate retroactively. The Court stated, quoting earlier precedent: “the validity of a retroactive tax provision depends upon whether ‘retroactive application is so harsh and oppressive as to transgress the constitutional limitation.’” 512 U.S. at 30-31. Since the transition tax ensures that the accumulated earnings and profits would not escape taxation, it serves a legitimate legislative purpose. Moore at 8.
The taxpayers argued, however, that a possible retroactive period back to 1986 was too long, thereby constituting an irrational means to affect a legitimate legislative purpose. Id. Although there was a concurring opinion in Carltonsuggesting that a period of retroactivity longer than a year would not pass constitutional muster, the Moore court stated that was not the majority view, and looked instead at “the nature of the tax and the circumstances in which it is laid,” (quoting Welch v. Henry, 305 U.S. 134, 147 (1938)). Id.
Looking at these factors, the court found the means to be rational. Section 965 was part of the enactment of a territorial tax system, and that section was a rational method to prevent undistributed earnings and profits from escaping taxation on the effective date of the TCJA. However, the court made a glaring error by stating:
“The TCJA attempts to cure this incentive by transitioning to a territorial tax model, which includes subjecting a U.S. shareholder’s ratable portion of a CFC’s earnings and profits to taxation regardless of whether the CFC distributes those funds.”
Moore at 9 (emphasis supplied). The court probably meant to say the opposite and should have used the word ”exempting…from” rather than “subjecting…to” in the quotation above. Notwithstanding this clear misstatement, the court’s main premise regarding rational basis remains correct. Although it is possible that the taxpayer may seize on this as grounds for appeal, I would expect that the District Court or appellate court could easily correct this statement without overturning the mandate to dismiss the case with prejudice.
The court also found retroactivity back to 1986 to be rational, as 1986 was the last major overhaul of the Tax Code prior to the TCJA, and in any event, duration of retroactivity was just one of the considerations relevant to determining a rational basis. Id.
Comment on this issue: The court found that the long retroactivity period did not give rise to a denial of due process. The transition tax is an integral part of the overall territorial tax scheme of the TCJA, and rationally furthers its purpose. The pre-TCJA structure of the international tax rules was one of deferral of CFCs’ accumulated earnings, not a permanent exemption. Congress has no legal obligation to keep taxpayer-favorable rules in place indefinitely. The enactment of section 965 did not surprise knowledgeable international tax advisors. Thus, the taxpayers were not denied due process.