Government Says Transition Tax Is Constitutional, Not Retroactive

CHARLES G. MOORE; KATHLEEN F. MOORE,
Plaintiffs-Appellants
v.
UNITED STATES OF AMERICA,
Defendant-Appellee

IN THE UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT

ON APPEAL FROM THE JUDGMENT OF THE UNITED STATES
DISTRICT COURT FOR THE WESTERN DISTRICT OF WASHINGTON

BRIEF FOR THE APPELLEE

DAVID A. HUBBERT
Acting Assistant Attorney General

FRANCESCA UGOLINI
(202) 514-3361
MICHAEL J. HAUNGS
(202) 514-4343
NATHANIEL S. POLLOCK
(202) 514-8139
Attorneys
Tax Division
Department of Justice
Post Office Box 502
Washington, D.C. 20044

Of Counsel:
TESSA GORMAN
Acting United States Attorney

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TABLE OF CONTENTS

Table of contents

Table of authorities

Glossary

introduction

Statement of jurisdiction

Statement of the issues

Applicable statutes and regulations

Statement of the case

Summary of argument

Standard of review

Argument:

Conclusion

Statement of related cases

Addendum

Certificate of compliance

TABLE OF AUTHORITIES

Cases:

Angelotti Chiropractic, Inc. v. Baker, 791 F.3d 1075 (9th Cir. 2015)

Avila v. Los Angeles Police Dep't, 758 F.3d 1096 (9th Cir. 2014)

Blodgett v. Holden, 275 U.S. 142 (1927)

Commissioner v. Fender Sales, Inc., 338 F.2d 924 (9th Cir. 1964)

Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955)

Cottage Savings Ass'n v. Commissioner, 499 U.S. 554 (1991)

Dougherty v. Commissioner, 60 T.C. 917 (1973)

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

Eisner v. Macomber, 252 U.S. 189 (1920)

Fein v. United States, 730 F.2d 1211 (8th Cir. 1984)

Ferman v. United States, 993 F.2d 485 (5th Cir. 1993)

Furlong v. Commissioner, 36 F.3d 25 (7th Cir. 1994)

Garlock Inc. v. Commissioner, 489 F.2d 197 (2d Cir. 1973)

GPX Int'l Tire Corp. v. United States, 780 F.3d 1136 (Fed. Cir. 2015)

Heiner v. Mellon, 304 U.S. 271 (1938)

Helvering v. Bruun, 309 U.S. 461 (1940)

Helvering v. Enright's Estate, 312 U.S. 636 (1941)

Helvering v. Griffiths, 318 U.S. 371 (1943)

Helvering v. Horst, 311 U.S. 112 (1940)

Helvering v. Nat'l Grocery Co., 304 U.S. 282 (1938)

Hylton v. United States, 3 U.S. (Dall) 171

Landgraf v. USI Film Products, 511 U.S. 244 (1994)

Murphy v. United States, 992 F.2d 929 (9th Cir. 1993)

Nat'l Fed'n of Indep. Bus. (NFIB) v. Sebelius, 567 U.S. 519 (2012)

Nathel v. Commissioner, 615 F.3d 83 (2d Cir. 2010)

Nichols v. Coolidge, 274 U.S. 531 (1927)

Pollock v. Farmers' Loan & Trust Co., 158 U.S. 601 (1895)

Polone v. Commissioner, 505 F.3d 966 (9th Cir. 2007)

Prescott v. Commissioner, 561 F.2d 1287 (8th Cir. 1977)

Quarty v. United States, 170 F.3d 961 (9th Cir. 1999)

Sidney v. Commissioner, 273 F.2d 928 (2d Cir. 1960) (Friendly, J.)

Spreckels Sugar Ref. Co. v. McClain, 192 U.S. 397 (1904)

Springer v. United States, 102 U.S. 586 (1880)

United States v. Carlton, 512 U.S. 26 (1994)

United States v. Davis, 370 U.S. 65 (1962)

United States v. Hemme, 476 U.S. 558 (1986)

United States v. James, 333 F.2d 748 (9th Cir. 1964)

United States v. Kirby Lumber Co., 284 U.S. 1 (1931)

United States v. Safety Car Heating & Lighting Co., 297 U.S. 88 (1936)

Untermyer v. Anderson, 276 U.S. 440 (1928)

Veazie Bank v. Fenno, 75 U.S. 533 (1869)

Whitlock's Estate v. Commissioner, 494 F.2d 1297 (10th Cir. 1974)

Whitlock's Estate v. Commissioner, 59 T.C. 490 (1972)

Statutes:

Internal Revenue Code (26 U.S.C.):

28 U.S.C.:

Tax Cuts and Jobs Act of 2017 (TCJA)

Regulations:

U.S. Constitution:

U.S. Const. Art. I, sec. 8, cl. 1

U.S. Const. Art. I, sec. 9, cl. 4

U.S. Const., amend. XVI

Miscellaneous:

GLOSSARY

Acronym	Definition
CFC	controlled foreign corporation
IRS	Internal Revenue Service
I.R.C.	Internal Revenue Code
TCJA	Tax Cuts and Jobs Act of 2017

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INTRODUCTION

This lawsuit seeks to invalidate the mechanism Congress chose in the Tax Cuts and Jobs Act of 2017 (TCJA) to collect taxes on previously accumulated corporate foreign earnings as the TCJA moved the United States to a system that largely eliminates tax deferral and allows tax-free repatriation of untaxed foreign earnings going forward. This mechanism for maintaining the status quo of taxation for amassed pre-TCJA foreign earnings (though at reduced rates) — the transition tax (I.R.C. § 965) — will bring in an estimated $340 billion of tax revenue. So the real stakes here are quite a bit higher than the $14,729 tax refund that Charles and Kathleen Moore seek. If this lawsuit succeeds in eliminating the transition tax, U.S. multi-national corporations not only would avoid certain future U.S. taxes on the earnings of their foreign subsidiaries, they also would permanently avoid the tax on their substantial (more than $2.6 trillion in all) previously accumulated foreign earnings that cleared the decks for the new regime TCJA sets up.

To achieve the goal of this lawsuit, the Moores invite this Court to become the first court since at least 1920 (and arguably 1895) to determine that a federal tax is unconstitutional because it must be apportioned by state population. This Court should decline that invitation. And this Court also should decline to hold that the transition tax is both retroactive and that any such (we submit nonexistent) retroactivity lacks even a rational basis.

STATEMENT OF JURISDICTION

The district court had jurisdiction over this tax refund suit, and this Court has jurisdiction over this appeal. On October 26, 2018, Charles G. Moore and Kathleen F. Moore filed an amended tax return for 2017 and paid $15,130, which they reported as the additional amount owed under I.R.C. (26 U.S.C.) § 965. (ER94.) On March 25, 2019, the Moores filed a refund claim asserting that Section 965 is unconstitutional and seeking a refund of most of the October 26, 2018, payment ($14,729). (ER94-95.) See I.R.C. § 6511(a). On September 26, 2019, after six months had elapsed without the IRS acting on the claim, the Moores timely filed this suit for refund. (ER 98, 107.) See I.R.C. § 6532(a)(1). The district court had subject matter jurisdiction under I.R.C. § 7422(a) and 28 U.S.C. § 1346(a)(1).

On November 19, 2020, the district court granted the government's motion to dismiss and entered a final judgment. (ER13, 15.) The Moores filed a timely notice of appeal on December 24, 2020. (ER100.) See 28 U.S.C. § 2107(b) & Fed. R. App. P. 4(a)(1)(B)(i). This Court has jurisdiction under 28 U.S.C. § 1291.

STATEMENT OF THE ISSUES

1. Whether I.R.C. § 965's transition tax violates the apportionment requirement of Article 1 of the U.S. Constitution.

2. Whether I.R.C. § 965's transition tax is impermissibly retroactive in violation of the Fifth Amendment's Due Process Clause.

APPLICABLE STATUTES AND REGULATIONS

The constitutional provisions and statutes relevant to the disposition of this appeal are included as an addendum to this brief. See Fed. R. App. P. 28(f); 9th Cir. R. 28-2.7.

STATEMENT OF THE CASE

A. Overview of the case and proceedings below

As shareholders who owned at least 10% of a controlled foreign corporation (CFC), the Moores owed the I.R.C. § 965 transition tax in 2017. They calculated their Section 965 tax liability as $15,130, paid it, and then (having taken the appropriate administrative steps) sued for a refund based on a two-pronged constitutional challenge. The district court rejected the Moores' contention that Section 965 is an unapportioned direct tax that violates Article I of the Constitution and the Sixteenth Amendment. The district court also determined that Section 965 is not impermissibly retroactive in violation of the Fifth Amendment's Due Process Clause.

