Section 965 Constitutional Attack in Ninth Circuit Rejected

Section 965 Constitutional Attack in Ninth Circuit Rejected

Section 965 Constitutional Attack in Ninth Circuit Rejected

Internal Revenue Code 965 refers to the Treatment of Deferred Income in certain situations, otherwise referred to as the transition tax. The law came into existence in accordance with TCJA (Tax Cuts and Jobs Act) and specifically applies to Controlled Foreign Corporations with post-1986 income. The tax law is a big deal to the IRS – so much so that they created a compliance campaign aimed at facilitating compliance since compliance would result in a significant tax windfall for the IRS for monies not even distributed/repatriated to the United States. In the state of Washington, Charles and Kathleen Moore waged a battle against the US Government, claiming the law is unfair (and it is surely unfair), but unfortunately, the Ninth Circuit Court of Appeals (in a published opinion) rejected the Moore’s position.

Let’s take a look at some of the key portions of the holding:

What is the Transition Tax?

      • In 2017, the Tax Cuts and Jobs Act (TCJA) created a new, one-time tax: the Mandatory Repatriation Tax (MRT). Under the MRT’s modified version of Subpart F, U.S. persons owning at least 10% of a CFC are taxed on the CFC’s profits after 1986, regardless of whether the CFC distributed earnings. Additionally, going forward, a CFC’s income taxable under subpart F includes current earnings from its business. 

Procedural History

      • Taxpayers challenged the constitutionality of Subpart F’s ability to permit taxation of a CFC’s income after 1986 through the MRT. The district court dismissed the action for failure to state a claim, denied taxpayers’ crossmotion for summary judgment, and taxpayers appealed.

Factual Background

      • The Moores invested $40,000 in return for 11% of the common shares. KisanKraft is a controlled foreign corporation (“CFC”), which means that it is a foreign corporation whose ownership or voting rights are more than 50% owned by U.S. persons. KisanKraft is located in India, and the Moores have never participated in its day-to-day operations or management.

      • While KisanKraft has turned a profit every year, KisanKraft has never distributed any earnings to its shareholders. Instead, KisanKraft has reinvested all of its earnings as additional shareholder investments in its business. 

The Law 

      • Before 2017, the primary method used to tax a CFC’s U.S. shareholders on foreign earnings held offshore was a provision of the tax code called Subpart F. See 26 U.S.C. § 951 (2007). Subpart F permitted the taxation of certain types of a U.S. person’s CFC earnings when that U.S. person owned at least 10% of a CFC’s voting stock. Id. Specifically, U.S. shareholders who owned at least 10% of a CFC could be taxed on a proportionate share of particular categories of its undistributed earnings such as dividends, interest, and earnings invested in certain U.S. property. Id. § 951(a).

      •  Neither Subpart F nor any other provision of the tax code permitted the U.S. Government to tax U.S. shareholders on the CFC’s active business income attributable to the CFC’s own business held offshore, such as when a CFC manufactures and sells products to a third party in a foreign country. Such income was only taxable if and when repatriated to the U.S. through a distribution to U.S. shareholders, loan to U.S. shareholders, or an investment in U.S. property.

Court Holding

      • The Moores’ counterarguments are unpersuasive. Although the Moores may have expected their tax to remain deferred, their “reliance alone is insufficient to establish a constitutional violation. Tax legislation is not a promise, and a taxpayer has no vested right in the Internal Revenue Code.” Carlton, 512 U.S. at 33. Further, while the MRT’s retroactive period is long, it does not decide the analysis.

      • The Moores cannot cite a bright-line rule regarding how long ago a retroactive tax can apply because courts deferentially review tax legislation’s purpose on a case-by-case basis. See Quarty, 170 F.3d at 965. Moreover, courts that have considered the retroactive nature of tax legislation often only view the period of retroactivity as one, non-dispositive consideration. See, e.g., GPX Int’l Tire Corp. v. United States, 780 F.3d 1136, 1142 (Fed. Cir. 2015) (discussing five “considerations,” of which retroactivity was only one).

      • Nor is the MRT a “wholly new tax,” a label applied to unconstitutionally retroactive taxes by early cases “under an approach that has long since been discarded.” Quarty, 170 F.3d at 966 (quoting Carlton, 512 U.S. at 34). We have very narrowly interpreted what qualifies as a “wholly new tax,” determining that a “a new tax is imposed only when the taxpayer has ‘no reason to suppose that any transactions of the sort will be taxed at all.’” See Quarty, 170 F.3d at 967 (quoting United States v. Darusmont, 449 U.S. 292, 298 (1981)).

      • The MRT is not a “wholly new tax” because prior to the MRT, U.S. shareholders were taxed on CFC earnings when they were distributed. The Moores had reason to expect that such transactions would eventually be taxed. See id. This is especially true because as 11% shareholders of KisanKraft, the Moores were already subject to certain preMRT taxes that applied to shareholders who owned at least 10% of a CFC regardless of whether earnings were distributed. See 26 U.S.C. § 951(a)(1) (2007).

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