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The TCJA’s Repatriation Tax Is Constitutional

Posted on Oct. 7, 2019
Benjamin M. Willis
Benjamin M. Willis

Benjamin M. Willis (@willisweighsin on Twitter; ben.willis@ taxanalysts.org) is a contributing editor for Tax Notes Federal. He formerly worked in the mergers and acquisitions and international tax groups at PwC, and then with the Treasury Office of Tax Policy, the IRS, and the Senate Finance Committee. Before joining Tax Analysts, he was the corporate tax leader in the national office of BDO USA LLP.

In this article, Willis examines Moore, a recent case challenging the constitutionality of the repatriation tax in section 965.

Recently, a couple from Washington state submitted the first challenge to the constitutionality of section 965’s one-time mandatory repatriation tax. Several articles have made the same constitutionality argument, but this is the real deal. Unfortunately, no matter how sympathetic the taxpayers’ facts are, the tax is constitutional. Let’s discuss the case, the top analogies that support the constitutionality of section 965, and how Treasury could help taxpayers with similar facts and other small taxpayers.

The Moore Complaint

On September 26 Charles G. and Kathleen F. Moore of Redmond, Washington, filed a complaint in the U.S. District Court for the Western District of Washington, petitioning for a federal tax refund for the tax year ended December 31, 2017.1 Since 2006, the Moores owned 12.937 percent of KisanKraft Ltd., an Indian controlled foreign corporation.

KisanKraft primarily provides agricultural equipment to small, underserved farmers throughout India. Although KisanKraft has experienced steady revenue growth and reported positive earnings almost every year since 2006, those profits were retained and reinvested.

The Moores argue that the deemed mandatory repatriation tax in the Tax Cuts and Jobs Act violates the Constitution’s requirement that direct federal taxes must be apportioned among the states. While it is an interesting issue, similar challenges have been defeated in court.

The Moores argue that the tax violates the due process clause of the Fifth Amendment because the tax imposes retroactive liability for earnings dating back more than three decades, to 1986.2 The Moores believe the tax liability of $15,130 on their $132,512 pro rata share of post-1986 earnings and profits could not have been foreseen or planned for when the TCJA was enacted, let alone 30 years previously. Their minority shareholder status might have made yearly dividends unforeseeable, with resulting taxes that would have far exceeded the TCJA’s 15.5 percent and 8 percent rates. And it appears they could have sold the stock and picked up the historic E&P as a deemed dividend under section 1248.

The Moores have sympathetic facts. Unfortunately their arguments will fail because section 965 presents no greater challenges than the many tax provisions that have withstood constitutional scrutiny.

Several provisions of the code impose income taxes based on decades of appreciation and earnings. No court has held those provisions to be unconstitutional, and many agree that Congress can enact law to determine the calculation and timing of income inclusions in addition to altering jurisdiction (for example, moving to a territorial system), tax rates, and much more.3

Still, the Moores’ case is a good reason for Treasury to use the regulatory authority it has to help those it has indicated were not the intended targets, based on its interpretation of the law and congressional intent.

Constitutionality of Similar Tax Regimes

The code is filled with provisions that impose tax on decades of appreciation and disallow the deferral of earnings and gains; in this article we review some of those that present concerns most similar to the section 965 tax. There are certainly factors supporting the Moores’ complaint that have been explored in recent articles.4

In Eder,5 the court upheld the constitutionality of the foreign personal holding company rules. The court explained: “We do not agree with taxpayer’s argument that inability to expend income in the United States, or to use any portion of it in payment of income taxes necessarily precludes taxability.” The court recognized that the operation of the statutory rules to the facts at hand “may be harsh” but “interpreting the statute to bring about such a consequence does not render the statute unconstitutional; the Congressional purpose was valid and the method of taxation was a reasonable means to achieve the desired ends.”

The CFC rules enacted in 1962 were upheld in Garlock,6 against a taxpayer’s challenge that it was unconstitutional to require the taxpayer to include in his taxable income a pro rata share of the corporation’s subpart F income, regardless of whether that income has been distributed to shareholders. The Second Circuit held that this constitutional argument “borders on the frivolous in the light of this court’s decision in Eder.”