B. Legal framework

Operating under a system of worldwide taxation, the United States has traditionally taxed the foreign income of its citizens and residents just as it taxes their domestic income (providing a foreign tax credit to alleviate double taxation). I.R.C. §§ 61(a), 901-909. Thus, if a U.S. taxpayer (whether a corporation or an individual) conducts business and earns income in a foreign country, the U.S. taxpayer pays U.S. income tax on those earnings. Kuntz & Peroni, U.S. International Taxation § A1.03, 2000 WL 530073. But there has been a significant exception to this principle. With exceptions for certain anti-deferral regimes, like subpart F (described below), U.S. taxpayers have not had to pay U.S. tax on the earnings of foreign corporations until those earnings were distributed to them. Id; see also S. Rep. 87-1881, at 78 (1962). The result for U.S. owners of CFCs — i.e., generally a foreign corporation with more than 50% U.S. ownership — was “the deferral of U.S. taxes.” Kuntz & Peroni § A1.03 (emphasis in original). To exploit this tax deferral opportunity, many U.S. taxpayers (especially U.S. corporations) have separately incorporated their foreign operations. Often, they have then kept foreign earnings offshore rather than bringing those earnings back to the United States, which would cause them to be taxed. The Joint Committee on Taxation estimated that, by 2015, CFCs had accumulated more than $2.6 trillion in earnings offshore. See August 31, 2016, Joint Committee on Taxation Letter.¹

For decades, Congress has sought to limit the tax deferral available through CFCs. Its main mechanism for doing that has been a set of tax laws enacted in 1962, and commonly known as subpart F, a reference to their placement in the Tax Code. In general, subpart F limits tax deferral on foreign income for U.S. shareholders of CFCs by currently taxing the U.S. shareholders on portions of the CFC's earnings even though those earnings were not distributed to the U.S. shareholder. See I.R.C. § 951(a)(1). Subpart F only applies to U.S. shareholders who own 10% or more of a CFC (the term “U.S. shareholder,” for purposes of Section 965, means U.S. persons owning 10% or more of the total combined voting power of the CFC's stock). I.R.C. § 951(b); see also I.R.C. § 957(c) (defining “United States person”), and I.R.C. § 958(a)-(b) (defining stock ownership and providing constructive ownership rules). The portions of CFCs' undistributed earnings that have long been included under subpart F (and thus taxed currently, regardless of whether actually distributed) include (1) easily movable income, like interest, dividends, and certain sales income, and (2) earnings invested in certain U.S. property. See I.R.C. § 951(a)(1)(A) & (B).²

The Tax Cuts and Jobs Act of 2017 (TCJA) added Section 245A to the Code to change the tax-law incentives that had led to a large amount of corporate earnings being kept offshore. The TCJA did this by taking a step “toward a territorial tax system.” Tax Management Portfolio 926-3rd, CFCs II.C. Significant Subsequent Legislative Changes (2018). It set up a “participation exemption system” that “has two principal prongs.” Id. The first prong “provides a 100% dividend received deduction for the foreign-source portion of any dividend received by a domestic corporation that is a 10% U.S. shareholder in a 'specified 10-percent owned foreign corporation.'” Id. (quoting I.R.C. § 245A). In other words, under the new law, when CFCs repatriate untaxed earnings to a U.S. shareholder eligible for the Section 245A deduction, those earnings (generally speaking) are not taxed.³

By itself, Section 245A would have allowed CFCs to distribute tax-free dividends of their accumulated earnings to their corporate U.S. shareholders. See 10 Mertens Law of Fed. Income Tax'n § 38B:107 n.3 (June 2021). So, the U.S. income tax on much of the $2.6 trillion of CFCs' accumulated earnings would have been effectively forgiven. To prevent that result, Congress amended I.R.C. § 965.⁴ This second prong of the participation exemption system was meant to “'clear the decks' for §245A.” Tax Management Portfolio 926-3rd, CFCs II.C.17. As relevant here, the amended Section 965 includes in subpart F income the greater of a CFC's “accumulated post-1986 deferred foreign income” determined as of November 2, 2017, or December 31, 2017. See I.R.C. § 965(a), (d) & (e).⁵ Recall that subpart F works by essentially deeming certain undistributed CFC earnings to be distributed to their U.S. shareholders and taxing them currently. See I.R.C. § 951(a)(1). So, Section 965 essentially deems a pro-rata share of a CFC's accumulated post-1986 earnings and profits (earnings) to have been distributed to its U.S. shareholders. See I.R.C. § 965(a) & (d). Congress recognized that “companies have accumulated significant untaxed and undistributed foreign earnings” and, in enacting Section 965, it treated such foreign earnings “as if they had been repatriated” to “avoid a potential windfall for corporations that deferred income.” H.R. Rep. No. 115-409 at 375.⁶ The Section 965 one-time addition to subpart F income typically occurs (and so the tax on it typically is owed) in 2017, though taxpayers can elect to pay it over an 8-year period. I.R.C. § 965(a) & (h).⁷

Congress expected that Section 245A and the Section 965 transition tax would lead to the actual repatriation of a significant portion of the funds CFCs were holding offshore. H.R. Rep. No. 115-409 at 370-75. That expectation was a reasonable one. As with other subpart F income, amounts included in a U.S. shareholders' gross income under Section 965 can be repatriated without further U.S. taxation. I.R.C. §§ 959 & 965(d). So, it is not surprising that U.S. multinational enterprises “repatriated $777 billion in 2018” out of an estimated $1 trillion in cash holdings abroad.⁸

C. Facts of the case and the district court's decision

In 2006, the Moores became 11% owners of a majority-U.S.-owned Indian company called KisanKraft, Ltd. (ER5.) From 2006 through 2017, KisanKraft did not make any distributions of its earnings to its owners. (Id.) Thus, under the then-applicable rules, the Moores did not pay any U.S. tax on KisanKraft's earnings. (Id.)

As explained above, the law changed in 2017. Under I.R.C. § 965, the Moores owed a tax on their pro rata share of KisanKraft's post-1986 earnings. The Moores calculated the tax to be $15,130, which they paid. (ER5-6.) Then, after filing an administrative refund claim and satisfying the jurisdictional requirements, they sued for a refund in district court. They argued that the tax is unconstitutional under the Apportionment Clause of Article I, Section 9, and the Fifth Amendment's Due Process Clause. (ER6.) The government moved to dismiss, arguing that Section 965 is constitutional.

The district court granted the government's motion to dismiss. The court first rejected the Moores' argument that the transition tax is a direct tax on property that violates the Apportionment Clause. It explained that the Moores relied on the Supreme Court's determination in Eisner v. Macomber, 252 U.S. 189 (1920), that a stock dividend did not result in any realization of profits of the stockholder and thus did not supply a basis for income taxation. (ER7.) The district court determined, however, that “decisions dealing with foreign income have routinely departed from Macomber's realization standard.” (ER8.) The court discussed Second Circuit and Tenth Circuit cases that rejected challenges to similar Tax Code provisions that have long required current inclusion in shareholder income of undistributed income of foreign companies. (Id.) The court also found compelling the Tax Court's ruling in Dougherty v. Commissioner, 60 T.C. 917 (1973), that inclusion in shareholder income of accumulated earnings of a CFC was constitutional despite Macomber. (Id.)

The district court noted that there are “numerous contemporary statutory regimes, outside of subpart F, that require the current taxation of unrealized income — none of which have been successfully challenged on Macomber grounds.” (ER9 (citing I.R.C. §§ 1256, 475, and 877A).) The court explained that this Court, in United States v. James, 333 F.2d 748 (9th Cir. 1964), determined that Macomber's precedential value was limited to whether a stock dividend is income to the shareholder and that “insofar as it purported to offer a comprehensive definition of the term income as used in the Sixteenth Amendment, [Macomber] has been discarded.” (ER8 n.1 (quoting James).) The district court thus concluded that “[g]iven the cabining of Macomber by the Supreme Court and the clear departure from it by other courts, there is no reason for this Court to conclude that Macomber currently controls whether the [transition tax] is an income tax.” (ER9.) The court held that the tax is an income tax and that it therefore “does not violate the Apportionment Clause.” (Id.)

The district court then turned to the Moores' Due Process Clause challenge. It first concluded, contrary to the government's contentions, that the transition tax is retroactive. (ER10 (quoting I.R.C. § 965(d)).) The court determined, however, that the transition tax does not violate the Due Process Clause because it “(1) is supported by a legitimate legislative purpose and (2) is furthered by rational means.” (ER11 (citing United States v. Carlton, 512 U.S. 26, 30-31 (1994).) The court determined that the tax served the legitimate legislative purpose of ensuring that the TCJA's other changes to international taxation would not “eliminate U.S. tax on a CFC's undistributed earnings and profits originating before 2018.” (ER11.) The court held that the length of the retroactive period was reasonable in view of significance of the shift in international tax law and of the result, which would occur without a transition tax, of allowing previously undistributed CFC earnings to “escape the imposition of U.S. taxation.” (ER12.) The court also concluded that the transition tax was not a “wholly new tax” but “a change in subpart F.” (Id.)

SUMMARY OF ARGUMENT

1. The Section 965 transition tax is constitutional. The Moores' argument that it is unconstitutional because it is not apportioned requires this Court to accept the notion that the Constitution requires income to be “clearly realized” before it can be taxed. That notion conflicts with Supreme Court precedent; it conflicts with this Court's precedent; and it conflicts with decisions upholding related Tax Code provisions against similar constitutional attack. The Constitution does not bar Congress from attributing U.S. taxpayers' foreign corporate earnings to them and taxing them on those earnings.

