Contents
- 1 Supreme Court Rules in Favor of the Transition Tax
- 2 What is Section 965?
- 3 Key Parts of the Supreme Court’s Ruling
- 4 What Does This Mean for Taxpayers?
- 5 Late Filing Penalties May be Reduced or Avoided
- 6 Current Year vs Prior Year Non-Compliance
- 7 Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)
- 8 Need Help Finding an Experienced Offshore Tax Attorney?
- 9 Golding & Golding: About Our International Tax Law Firm
Supreme Court Upholds Taxes on Previous Year Foreign Income
Supreme Court Rules in Favor of the Transition Tax
Recently, the Supreme Court ruled in favor of the U.S. government on the legality of the Internal Revenue Code, Section 965 Repatriation Tax (aka Mandatory Repatriation Tax, MRT). Otherwise known as the Transition Tax, Section 965 was developed in order to require U.S. persons who have previously untaxed income overseas to pay a one-time repatriation tax. The rule is very complicated because it requires taxpayers to pay the U.S. tax on income generated, even if they have not received the money – and even if they do not actually repatriate the money. It is very common for taxpayers to have money overseas that they may have never intended on repatriating to the United States or have money in a corporation that they are shareholders in, but have not received distributions from yet. The key problem with this code section is that taxpayers must pay tax on the income for the previously untaxed income that qualifies under Section 965, even if that money is not being actually distributed to them or being repatriated back to the United States at this time. Technically, the taxpayer may end up paying tax on income that they never receive — which is the crux of the argument as to why this code section is unfair. It is important to note that the IRS does have other laws in place that require income taxes on income that has not been distributed (Subpart F) so MRT is not the first tax of its kind. In addition, the repatriation tax does not apply to all people and situations — it is limited to taxpayers who have non-repatriated income and controlled foreign corporations/specified foreign corporations. Let’s briefly look at Section 965 and why the IRS prevailed in this case.What is Section 965?
As provided by the IRS:-
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Section 965 requires United States shareholders (as defined under section 951(b)) to pay a transition tax on the untaxed foreign earnings of certain specified foreign corporations as if those earnings had been repatriated to the United States. Very generally, a specified foreign corporation means either a controlled foreign corporation, as defined under section 957 (“CFC”), or a foreign corporation (other than a passive foreign investment company, as defined under section 1297, that is not also a CFC) that has a United States shareholder that is a domestic corporation. Section 965 allows U.S. shareholders to reduce the amount of the income inclusion based on deficits in earnings and profits with respect to other specified foreign corporations. The effective tax rates applicable to income inclusions are adjusted by way of a participation deduction set out in section 965(c). A reduced foreign tax credit applies to the inclusion under section 965(g). Taxpayers may elect to pay the transition tax in installments over an eight-year period.
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Taxpayers may have to pay a section 965 transition tax when filing their 2017 tax returns. The tax is payable as of the due date of the return (without extensions). The IRS recently issued guidance on the calculation of the tax and filing for 2017 in the form of answers to frequently asked questions (FAQs) which can be found, along with additional IRS news releases on section 965, and other topics relating to tax reform and the Tax Cuts and Jobs Act.
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Key Parts of the Supreme Court’s Ruling
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Critically, however, the MRT does tax realized income— namely, income realized by the corporation, KisanKraft. The MRT attributes the income of the corporation to the shareholders, and then taxes the shareholders (including the Moores) on their share of that undistributed corporate income. So the precise and narrow question that the Court addresses today is whether Congress may attribute an entity’s realized and undistributed income to the entity’s shareholders or partners, and then tax the shareholders or partners on their portions of that income. This Court’s longstanding precedents, reflected in and reinforced by Congress’s longstanding practice, establish that the answer is yes.2
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Most notably, the courts have repeatedly invoked that principle in upholding subpart F, which Congress enacted in 1962. Like the MRT, subpart F treats certain foreign corporations as pass-throughs by attributing undistributed income of foreign corporations to their American shareholders, and then taxing the American shareholders on their pro rata shares of the income. As the Second Circuit concluded in a leading case upholding subpart F: The constitutional challenge to subpart F “borders on the frivolous” in light of Heiner v. Mellon. Garlock, Inc. v. Commissioner, 489 F. 2d 197, 202–203, and n. 5 (1973); see also Estate of Whitlock v. Commissioner, 59 T. C. 490, 507 (1972) (The “Supreme Court’s pronouncements have been to the effect that taxation of undistributed current corporate income at the stockholder level rather than at the corporate level is within the congressional power”), aff’d in relevant part, 494 F. 2d 1297, 1301 (CA10 1974) (adopting the Tax Court’s analysis); B. Bittker & L. Lokken, Federal Taxation of Income, Estates and Gifts ¶1.2.4 (2024) (noting the consensus in favor of Congress’s power to tax foreign corporations as pass-through businesses); cf. Eder v. Commissioner, 138 F. 2d 27, 28 (CA2 1943) (“In 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”).
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To sum up: The Court’s longstanding precedents plainly establish that, when dealing with an entity’s undistributed income, Congress may tax either (i) the entity or (ii) its shareholders or partners. Consistent with this Court’s case law, Congress has long taxed the shareholders and partners of business entities on the entities’ undistributed income. That longstanding congressional practice reflects and reinforces this Court’s precedents upholding those kinds of taxes.
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In short, the Moores cannot meaningfully distinguish the MRT from similar taxes such as taxes on partnerships, on S corporations, and on subpart F income.6 The upshot is that the Moores’ argument, taken to its logical conclusion, could render vast swaths of the Internal Revenue Code unconstitutional. See, e.g., 26 U. S. C. §305(c) (deemed stock distributions); §§446, 448 (accrual accounting); §701 (partnership taxation); §§951–965 (subpart F); §951A (pass-through tax on global intangible low-taxed income); §1256(a) (certain futures contracts); §1272(a) (originalissue discount instruments); §§1361–1379 (S corporations); §§2501–2524 (gift taxes). And those tax provisions, if suddenly eliminated, would deprive the U. S. Government and the American people of trillions in lost tax revenue. The logical implications of the Moores’ theory would therefore require Congress to either drastically cut critical national programs or significantly increase taxes on the remaining sources available to it— including, of course, on ordinary Americans.
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The MRT attributes the undistributed income of American-controlled foreign corporations to their American shareholders, and then taxes the American shareholders on that income. By doing so, the MRT operates in the same basic way as Congress’s longstanding taxation of partnerships, S corporations, and subpart F income. And the MRT is consistent with the principles that this Court articulated in upholding those kinds of taxes in cases such as Burk-Waggoner Oil Assn. v. Hopkins, Heiner v. Mellon, and Helvering v. National Grocery Co. The MRT therefore falls squarely within Congress’s constitutional authority to tax.
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