The IRS recently explained that untaxed earnings and built-in gains give rise to the same concerns:

The Treasury Department and the IRS have determined that net unrealized built-in gain in property held by an expatriated foreign subsidiary at the time of the exchange gives rise to the same policy concerns that arise with respect to earnings and profits of the expatriated foreign subsidiary that exist at the time of the exchange. Therefore, to prevent the avoidance of U.S. tax on such net unrealized gain, it is appropriate to require the exchanging shareholder to recognize all of the gain.7

Section 965 generally targets untaxed foreign E&P. In most respects E&P is taxable income, modified to reflect a corporation’s ability to pay non-return-of-capital distributions. E&P is frequently the flip side of capital gain, as evidenced by the code’s conversion of capital gains on stock sales to deemed ordinary income dividends under sections 1248 and 304, which can reach earnings from 1962 and before.

Section 1248, which applies subpart F principles to ensure earnings are eventually taxed, recharacterizes gain on the sale or exchange of CFC stock by some U.S. shareholders as dividend income to the extent of CFC E&P attributable to that stock. This amount is generally the post-1962 E&P attributable to the U.S. shareholder’s sold or exchanged shares that accumulated during that shareholder’s holding period for the stock and while the corporation was a CFC.8

Section 1248 follows the general principle that the earnings of a CFC should be recognized as ordinary income at least once by its U.S. shareholders by characterizing capital gain recognized on the taxable disposition of CFC stock as dividend income to the extent of the CFC’s previously deferred earnings. The concurrent enactment of section 1248 and subpart F in 1962 ensured that a disposition of or distribution on CFC shares, respectively, would result in ordinary income. Under section 1248, the deemed inclusion on the disposition of the stock of a CFC generally includes the earnings of lower-tier subsidiaries that are CFCs, similar to section 965.

Another example is section 877A, which can tax decades of appreciation upon a taxpayer’s change in taxing jurisdiction. The legislative history underlying this provision provides:

When property effectively is transferred to a new legal situs that alters the taxpayer’s, and the Government’s, legal relationship to the property . . . it is possible to characterize expatriation as being accompanied by a ‘realization’ with respect to certain assets in view of the change of the legal attributes of such assets, so that Government’s inchoate interest in its receiving its share of any increase in value need not be extinguished . . . even if the realization rules of the Code generally result in accrued gains being taxed later when there is no disposition of the underlying property, Congress has the constitutional power to modify these rules so that tax will be imposed sooner rather than later when gains that are potentially subject to tax are effectively being removed from U.S. tax jurisdiction.”9 [Emphasis added.]

In short, a change in taxing rights, such as moving to a quasi-territorial system, can result in a deemed realization event that would give the government its last chance to tax offshore earnings.10 That occurs, for example, in an outbound F reorganization when an all E&P inclusion may be required under sections 367 and 1248, which are merely a backstop to subpart F. The eventual taxation of all foreign earnings under the U.S. worldwide tax system should have been crystal clear to taxpayers since the 1962 enactment of subpart F and section 1248, including the Moores.

While the deferral provisions above require that taxpayers ultimately pay tax on their share of untaxed deferred earnings, it is worth looking at the flip side of those policies in the inversion rules that eliminated deferral altogether for certain corporations following the 2004 enactment of the rules. Generally, under section 7874 a corporation that expatriated with at least 80 percent continuity of ownership in the foreign corporation will continue to be taxed as a domestic corporation for all purposes of the code. This provision can cause foreign corporations that have merely acquired assets of U.S. corporations to be treated as domestic corporations under U.S. law and foreign under foreign law and perhaps both to third-party jurisdictions. The shareholders will be taxed under the rules of both jurisdictions, absent relief from law or treaty. Partially an inverted section 965, section 7874’s reach to tax future foreign earnings (potentially subject to the FDII deduction but not GILTI without controlled foreign subsidiaries) in the United States seems boundless.

Treasury Could Help Small Taxpayers

Section 965(o) provides a broad grant of authority to “prescribe such regulations or other guidance as may be necessary or appropriate to carry out the provisions of this section.” In determining if the section 965 regulations had significant economic impact on small businesses (less than $25 million) Treasury stated in its preamble that:

in-house estimates of section 965 suggest that very roughly . . . 10,000 small multinational corporations (defined as corporations with less than $25 million in gross receipts) are potentially subject to section 965. The in-house estimates further suggest that about 25% of these small multinational corporations would not owe any tax under section 965, because they do not have any accumulated E&P to which the tax would be applied.11

While Treasury explained why the section 965 tax shouldn’t tax many small corporations and their owners based on estimates, nothing was done to mitigate the impact on these small corporations.