2. Section 965 does not attach new legal consequences to completed conduct and thus is not retroactive. Correctly understood, the tax is imposed on a deemed repatriation of income to U.S. shareholders that happened after the TCJA was enacted. But even if the tax were understood as a tax on the earnings of the CFC, it would not be retroactive. The subpart F regime has always exercised a right of taxation over all the earnings of CFCs as earned, providing for current imposition of tax on certain earnings and deferred imposition of tax on other earnings. Thus, the legal consequence of a CFC's relevant earnings remained deferred taxability both before and after the TCJA. Section 965 merely altered prospectively the deferral period by changing it from an indefinite period to one that ends on a fixed future date.

Even if the Section 965 transition tax were retroactive, it would not violate due process because it serves a legitimate purpose by a rational means. When Congress decided to move to a more territorial system for taxing corporations on foreign earnings, it was legitimate for Congress to collect the taxes on trillions of dollars in prior accumulated foreign earnings rather than forgiving most of those taxes. Section 965 was a rational means of doing that.

STANDARD OF REVIEW

The constitutionality of Section 965's transition tax is a legal issue that this Court reviews de novo.

ARGUMENT

I. The transition tax is not a direct tax subject to the apportionment requirement

A. Constitutional framework

First, some background on direct taxes, apportionment, and the Sixteenth Amendment: The Constitution grants Congress the power “To lay and collect Taxes, Duties, Imposts, and Excises.” U.S. Const. Art. I, sec. 8, cl. 1. It also provides — in the Direct Tax Clause — that “No Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census or Enumeration herein before directed to be taken.” U.S. Const. Art. I, sec. 9, cl. 4; see Art. I, sec. 2, cl. 3 (“Representatives and direct taxes shall be apportioned among the several States which may be included within this Union, according to their respective Numbers. . . .”). The Sixteenth Amendment modifies the Direct Tax Clause by stating that “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.” U.S. Const., amend. XVI (emphasis added). Thus, after the Sixteenth Amendment, capitations and other direct taxes remain subject to the apportionment requirement unless they are “taxes on incomes.” “[T]axes on incomes” that are not capitations or other direct taxes never were subject to any apportionment requirement, and the Sixteenth Amendment did not change that.

History reveals that the meaning of “other direct tax” is both obscure and very narrow. During the Constitutional Convention, delegates discussed linking taxation to representation by requiring both to be apportioned⁹ in the same way. Edwin R. A. Seligman, The Income Tax 550-51 (1911). The purpose of this would have been to make southern states pay for the additional representation they were getting via the three-fifths compromise (under which three fifths of the number of enslaved persons were counted for representation purposes). Id. Ultimately, it was decided that only “direct taxes” would have to be apportioned. Id. at 551. The delegates avoided defining that term even to the point of ignoring one delegate's request for an explanation of its “precise meaning.” See Veazie Bank v. Fenno, 75 U.S. 533, 544 (1869); see also Ackerman at 11 (explaining that precisely defining direct tax would have threatened “to undo the desperate expedient on representation and taxation [the founders had] patched together.”). Thus, “[e]ven when the Direct Tax Clause was written it was unclear what else, other than a capitation (also known as a 'head tax' or a 'poll tax'), might be a direct tax.” Nat'l Fed'n of Indep. Bus. (NFIB) v. Sebelius, 567 U.S. 519, 570 (2012) (citation omitted).

In Hylton v. United States, 3 U.S. (Dall) 171 (1796), the Supreme Court unanimously ruled that a tax on the ownership of carriages was not a direct tax. Justice Paterson recalled that the requirement of apportionment for direct taxes was intended as a resolution on the treatment of slaves, not as a restriction on Congress's taxing authority, and concluded that “[t]he rule, therefore, ought not to be extended by construction.” Id. at 178. As the Court explained in NFIB, “those Justices who wrote opinions [in Hylton] either directly asserted or strongly suggested that only two forms of taxation were direct: capitations and land taxes.” Id. at 571.

“That narrow view of what a direct tax might be persisted for a century.” NFIB, 567 U.S. at 571; see also Springer v. United States, 102 U.S. 586, 602 (1880) (“[D]irect taxes, within the meaning of the Constitution, are only capitation taxes, as expressed in that instrument, and taxes on real estate.”). Then, in Pollock v. Farmers' Loan & Trust Co., 158 U.S. 601, 637 (1895), the Supreme Court held that a tax on income from real and personal property was a direct tax requiring apportionment, concluding that such a tax was, in substance, a tax on the property itself. The Sixteenth Amendment overturned that result (more on that below).

The Sixteenth Amendment did not address Pollock's apparent conclusion that taxes on personal property are direct taxes. And Eisner v. Macomber, 252 U.S. 189 (1920), also reflects the view that a tax on personal property is a direct tax. But rather than endorsing that view as the Moores suggest (Br. 21), NFIB casts it further into doubt. NFIB's recounting of the history of the Direct Tax Clause shows that the Pollock/Macomber conception of direct tax strays from the “narrow view of what a direct tax might be” that had held sway for the first century of the republic. 567 U.S. at 571. The Court avoided directly addressing whether a tax on personal property is a direct tax, but its observation that Macomber had “continued to consider taxes on personal property to be direct taxes” id., was not an endorsement of that view. Rather, NFIB seems to indicate misgivings about the Pollock/Macomber interpretation.

In any event, because neither Pollock nor Macomber actually ruled that taxes on personal property were direct taxes, it is far from clear that the notion that a tax on personal property is a direct tax is binding on this Court.¹⁰ Thus, even if Section 965's transition tax was a tax on property (rather than on income), issuing the first decision ever to hold that a tax on personal property is constitutional only if apportioned by population (an impossibility in practice) should give this Court pause.

Fortunately, this Court need not consider that weighty issue because the Section 965 transition tax is not a tax on property. It is a tax on a deemed repatriation of CFC income to certain U.S. shareholders. According to Pollock, a tax on income from personal property (like a stock dividend) is a direct tax. But the Sixteenth Amendment overturned that result by stating that Congress may tax incomes “from whatever source derived” without triggering the apportionment requirement. So a tax on a deemed repatriation of CFC income to U.S. shareholders is a tax on income from property that is, because of the Sixteenth Amendment, not subject to the apportionment requirement.

B. The Constitution does not require income to be realized in order to be taxed

Section 965's transition tax is an income tax and thus is not subject to the apportionment requirement. The Moores principally argue that, to be income for Sixteenth Amendment purposes, a gain must be “clearly realized” by the taxpayer. (Br. 15.)¹¹ They are wrong. It is true that “the revenue laws have been interpreted as defining 'realization' [i.e., full receipt] of income as the taxable event rather than the acquisition of the right to receive it.” Helvering v. Horst, 311 U.S. 112, 115 (1940). And the Tax Code still normally taxes income when it is realized. But the Moores mistake this general statutory rule, borne of administrative convenience, for a constitutional command.

1. There is no support for a realization requirement in the Sixteenth Amendment's text

The Moores briefly argue (Br. 15) that the Sixteenth Amendment's text contains a realization requirement because it exempts from the apportionment requirement “incomes, from whatever source derived.” That language does not suggest that a taxpayer must realize a gain for it to be income. This Court has directly stated that “[t]he Sixteenth Amendment uses, but does not purport to define, the term 'income.'” United States v. James, 333 F.2d 748, 751 (9th Cir. 1964) (en banc). Additionally, the phrase “from whatever source derived” has a definite historical meaning that has nothing to do with whether a gain must be realized to be income. In Pollock, the Supreme Court determined that a tax on income from real and personal property was a direct tax, but also explained that a tax on income from other sources — like wages and “gains or profits from business” — is not a direct tax. 158 U.S. at 635-37. The Sixteenth Amendment superseded the determination that a tax on income from certain sources (i.e., property) is a direct tax by stating that incomes “from whatever source derived” could be taxed without apportionment. In short, there is no basis for the notion that the Sixteenth Amendment's text contains a realization requirement.

2. Precedent forecloses the Moores' realization-requirement argument

The Moores' main argument in favor of a constitutional realization requirement is their contention (Br. 15-18) that the Supreme Court recognized such a requirement in Macomber and carried it forward in Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955). That contention conflicts with Supreme Court precedent, and that of this Court.

As the Supreme Court “recognized” in 1940 and reaffirmed in 1991, “the concept of realization is 'founded on administrative convenience.'” Cottage Savings Ass'n v. Commissioner, 499 U.S. 554, 559 (1991) (quoting Horst, 311 U.S. at 116). The Court explained in Cottage Savings that the general rule that gains are taxed when they are realized allows the IRS to avoid “the cumbersome, abrasive, and unpredictable administrative task of valuing assets on an annual basis to determine whether the assets had appreciated or depreciated in value.” Id. (citation and internal quotation marks omitted).

