The US Supreme Court to Rule on the TCJA Transition Tax: Is the Realization Requirement Soon to Be No Moore?

The Transition Tax

The Tax Cuts and Jobs Act of 2017 (TCJA) moved the US taxation of foreign corporations toward a participation exemption system. Under this new system, the foreign-source portion of dividends received by a US corporation from a foreign subsidiary in which it holds at least 10% of the voting power or 10% of the total value of shares generally is not subject to US tax.

As part of the transition to a participation exemption system, the TCJA enacted the MRT, which required a one-time inclusion in 2017 or 2018 of accumulated post-1986 deferred foreign income of certain foreign corporations, predominantly controlled foreign corporations (CFCs), in the income of US persons owning at least 10% of such foreign corporations. The included income was subject to a deduction that was intended to result in an effective tax rate of 15.5% or 8% (or a mix of the two), depending on the nature of the inclusion.

The Moores’ Case

Charles and Kathleen Moore held an interest just north of 10% in KisanKraft Machine Tools Private Limited, an India-based corporation that provided affordable farming equipment to underserved rural farmers in India. As a result of the MRT, the Moores were required to include an additional amount in their income in 2017, which resulted in an additional income tax liability of approximately $15,000. The Moores paid the tax and then filed an action for refund in US district court, which ruled against them, a decision that was upheld by the US Court of Appeals for the Ninth Circuit.

The main legal issue in the case revolves around whether the 16th Amendment to the US Constitution, which gives Congress the “power to lay and collect taxes on incomes, from whatever source derived, without apportionment,” requires that income be “realized” for a tax imposed on it to fall within the scope of the amendment.

The Constitution generally divides taxes into direct and indirect types. Indirect taxes include duties, imposts, and excises and are required to be imposed uniformly (on a geographic basis) throughout the United States. Direct taxes encompass certain other categories of taxes, generally including income taxes. Direct taxes are required to be apportioned among the states, meaning that each state must pay tax proportionately to its number of residents as of the last census. The difficulties in implementing an apportioned tax make it challenging for Congress to enact a direct tax. An income tax that falls under the 16th Amendment, however, is not required to be apportioned.

The Moores’ argument is that the MRT is a tax on income that they had not realized at the time the tax was imposed, since they had not actually received a dividend from KisanKraft, and therefore is not “income” within the scope of the 16th Amendment. Their argument relies on the 1920 Supreme Court decision in Eisner v. Macomber, which introduced the concept of realization to 16th Amendment jurisprudence. If the MRT is not an income tax described under the 16th Amendment, then it would need to be apportioned among the states — which it was not — to be constitutional.

The government, on the other hand, disputes the ongoing vitality of Macomber and the extent to which realization is a requirement for an income tax to fall under the 16th Amendment.

What Next?

The Supreme Court is expected to hear and decide the Moore case during its 2023-24 term that begins in October. The case is being closely watched not just for its direct relevance to the constitutionality of the MRT (which may be of limited significance, as the statute of limitations on refund for the 2017 or 2018 tax year is likely to have run for most taxpayers) but also its potential implications for other types of taxes that are or may be imposed on unrealized income.

Examples of tax provisions that could be called into question depending on how the Supreme Court rules in Moore include the imputation of interest under Code section 7872, the subpart F regime for CFCs under Code sections 951 through 965, and the Code section 1256 mark-to-market regime for certain contracts and options, among others. Similarly, the exit tax regime under Code section 877A for certain expatriates imposes tax without regard to the realization of income and also could be vulnerable. And, as underscored by the Moores in their petition for a writ of certiorari, proposals have been advanced recently to impose a wealth tax and a tax on appreciation in property, which too may be impacted by Court’s decision in Moore.

The ArentFox Schiff Tax and Private Clients, Trusts & Estates teams are closely monitoring this case. To discuss how this case may affect you or your business, please contact the tax professionals at ArentFox Schiff.