In contrast, consider section 163(j), which disallows a deduction for net business interest expense of any taxpayer exceeding 30 percent of a business’s adjusted taxable income plus motor vehicle financing interest. Some small businesses with gross receipts of $25 million or less for the preceding three tax years and specific trades or businesses are not subject to the limits under this provision.

As Treasury Secretary Steven Mnuchin expressed, in response to reduction of regulatory burdens under the Trump administration’s executive orders,12 base erosion concerns were likely addressed by section 163(j) despite its relief for small taxpayers.13 Section 965 provides generous rules for small business corporations as defined in section 1361, known as S corporations, and their shareholders. A regulatory exception could be provided for taxpayers that would meet the section 1202(d)(1) $50 million gross asset threshold for qualified small businesses.

Further, Treasury issued recent guidance for taxpayers that went offshore under section 877A to ease burdens on those with net assets of less than $2 million and a tax liability does not exceed $25,000. Treasury could apply similar taxpayer-favorable rules to ease undue regulatory costs on American business conduct.14

If there are more small taxpayers subject to the base erosion concerns precipitating section 965 that can benefit from regulatory cost reductions, Treasury can help them and avoid the costs of litigation arising from small taxpayers who were not the focus of the provision targeting the earnings of large multinational corporations. A de minimis exception can be made, if, as Treasury suggests, small taxpayers have not been targeted.

FOOTNOTES

1 Moore v. United States, No. 2:19-cv-01539 (W.D. Wash. Sept. 26, 2019).

2 Paul Jones and Annagabriella Colón, “Washington Couple’s Suit Challenges Repatriation Tax,Tax Notes Federal, Oct. 7, 2019, p. 164.

3 Patricia D. White, “Realization, Recognition, Reconciliation, Rationality and the Structure of the Federal Income Tax System,” 88 Mich. L. Rev. 2034 (1990) (explaining that there is “widespread sentiment among tax commentators, however, that Congress could, if it chose to, tax appreciation currently”).

4 See Mark E. Berg and Fred Feingold, “The Deemed Repatriation Tax — A Bridge Too Far?Tax Notes, Mar. 5, 2018, p. 1345; Hank Adler and Lacy Willis, “The Worst Statutory Precedent in Over 100 Years,” Tax Notes, Sept. 3, 2018, p. 1413.

5 Eder v. Commissioner, 138 F.2d 27 (2d Cir. 1943).

6 Garlock Inc. v. Commissioner, 489 F.2d 197 (2d Cir. 1973), cert. denied, 417 U.S. 911 (1974).

7 Notice 2015-79, 2015-49 IRB 775; see also Notice 2016-73, 2016-52 IRB 908 (similar).

8 See section 1248(a). However, it excludes some categories of income, such as income effectively connected with a U.S. trade or business or earnings previously taxed under subpart F.

9 Joint Committee on Taxation, “Issues Presented by Proposals to Modify the Tax Treatment of Expatriation,” JCS-17-95 (June 1, 1995).

10 Similar principles apply to U.S. mark-to-market and estate tax regimes.

11 T.D. 9846, 84 F.R. 1838 at 1868 (Feb. 5, 2019).

12 Executive Order 13789, issued April 21, 2017, instructs the Treasury secretary to review all significant tax regulations issued on or after January 1, 2016, and to take concrete action to alleviate the burdens of regulations that impose an undue financial burden on U.S. taxpayers, add undue complexity to the federal tax laws, or exceed the statutory authority of the IRS. In Executive Order 13771, issued January 30, 2017, the president directs the repeal of two existing regulations for every new regulation. Executive Order 13777, issued February 24, 2017, specifically provides that “in order to lower regulatory burdens on the American people,” the president will ensure that regulations that inhibit job creation, are unnecessary, or impose costs that exceed benefits are eliminated.

13 Treasury’s second report to the president on identifying and reducing tax regulatory burdens under Executive Order 13789 identifies eight regulations to be substantially revoked or revised. Treasury, “Identifying and Reducing Regulatory Burdens,” 2018-03004 (Oct. 2, 2017). Mnuchin’s fifth deregulatory target in this report is the final section 385 regulations.

14 Colón, “IRS Offers Relief Procedures to Some U.S. Expats,” Tax Notes Federal, Sept. 16, 2019, p. 1956. If the tax liability does not exceed $25,000, the taxpayer is relieved from paying U.S. taxes under the new procedures.

END FOOTNOTES

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