The Court's determination in Cottage Savings that the realization requirement was borne of administrative convenience — and thus not of constitutional necessity — was not some ill-considered dictum. It was material to the Court's ruling. The Court rejected the Commissioner's determination that a financial institution's exchange of one group of residential mortgages for another did not amount to a realization of income in part because it concluded that “the complexity of the Commissioner's approach ill serves the goal of administrative convenience that underlies the realization requirement.” Cottage Savings, 499 U.S. at 565. And while the Court rejected the government's bottom-line position, it deferred to the Commissioner's regulatory determination that an exchange of one property for another property meets the realization requirement when the exchanged properties are materially different from one another. Id. at 560-61. The Supreme Court does defer to Treasury Regulations when they reasonably interpret Tax Code provisions, but it does not defer to the Commissioner's interpretation of the Constitution. If the realization rule were a constitutional requirement, the Court would not have deferred to an administrative determination of what counts as realization; nor would the Court have based its rejection of the Commissioner's specific determination of whether a property exchange satisfied the realization requirement on a conclusion that that determination “ill serves the goal of administrative convenience.”

In Helvering v. Griffiths, 318 U.S. 371, 393 (1943), the Court directly recognized that its post-Macomber decisions reject the notion of a strict constitutional realization requirement for income taxation. The Court explained that Helvering v. Bruun, 309 U.S. 461 (1940), “rejected the concept that taxable gain could arise only when the taxpayer was able to sever increment from his original capital,” and the Court then concluded that Bruun and other later decisions undermine the “theoretical bases of the decision in Eisner v. Macomber.” Id. (also quoting Helvering v. Horst). The Court, in Griffiths, did not overrule Macomber's specific holding concerning the taxation of stock dividends because it concluded that Congress did not intend to tax the dividends in question. Id. at 404. But notably, Justice Douglas, joined by Justices Black and Murphy, stated, in analysis that was not inconsistent with the majority's, that he saw “no reason” that the Constitution should be interpreted to prevent Congress from treating stockholders' increased wealth from “earnings of the corporation in which they hold shares” as income to the shareholders. Id. at 409 (Douglas, J. dissenting).

Like the Supreme Court, this Court does not interpret Macomber to constitutionalize a realization requirement for income tax. In United States v. James, this Court explained that Macomber is authority for the proposition “that a stock dividend is not income to the shareholder, at least if the stock is of the same class and in the same corporation as that previously held by the taxpayer.” 333 F.2d at 752 (en banc). But Macomber is not good authority on the issue of what counts as income under the Sixteenth Amendment: “insofar as [Macomber] purported to offer a comprehensive definition of the term income as used in the Sixteenth Amendment, it has been discarded.” Id. This Court traced the demise of Macomber beginning in United States v. Kirby Lumber Co., 284 U.S. 1 (1931), through United States v. Safety Car Heating & Lighting Co., 297 U.S. 88, 99 (1936), and Helvering v. Bruun, culminating in Glenshaw Glass. James, 333 F.2d at 751-52. This Court's discussion of Bruun is particularly relevant: The Supreme Court there rejected the notion that Macomber precluded the government from taxing an unrealized increase in value of a taxpayer's real property. James, 333 F.2d at 752 (discussing Bruun).

This Court also rejected the notion that Macomber imposes a constitutional realization requirement for income tax in Commissioner v. Fender Sales, Inc., 338 F.2d 924 (9th Cir. 1964). There, stockholder-employees of a company received additional stock in exchange for discharging indebtedness for unpaid salaries, with the value of the newly received stock and discharged debt being identical. Id. at 925-26. The Tax Court had relied on Macomber to hold that the issuance of the new shares “did not constitute income to [the shareholder-employees] within the meaning of the 16th Amendment.” Id. at 926 (quoting the Tax Court opinion). This Court reversed. It interpreted Macomber as having held that the issuance of a stock dividend does not result in taxable income because it “represents nothing of value.” Id. at 927. This Court viewed Macomber's ruling as based on recognizing that a stock dividend “is just a piece of paper” that does not change “the basic net worth of the corporation.” Id; see also Macomber, 252 U.S. at 202-05 (explaining that by itself a stock dividend leaves the corporation “no poorer” and the stockholder “no richer than they were before” and that its decision in the case could rest on its prior recognition that “the essential nature of a stock dividend necessarily prevents its being regarded as income in any true sense”). And because it determined that the transaction at issue in Fender Sales did increase the value of the taxpayers' capital interest in the company, this Court held that Macomber was “not even apposite, let alone controlling.” Id. In other words, this Court held that the increase in value of the taxpayers' capital interests in a corporation was taxable and that Macomber is no impediment to that conclusion. See also id. at 930 (Barnes, J., dissenting in part) (disagreeing with the majority's recognition of “a realization of income by shareholders upon an increase in corporate net worth, where no dividend has been declared or capital gain yet realized by the shareholders”).

In sum, the Supreme Court in Cottage Savings, long after Macomber, has understood the realization requirement to be a rule of administrative convenience and — by direct implication — rejected the notion that realization is required under the Sixteenth Amendment. And this Court has (twice) directly rejected the notion that, under Macomber, realization is a constitutional prerequisite to income taxation.¹²

3. Glenshaw Glass does not support the Moores' realization-requirement argument

Perhaps aware that the much-maligned Macomber is a slender reed to support their argument, the Moores focus on Glenshaw Glass. They assert (Br. 21) that “[e]ven putting Macomber aside,” the transition tax is unconstitutional under Glenshaw Glass, which undisputedly “remains good law.” And they contend (Br. 22) that Glenshaw Glass “maintained Macomber's realization requirement.” Given the clear state of present law (see above), whether Glenshaw Glass “carried forward” (Br. 17) from Macomber a constitutional realization requirement is largely academic. But, it did not.

Glenshaw Glass did not address the question of realization at all. The issue in Glenshaw Glass was whether punitive (or exemplary) damages are gross income under the Tax Code. There was no dispute about whether the taxpayers had realized the damages awards. The issue was whether the source of these awards — i.e., the fact that they were “windfalls flowing from the culpable conduct of third parties” rather than gains from capital or labor — should prevent them from being included in gross income. Glenshaw Glass, 348 U.S. at 429. The Court determined that Macomber's definition of income, as gain from capital or labor, did not prevent this other kind of gain from being recognized as income. Id. at 431.

The Court in Glenshaw Glass explained that the issue in Macomber was “whether the distribution of a corporate stock dividend constituted a realized gain to the shareholder, or changed 'only the form, not the essence,' of his capital investment.” Glenshaw Glass Co., 348 U.S. at 430-31. The Court then distinguished the situation in Macomber from that at hand: “Here we have instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” Id. at 431 (emphasis added). The court was simply saying that, unlike in Macomber, the gain at issue in Glenshaw Glass was “clearly realized.” The Court did not say or suggest that, to be gross income (or income for Sixteenth Amendment purposes) gains always must be “clearly realized” by the taxpayer. Glenshaw Glass also does not suggest that a “taxable event” is a prerequisite to income taxation, as the Moores appear to assert (Br. 15-16). The Court merely noted that, in Macomber, the distribution of a stock dividend “was held not a taxable event.”

That Glenshaw Glass did not address, and had no occasion to address, whether realization by the taxpayer is required (by either the Constitution or Tax Code) — or, if so, what satisfies the realization requirement — is sufficient to refute the notion that Glenshaw Glass carried this so-called requirement forward from Macomber. But there is more.

After explaining that Macomber's definition of income “was not meant to provide a touchstone to all future gross income questions,” Glenshaw Glass cites Bruun. In Bruun, the Court held that a lessor who, at the termination of the lease, “received back his land with a new building on it, which added an ascertainable amount to its value” received taxable income equal to the increased value of the property. 309 U.S. at 469. The Court explained that the Macomber language the taxpayer relied on sought to “clarify the distinction between an ordinary dividend and a stock dividend” and was “not controlling here.” Bruun, 309 U.S. at 468-69.

In short, Bruun held that Macomber's determination that a gain must be “severed from the capital” and received for the taxpayer's “separate use, benefit, and disposal” before it can be taxed — that is, the so-called realization requirement — was not controlling. And it determined that an increase in value of a capital investment could be taxed as income. So the Supreme Court's citation of Bruun in Glenshaw Glass after it stated that the Macomber definition of income was not “a touchstone” suggests (to put it mildly) that Glenshaw Glass did not carry forward the Macomber realization requirement.

The Moores contend (Br. 21-22) that Nathel v. Commissioner, 615 F.3d 83 (2d Cir. 2010), shows that Macomber remains good law on the distinction between income and capital. But Nathel's discussion of Macomber and Glenshaw Glass was limited to its conclusion that the distinction between income and capital remains relevant to the determination of what the Tax Code considers as income. Id. at 92. Nathel does not endorse Macomber's suggestion that the Sixteenth Amendment bars taxation of shareholders on a corporation's accumulated profits.

Finally, the Moores wrongly contend (Br. 22) that Macomber binds this Court. This Court is free to conclude that a precedent has eroded so much that it is precedential only in its narrow holding. That is what this Court has already concluded, correctly, about Macomber. See James, 333 F.2d at 752 and pp.26-27, supra. This case is not about whether Congress can tax a shareholder on the issuance of a stock dividend in the same class of stock and thus Macomber's narrow holding is not controlling.

4. Cases upholding the pre-TCJA subpart F against similar constitutional challenges refute the Moores' realization-requirement argument

The logic of the Moores' realization-requirement argument applies as much to other provisions of subpart F as to Section 965. So the reasoning of decisions rejecting direct-tax challenges to the pre-TCJA subpart F applies here.

a. Like Section 965, other subpart F provisions require U.S. shareholders of CFCs to include in their income a certain portion of the corporation's income “whether or not that income has been distributed to the shareholder.” Garlock Inc. v. Commissioner, 489 F.2d 197, 198 (2d Cir. 1973). The Second Circuit rejected a constitutional challenge to subpart F based on Macomber as an argument that “borders on the frivolous.” Id. at 202. The Court determined that the “doctrine of” Macomber lacked any continuing validity “as applied to the facts of this case.” Id. at 203 n.5 (citing Heiner v. Mellon, 304 U.S. 271, 281 (1938)). The Supreme Court in Mellon held that taxing a partner's “distributive share” of a partnership, even though that share could not be paid to the partner under state law, was permissible “and the fact that it may not be currently distributable, whether by agreement of the parties or by operation of law, is not material.” Mellon, 304 U.S. at 281.

In rejecting the Macomber-based constitutional challenge to subpart F, Garlock relied on Eder v. Commissioner, 138 F.2d 27 (2d Cir. 1943). In Eder, the Second Circuit rejected a challenge to taxation of a U.S. shareholder's interest in a foreign corporation. The shareholder argued that taxing him on the corporation's income was unconstitutional because Colombian law prevented most of that income from being distributed to him. Id. at 28. The court, however, observed that “[i]n a variety of circumstances it has been held that the fact that the distribution of income is prevented by operation of law, or by agreement among private parties, is no bar to its taxability.” Id. (citing Mellon, Bruun, and Helvering v. Enright's Estate, 312 U.S. 636, 641 (1941), another case upholding taxation of a partner on partnership income that the partner (or his estate) did not receive in the year at issue). See also Whitlock's Estate v. Commissioner, 494 F.2d 1297, 1301 (10th Cir. 1974) (concluding that Article I, the Sixteenth Amendment, Glenshaw Glass, Macomber, and Pollock “considered together” reveal that there is “no merit” in the direct tax challenge to subpart F).

The Moores fault (Br. 23) the Second Circuit's alleged “non-existent” reasoning in Eder and Garlock and contend that “there is no indication in Garlock that the Second Circuit regarded Macomber's realization-event holding as overruled.” But there is such an indication, and quite a strong one. Garlock cited Mellon, which held that a partner can constitutionally be taxed on partnership income he has not received for his separate use and benefit — i.e., has not realized. Garlock also cited Eder, which, in turn, even more directly stated that the fact that corporate income has not been distributed to a taxpayer “is no bar to its taxability.” Eder, 138 F.2d at 28.

The Moores note that Eder and Garlock involved current rather than accumulated earnings. But the Moores argue that, under the Constitution, corporate income cannot be taxed to shareholders until it is distributed to them. Under that argument, whether the corporate earnings are from the current year or accumulated from prior years is irrelevant.

b. The Tax Court also rejected an argument that subpart F is an unconstitutional direct tax when it taxes prior accumulated earnings in Dougherty v. Commissioner, 60 T.C. 917 (1973). It observed that Macomber “does not prevent Congress from bypassing the corporate entity in determining the incidence of Federal income taxation.” Id. at 928. The court explained that subpart F represents Congress's judgment that 10% U.S. shareholders of CFCs have a “degree of control over their foreign corporation” that “allows them to treat the corporation's undistributed earnings as they see fit.” Id. at 928 & n.13. The court explained that, in exercising its legitimate discretion over whether to disregard the form of a CFC, Congress elected to tax U.S. shareholders directly on some types of CFC income (I.R.C. § 951(a)(1)(A)) but to tax other CFC income only when the CFC invests it in U.S. property (I.R.C. § 951(a)(1)(B)). Id. at 930. The court recognized that such investment in U.S. property did not separate the assets from the CFC or distribute assets to shareholders “for their separate use and benefit.” Id. (citing Macomber). But the court determined that Macomber nonetheless did not “interpose a constitutional barrier” to such taxation. Id.

The Moores contend (Br. 24) that Dougherty (and Whitlock's Estate) do not support the district court's rejection of their direct tax argument because (they assert) those cases, unlike this one, involved a taxable event — the CFCs' investment in U.S. property. There are several problems with that.

One problem is that the Moores seek to create an equivalence between the notion (from Macomber) that the Sixteenth Amendment prohibits taxation of unrealized gains and the concept of a taxable event. These concepts are distinct. Macomber does not use the term “taxable event.” Glenshaw Glass described Macomber as having determined that the stock dividend there at issue was “not a taxable event.” Glenshaw Glass, 348 U.S. at 431. It does not follow from that description that the Constitution contains a “taxable event” requirement that is equivalent (or similar) to the so-called Macomber realization requirement. In reality, “taxable event” is merely a descriptive term used to identify the event that triggers taxation. See United States v. Davis, 370 U.S. 65, 69-71 (1962) (treating whether a stock transfer was a taxable event as a statutory issue resolved by determining “whether the transfer in issue was an appropriate occasion for taxing the accretion to the stock”).

A second problem with the Moores' effort to distinguish Dougherty is that the distinction undercuts their central argument that Macomber and Glenshaw Glass require a gain to be realized — i.e., distributed for the taxpayer's separate use and benefit — to be income subject to taxation. As Dougherty specifically recognized, a foreign company's investment in U.S. property does not actually separate and distribute anything to that company's U.S. shareholders. 60 T.C. at 930. Thus, the subpart F provision at issue in Whitlock's Estate and Dougherty (§ 951(a)(1)(B)) violates the (supposed) Macomber realization rule just as much, and for the very same reason, as Section 965. Both statutes (as relevant here) tax U.S. shareholders of CFCs on amounts they have not received for their separate use and benefit. Thus, if Whitlock's Estate and Dougherty correctly determined that Macomber does not invalidate Section 951(a)(1)(B), it also does not invalidate Section 965(a).

The third problem with the Moores' attempt to distinguish Dougherty (and Whitlock's Estate) is their claim that the outcome in those cases turned on the ability of the litigant-taxpayers to control the foreign corporation. The notion that Section 951(a)(1)(B) or the transition tax could be a direct tax as to some taxpayers (who lack control over their CFC) but not others (who have sufficient control) is nonsensical. Either a tax is a direct tax that must be apportioned, or not. In any event, the control the Tax Court focused on was the level of control sufficient for inclusion within the subpart F regime, not the taxpayer's particular amount of influence over the CFC. See Doughterty, 60 T.C. at 928, 930 & n.13.¹³

5. A closely analogous case in another context, as well as other Tax Code provisions, refute the notion of a constitutional realization requirement

a. Perhaps the most closely analogous case to this one is Prescott v. Commissioner, 561 F.2d 1287 (8th Cir. 1977). That case did not involve subpart F, but rather a 1954 law that allowed unincorporated sole proprietorships and partnerships to elect to be treated as corporations for tax purposes. Id. at 1289; see also id. at 1289 n.2 (quoting this law, which was then codified at I.R.C. § 1361). Congress repealed the law in 1966, and the taxpayers who had made use of it, unless they transferred the business assets to a real corporation, were taxed as if the “section 1361 corporation” was liquidated on January 1, 1969. Id. at 1289-90. Two taxpayers who owned sole proprietorships and had elected to treat them as corporations for tax purposes were assessed significant tax deficiencies when they failed to pay tax on the gains from the deemed liquidation of their § 1361 corporations. Id. at 1290. The court acknowledged that the taxpayers were not “in any different situation on January 1, 1969” than on the day before but were still “taxed as of that date on the appreciation in value of their businesses.” Id. at 1292. The court explained, however, that a condition of the benefit of elective corporate tax treatment was separate taxation of distributions to the (for tax purposes) shareholders of the fictional corporation. Id. Thus, failing to tax the appreciation in the value of the businesses would have been in essence a tax-free distribution of corporate profits — a benefit the 1954 law had not contemplated — causing “an unmerited windfall” to the taxpayers. Id.

The taxpayers contended that the deemed-liquidation treatment of their Section 1361 corporations “unconstitutionally impos[ed] an unapportioned direct tax on something other than income.” Prescott, 561 F.2d at 1290. The court of appeals noted that Macomber could be understood to support the taxpayers' direct tax argument. Id. at 1293. But the court concluded that, in Bruun, the Supreme Court “abandoned the idea that gain must be severed from capital to be taxable.” Prescott, 561 F.2d at 1293. The court also recognized that Glenshaw Glass “not[ed] this change” — a recognition presumably based on Glenshaw Glass's citation of Bruun for the proposition that Macomber was not the “touchstone” for “gross income questions.” Prescott, 561 F.2d at 1293 (citing Glenshaw Glass, 348 U.S. at 431). And the court saw Glenshaw Glass and Davis as replacing “the concept of severance” — i.e., realization — with the inquiry, which Davis makes plain is not a constitutional requirement (370 U.S. at 69-71), that asks “whether some event has occurred which marks an appropriate time to tax the increase in value of assets.” Prescott, 561 F.2d at 1293. The court determined that the change in the law on fictional corporate status for sole proprietorships and corresponding deemed liquidation of the fictional corporations “created an event upon which it was appropriate to tax the increase in value [of taxpayers'] businesses.” Id.

The parallels between Prescott and this case are striking. Both cases involve a change in tax law that, unaddressed, would allow certain taxpayers to receive tax-free corporate dividends. In fact, the situation here, without the transition tax, would be a far greater windfall to certain U.S. taxpayers than the situation in Prescott. This Court should reject the Moores' direct tax argument for the same reasons that the Eighth Circuit rejected the direct tax argument in Prescott. There is no constitutional realization requirement for income taxation. And a deemed repatriation of income, like a deemed liquidation of an entity recognized as a corporation for tax purposes, is an event that Congress is free to determine marks an appropriate time to impose an income tax. See Prescott, 561 F.2d at 1293.

b. Under the logic of the Moores' constitutional-realization-requirement argument, other Tax Code provisions would also fall. For instance, I.R.C. § 877A(a) taxes certain U.S. citizens who relinquish their citizenship after June 16, 2008, on the value of their property in excess of $600,000 by treating the property as “sold on the day before the expatriation date for its fair market value.” This deemed sale would no more satisfy the Moores' asserted constitutional realization requirement than does the deemed repatriation of CFC accumulated earnings here.

Similarly, partners and shareholders in S corporations must pay tax on a share of the partnership or S corporation income whether or not that share is distributed to them. See I.R.C. §§ 702(a) and 1366(a). These Tax Code provisions would also fall if realization were a constitutional prerequisite to taxation. Yet the Supreme Court has held that taxing a partner on income not distributed to him is permissible. Mellon, 304 U.S. at 281.

The Moores appear to contend (Br. 26) that this Court's decision in Murphy v. United States, 992 F.2d 929 (9th Cir. 1993), supports the notion that it is unconstitutional to impose a tax on an unrealized gain. That is incorrect. This Court declined to reach the constitutional issue in Murphy because it concluded that gains in commodities futures contracts are “little different from” interest credited to a bank account. Id. at 931. But although this Court did not resolve “whether Congress could tax the gains inherent in capital assets prior to realization or constructive receipt,” it included a “Cf.” citation to its decision in James, which it described as establishing that the “concept of income is flexible.”

6. A tax on business earnings is an income tax and, in any event, not a direct tax and thus is not subject to the apportionment requirement

If the Section 965 transition tax was considered as a tax on the CFC's earnings themselves rather than on the deemed repatriation of those earnings, Section 965 would still be constitutional. Considered in this way, Section 965 is a statute that looks through the corporate form and taxes the CFC's shareholders directly on its earnings. As the Tax Court has recognized, Macomber does not prevent Congress from disregarding the corporate form. Dougherty, 60 T.C. at 928-30; Whitlock's Estate v. Commissioner, 59 T.C. 490, 507-09 (1972). Indeed, until 1921, excess corporate gains and profits were taxed to the shareholder even absent distribution and despite lack of control. Helvering v. Nat'l Grocery Co., 304 U.S. 282, 288–89 & n.4 (1938); see also id. (noting the varied ways in which imposition of tax looks through the corporate form to the taxpayer); Whitlock's Estate, 59 T.C. at 507 (“[T]he history of U.S. income taxation shows that Congress has for decades been drafting income tax statutes which have bypassed the corporate entity.”).

The realization-requirement issue is irrelevant when the tax is considered from this perspective. Recall that the Sixteenth Amendment was only necessary to relieve taxes on income from certain property from the apportionment requirement that would otherwise, under Pollock, have applied to such taxes. See p. 23, supra. Even under Pollock, other types of income taxes, including taxes “on profits and gains from business” are not direct taxes. 158 U.S. at 635. Because the Sixteenth Amendment does not address or impact taxes on business income, any Sixteenth Amendment realization requirement (even if it existed) would not affect such taxes.

The Moores argue (Br. 18-19) that under the Sixteenth Amendment, the income of a corporation is no longer income at all (even to the corporation) once the corporation reinvests it in the business, but becomes capital that can no longer be taxed. This argument is meritless. For one thing, it misinterprets Macomber. Macomber stated, in dicta, that a “stockholder's share in the accumulated profits of the company is capital” and cannot be taxed as the shareholder's income. 252 U.S. at 219. This was incorrect, as we have explained, but even Macomber merely indicated that the company's accumulated profits were the shareholders' capital; it did not suggest that Congress is powerless to tax the corporation itself on accumulated profits. If that were true, corporations (and perhaps any taxpayer) would have a constitutional right not to pay income tax on income that the taxpayer used to make a capital investment. We are unaware of any authority (nor do the Moores cite any) supporting that notion. In any event, even if the Sixteenth Amendment somehow excluded income used for capital investment from its definition of income, that would not impact Congress's authority under Article I of the Constitution to tax business gains. Indeed, the Supreme Court has upheld Congress's determination to tax the gross receipts of certain businesses against constitutional challenge. See Spreckels Sugar Ref. Co. v. McClain, 192 U.S. 397, 410-11 (1904) (upholding a tax on the gross receipts of certain businesses).

II. The Section 965 transition tax does not violate the Fifth Amendment's Due Process Clause

A. Section 965 is not retroactive

Contrary to the district court's conclusion (ER9-10), the Section 965 transition tax does not have a retroactive effect; it does not attach new legal consequences to completed conduct. See Landgraf v. USI Film Products, 511 U.S. 244, 269-70 (1994).

The Moores' retroactivity argument relies on subtly shifting the description of the pre- and post-TCJA law. They describe the new law as a tax on prior CFC earnings and the old law as imposing a tax only on a repatriation of such earnings. (Br. 29-31.) In fact, the pre-TCJA law imposed a tax on repatriation and the post-TCJA law imposes a tax on a deemed repatriation. Because the taxable event is a deemed repatriation that occurred (as relevant here) after the TCJA was enacted, Section 965 is not retroactive.

But if the Moores' description of the new law (as a tax on the underlying CFC earnings) is adopted, the old law should be understood in the same terms. The subpart F regime has always exercised a right of taxation over all the earnings of CFCs as earned, providing for current imposition of tax on certain earnings and deferred imposition of tax on other earnings. Under pre-TCJA law, deferral of income other than subpart F income was allowed until the earnings were repatriated (or deemed repatriated via an investment in United States property) and under post-TCJA law deferral of such income was allowed until December 31, 2017 (or, in some instances, a later date). The legal consequence of completed conduct (the relevant CFC earnings) remained deferred taxability before and after the TCJA; the TCJA merely altered the deferral period prospectively by changing it from an indefinite period to one that ends on a fixed future date.

1. Considered as a tax on a deemed repatriation, Section 965 is not retroactive

The taxable event for the transition tax — that is, the event that triggers the tax — is the deemed repatriation of KisanKraft's accumulated earnings. For many U.S. shareholders of CFCs, including the Moores, that deemed repatriation occurred on December 31, 2017, just over a week after Congress enacted Section 965.¹⁴ Because Section 965 taxes a post-enactment deemed repatriation, it is not retroactive.

This situation is much like the situation in Prescott. As discussed above (pp. 40-43), Prescott considered a challenge to the deemed liquidation that accompanied the elimination of elective corporate tax treatment for partnerships and sole proprietorships. The Eighth Circuit concluded that the tax was not retroactive because the taxable event was the deemed liquidation of the fictional corporation that “occurred after the enactment of” the challenged statute and regulation. Prescott, 561 F.2d at 1294.

The Tax Court reached a very similar conclusion on retroactivity in Dougherty. As discussed above (pp. 37-40), the tax there at issue was the subpart F inclusion based on a CFC's investment in U.S. property (§ 951(a)(1)(B)). The taxpayer argued that the tax was unconstitutionally retroactive because it taxed “earnings and profits of a controlled foreign corporation accumulated before the effective date of subpart F.” Dougherty, 60 T.C. at 929. The Tax Court rejected that argument. It explained that the event that triggered the tax (subpart F inclusion) was the CFC's investment in U.S. property and that that event happened “during a year subject to the operation of the statute.” Id. It also determined that Congress has the power to tax income of a CFC “imputed to its shareholders” even when “the measure of the income is generated by income of a past year prior to the effective date of the statute.” Id.

The foreseeable retort is that, in Dougherty, the taxable event was a real occurrence rather than (as here and Prescott) the deeming-to-have-occurred of an event that has not (or, at least, not yet) occurred. But the tax at issue in Dougherty is not truly a tax on the CFC's investment in U.S. property. Rather, that investment triggers a different taxable event — a mandatory inclusion in the U.S. shareholders' gross income that is, in effect, a deemed distribution to the CFC's U.S. shareholders equal to the amount of the investment. See I.R.C. §§ 951(a)(1)(B) & 956(a). The Tax Court recognized that the tax depended on a legal fiction because the U.S. shareholders did not receive assets from the CFC “for their separate use and benefit.” Dougherty, 60 T.C. at 930. Indeed, the court noted that the mere act of investing in U.S. property “might well be insufficient to justify taxation under the judicially created doctrine of constructive dividends.” Id. So the salient retroactivity point in Dougherty is that the deemed inclusion of CFC income in a U.S. shareholder's income is the taxable event for retroactivity purposes — not the prior earning of that income. Likewise, here. The taxable event is the deemed inclusion of KisanKraft's accumulated earnings in the income of its U.S. shareholders (i.e., deemed repatriation) that occurred after Section 965's enactment — not KisanKraft's prior earning of those amounts.

Moreover, the deemed repatriation here (and the deemed liquidation in Prescott) are just as closely tied to real world events as the deemed income inclusion in Dougherty. Here the deemed repatriation is tied to a major change in the law that will mean that many CFCs' future untaxed earnings are likely to be repatriated tax free. As explained above, the TCJA provides a deduction for dividends CFCs issue to their U.S. corporate shareholders. See pp. 7-8, supra. Thus, as the district court determined (ER12), enacting Section 245A without enacting Section 965 (or a similar provision) would have been a major change in the status quo for CFCs' accumulated untaxed earnings. Without Section 965, a CFC's pre-2017 earnings that would have been taxed when they were distributed to U.S. corporate shareholders under the old law would now be able to be distributed to those shareholders tax free.

The Moores' argument relies on mixing two descriptions of the Section 965 transition tax. Their direct tax argument attacks the deemed distribution, but their retroactivity argument treats the tax as a tax on old earnings that they contend were not taxed under prior law. The taxpayer in Dougherty tried something similar. The Tax Court correctly declined to play along with the taxpayer's shifting characterization of the tax there at issue. After determining that Congress could impose a tax on what was, in effect, a deemed distribution to U.S. shareholders occasioned by the CFC's investment in U.S. property, the court rejected the notion that the CFC's original earning of the income was the relevant event for retroactivity purposes. Dougherty, 60 T.C. at 927-30. The relevant question was whether the deemed income inclusion (effectively a deemed distribution) was impermissibly retroactive, not whether a tax on earnings in years before the statute's effective date was. Id. at 929.

2. Considered as a tax on KisanKraft's prior earnings, Section 965 is not retroactive in a way that is adverse to the Moores

Even if Section 965 is viewed as imposing a tax on prior earnings of the CFC, it would still not be a retroactive tax, except perhaps in the sense that it retroactively lowers the tax rates previously applicable to those earnings — an aspect of Section 965 the Moores do not challenge.

The Section 965 transition tax is a continuation of the pre-TCJA law that exercised taxing jurisdiction over deferred earnings. If the transition tax is viewed as a tax on the original generating of business earnings, then the prior law should be viewed the same way. So viewed, pre-TCJA law made all earnings of CFCs subject to taxation under the subpart F regime as earned, with current imposition of tax on certain earnings (for example, subpart F income) and deferred imposition of tax on other earnings.

Thus, if the old and new laws are viewed as imposing taxes on CFC earnings, the new law does not have any adverse retroactive effect. The old law treated CFC earnings as taxable, and simply deferred the calculation and imposition of the tax until the earnings were distributed to the CFC's U.S. shareholders (taxing the earnings at a rate corresponding to the tax rate of its U.S. shareholders, which would normally be higher than 15.5%). Section 965 taxes CFC earnings at about 8 or 15.5% (depending on asset makeup) and changed the period of deferral from an indefinite period that would end when a distribution is made to a definite period that ends on a fixed future date (frequently, as here, December 31, 2017).

The alteration of the tax deferral period is not retroactive. Both before and after Section 965's enactment the legal consequence of CFC earnings was deferral of U.S. taxation. Section 965 does not retroactively affect that tax deferral. It does not, for instance, treat the corporation's 2006 earnings as taxed in 2006 at the then-applicable rates and impose interest and penalties for the corporation's failure to pay that tax until 2017. Thus, Section 965 did not alter the legal consequence — tax deferral — of CFCs' prior earnings; it only prospectively altered the deferral period by (as relevant here) ending it on a fixed future date.

To be sure, Section 965 may well have upended CFCs' and CFC shareholders' expectations about how long the tax deferral would continue. That, however, does not make it retroactive. Of course, people commonly arrange their affairs based on current tax law and would have arranged them differently had they known the law would change. But the fact that a law “upsets expectations based in prior law” does not make it retroactive. Polone v. Commissioner, 505 F.3d 966, 972. (9th Cir. 2007) (quoting Landgraf, 511 U.S. at 269-70); see also Landgraf, 511 U.S. at 269 n.24 (listing examples of “uncontroversially prospective statutes [that] may unsettle expectations”). So, “even though 'a new property tax or zoning regulation may upset the reasonable expectations that prompted those affected to acquire property,' a change in the property tax regime would not be considered retroactive with respect to all who had purchased property prior to the effective date of the amendment.” Polone, 505 F.3d at 972 (quoting Landgraf, 511 U.S. at 269 n.24).

The tax deferral provided under I.R.C. § 401(k) may supply another useful example. Currently (subject to certain conditions), the tax owed on income contributed to a Section 401(k) plan can be deferred until the beneficiary is 72 years old. I.R.C. § 401(a)(9). Suppose John is 64 years old and plans to wait until he is 72 to take distributions from his Section 401(k) plan. Now suppose that Congress changes the law so that Section 401(k) plan beneficiaries must begin taking minimum distributions at age 65. Certainly, the change disrupts John's plans. But no retroactive effect has occurred. The legal effect of John's past conduct (instructing his employer to deposit part of his earnings into the Section 401(k) account) remains tax deferral. The only change is a prospective change that affects John's expectation about how long that legal consequence will persist.

But the Moores argue (Br. 30) that, under the pre-2017 law, the tax on a CFC's active earnings could be deferred forever and the district court seems to have agreed (ER10). In reality, though, the indefinite deferral period for the tax on CFC earnings under the old law does not make Section 965 retroactive. Returning to our Section 401(k) example, suppose (counterfactually) the law allowed potentially perpetual deferral — i.e., suppose that if John dies before taking distributions his heir would get a fresh deferral period, and that his heir's heir could likewise receive the Section 401(k) account with a fresh deferral period so that a long chain of beneficiaries might die during the deferral period before taking any distributions or paying any tax. Under this hypothetical, the mere fact that perpetual tax deferral is possible would not mean that the income in the Section 401(k) account is not subject to tax. So a law that cut short such a theoretically perpetual deferral period by lowering the mandatory distribution age would “simply accelerate tax already owing.” (ER10.)¹⁵

B. Even if the Section 965 transition tax is retroactive, it does not violate the Due Process Clause

Even if the transition tax were retroactive, it would not violate the Fifth Amendment's Due Process Clause. As this Court has noted, “[t]he Supreme Court repeatedly has upheld retroactive tax legislation against a due process challenge.” Quarty v. United States, 170 F.3d 961, 965 (9th Cir. 1999) (citations and quotation marks omitted). The test for determining whether a retroactive tax statute violates due process is whether its “retroactive application itself serves a legitimate purpose by rational means.” Id. (citing United States v. Carlton, 512 U.S. 26, 30 (1994).

1. The transition tax is not a wholly new tax

Like the taxpayers in Quarty, the Moores argue mainly (Br. 32-36) that the Carlton test is inapplicable because the transition tax is a wholly new tax. In so doing, they “attempt to gain succor from whatever vitality remains in Blodgett v. Holden, 275 U.S. 142 (1927), and Untermyer v. Anderson, 276 U.S. 440 (1928).” Quarty, 170 F.3d at 966; see also id. at 966-67 (rejecting that attempt). Indeed, Carlton, suggests that Blodgett and Untermyer — as well as Nichols v. Coolidge, 274 U.S. 531 (1927), on which the Moores also rely (Br. 32) — are on life support. 512 U.S. at 34. It explained that “[t]hose cases were decided during an era characterized by exacting review of economic legislation under an approach that 'has long since been discarded.'” Id. (citation omitted). And it cautioned that Blodgett and Untermyer “essentially have been limited to situations involving 'the creation of a wholly new tax,'” but that their “authority is of limited value in assessing the constitutionality of subsequent amendments that bring about certain changes in operation of the tax laws.” Id. (quoting United States v. Hemme, 476 U.S. 558, 568 (1986)); see also Angelotti Chiropractic, Inc. v. Baker, 791 F.3d 1075, 1084 (9th Cir. 2015) (interpreting Carlton as expressing “skepticism as to the degree to which Nichols and Untermyer still apply”).

The Moores argue that Section 965 imposed a wholly new tax because it taxed “transactions that were never subject to U.S. taxation” and because they “had no reason to expect that the Government would tax them on foreign-corporation income that is not their own.” (Br. 34.) This argument fails for two, alternative, reasons.

First, the Moores had every reason to expect that the Government would tax them on their share of their CFC's earnings as soon as that share was distributed to them. See I.R.C. § 301.¹⁶ The Moores' frustrated expectations over the tax on their share of KisanKraft's accumulated earnings is about the timing of that tax, not its existence.

Second, the transition tax builds upon subpart F. Prior to 2017, the Moores, as greater-than-10-percent U.S. shareholders of a CFC, knew that certain categories of KisanKraft's earnings could be taxable to them in the current tax year even if those earnings were not distributed to them. See I.R.C. § 951(a)(1). They knew that if KisanKraft had earned passive income, or engaged in certain sales transactions, or invested earnings in U.S. property, they would be subject to present tax liability even though such activities would not provide them with any assets for their separate use and benefit. See I.R.C. §§ 951(a)(1), 952, 954, and 956. So Section 965 simply expands the categories of undistributed CFC earnings on which an existing tax is owed.¹⁷ Section 965's enactment thus is not a “situation[ ] involving 'the creation of a wholly new tax,'” Carlton, 512 U.S. at 34 (1994) (quoting Hemme, 476 U.S. at 568).¹⁸

In Carlton and Hemme, the Supreme Court explained that Untermyer and Blodgett involved the levy of “the first gift tax.” Carlton, 512 U.S. at 34; Hemme, 476 U.S. at 568. Hemme's discussion of Untermyer, which Carlton quotes, juxtaposes “wholly new tax” with “certain changes in operation of the tax laws.” Hemme, 476 U.S. at 568. That shows that the Court used the term “wholly new tax” to mean a new type of tax — i.e., a tax like the first gift tax. See also Sidney v. Commissioner, 273 F.2d 928, 932 (2d Cir. 1960) (“If Untermyer remains authority at all, it is so only for the particular situation of a wholly new type of tax there under consideration.”) (emphasis added) (Friendly, J.). Section 965 is not a new type of tax. Rather, it is a change “in operation of the tax laws.” Hemme, 476 U.S. at 568. Thus, even if Section 965 could be characterized as imposing income tax on previously untaxed transactions (and it really cannot), Untermyer and Blodgett would still be “of limited value.” Id.

Other courts of appeals have rejected contentions that new laws that make some change to the income, gift, or estate taxes are “wholly new taxes” for due process purposes. See, e.g., Furlong v. Commissioner, 36 F.3d 25, 27 (7th Cir. 1994) (rejecting the contention that a Tax Code provision that subjected previously untaxed loan proceeds to income tax (I.R.C. § 72(p)(1)(A)) was a wholly new tax because that law “is part of the larger income tax code, which has existed since the beginning of this century”); Ferman v. United States, 993 F.2d 485, 490 (5th Cir. 1993) (determining that a law retroactively limiting an estate tax deduction was not a wholly new tax because, among other things, “[t]he estate tax was in place before [that law] was introduced”); Fein v. United States, 730 F.2d 1211, 1213 (8th Cir. 1984) (determining that a law that reduced the categories of property eligible for exclusion from the existing estate tax on gifts made within three years of the decedent's death was not a wholly new tax because “[t]here were estate and gift taxes long before 1977,” when that law took effect).

The Moores contend that Section 965 imposes a wholly new tax because that is how “Congress” and “the White House” described it. (Br. 35 (citing a House Report and a White House press release).) This argument is meritless. The Moores' cite no authority (because none exists) for the notion that such descriptions bear on whether a law imposes a wholly new tax for due process purposes.

2. The transition tax meets the rational basis standard

Retroactive application of Section 965 (if it is retroactive) passes muster under the Due Process Clause because such application “serves a legitimate purpose by rational means.” Quarty, 170 F.3d at 965 (citing Carlton, 512 U.S. at 30). The district court accepted the Moores' contention that the transition tax has a retroactivity period of 30 years, but it still determined that Section 965 serves a legitimate purpose by a rational means. Section 965 easily clears rational-basis scrutiny.

The district court's conclusion that Congress enacted Section 965 for a legitimate legislative purpose is unassailable. As the court explained, without Section 965, the TCJA's other changes to the Tax Code would often “effectively eliminate U.S. tax on a CFC's undistributed earnings originating before 2018.” (ER11); see also pp. 7-10, supra. So the legitimate legislative purpose of Section 965 was preserving the status quo for past CFC earnings because Section 245A would otherwise have eliminated the repatriation tax on much of those past earnings going forward. Preserving the status quo and thereby preventing large windfalls for corporate U.S. shareholders of CFCs was sound fiscal policy, not, as the Moores would have it (Br. 39), “a cash grab.”

Because its legislative purpose is legitimate, the relevant question is whether Section 965 is a “rational means” of achieving that purpose. The Moores ignore that means-purpose link, instead discussing (Br. 40-42), without reference to Section 965's purpose, a nondispositive series of “considerations” enumerated in GPX Int'l Tire Corp. v. United States, 780 F.3d 1136, 1141-45 (Fed. Cir. 2015). Yet even that case makes clear that the various non-dispositive factors discussed are meant to be an aid to determining whether retroactive application of the law has “a rational basis” — that is, whether the law's retroactive application rationally achieves its legitimate purpose. Id. at 1141-45.

If looking back as far as 1987 to measure the accumulated CFC earnings deemed to be repatriated in 2017 makes Section 965 retroactive, it is retroactivity born of necessity. Having eliminated the repatriation tax on CFCs' distributions to corporate U.S. shareholders, Congress needed some way to avoid forgiving the repatriation tax on previously accumulated offshore earnings. Conceivably, Congress could have found a different way such as continuing to collect the repatriation tax on dividends and portions of dividends paid out of a CFC's pre-2017 earnings, while eliminating that tax for dividends and portions of dividends paid out of post-2017 earnings. But such a two-tiered system would impose substantial administrative costs. Among other things, there would have to be some kind of reporting requirement for U.S. shareholders of CFCs to tell the IRS what portion of any dividends were paid out of pre- and post-2017 earnings, and the IRS would need to devote resources to checking the accuracy of such reporting.

It was at least rational for Congress to opt, instead, to tax all at once the accumulated pre-2017 CFC earnings that would have been taxed eventually under the old law. The Moores focus most of their criticism on the supposed 30-year retroactivity period. But, basing the calculation on post-1986 earnings was rational (and in fact a targeted exercise of a taxation right that extended to all pre-2017 earnings). Taxpayers were already required to track post-1986 earnings of their CFCs for purposes claiming foreign tax credits on actual dividends and inclusions under subpart F.¹⁹ Thus, Congress made use of data that U.S. shareholders were already calculating rather than requiring a new calculation based on an arbitrary date.

Further, if the goal of maintaining the status quo of taxation of pre-2017 CFC earnings is legitimate, then shortening the 30-year period makes little sense. Presumably, including earnings accumulated beginning in 1987 covers almost all accumulated earnings. Thus, as a practical matter, shortening the period would simply make the law less effective in achieving the legitimate legislative purpose of preserving the status quo. If, for instance, Congress had used a 5-year period, the law would have forgiven the repatriation tax on accumulated earnings from 2012 and earlier — leading to windfalls to U.S. shareholders of CFCs with long-held accumulated earnings. It was rational for Congress to calculate the tax based on data taxpayers were already tracking and a 30-year period that would sweep in most of the pre-2018 accumulated earnings rather than a shorter period that would not.

Finally, it is far from clear that the Moores' invocation of their minority-shareholder status (Br. 39) constitutes a distinct alternative argument that, even if Section 965 is rational as to shareholders that could induce an income distribution by the CFC, it is irrational as to shareholders who cannot. See Avila v. Los Angeles Police Dep't, 758 F.3d 1096, 1101 (9th Cir. 2014) (“Arguments 'not raised clearly and distinctly in the opening brief' are waived”) (citation omitted). But making Section 965 applicable only to U.S. shareholders who own 50% or more of a CFC's stock would certainly have been a windfall for corporate shareholders under that threshold. It was rational for Congress to choose 10%. Section 965 is a part of subpart F, which has long taxed U.S. taxpayers that own 10% or more of a CFC on certain earnings of the CFC. See I.R.C.§ 951(b) and Dougherty, 60 T.C. at 928, 930 & n.13. In any case, such an as-applied argument would require fact finding about the Moores' ability to induce KisanKraft to issue a dividend.

CONCLUSION

The judgment of the district court should be affirmed.

Respectfully submitted,

DAVID A. HUBBERT
Acting Assistant Attorney General

NATHANIEL S. POLLOCK (202) 514-8139
FRANCESCA UGOLINI (202) 514-3361
MICHAEL J. HAUNGS (202) 514-4343
Attorneys
Tax Division
Department of Justice
Post Office Box 502
Washington, D.C. 20044

Of Counsel:
TESSA GORMAN
Acting United States Attorney

JULY 22, 2021

STATEMENT OF RELATED CASES

Pursuant to Ninth Circuit Rule 28-2.6, counsel for the United States respectfully inform the Court that they are unaware of any cases related to the instant appeal that are pending in this Court.