Huge news!! The US Supreme Court has agreed to consider the constitutionality of the IRC S. 965 @USTransitionTax. The issues include whether real tax can be imposed on deemed income that the person never received. The result may have some bearing on the 877A expatriation tax too! https://t.co/GeXLKp3SkA

— John Richardson – lawyer for "U.S. persons" abroad (@ExpatriationLaw) June 26, 2023

In my last post I discussed the fact that the U.S. Supreme Court has agreed to hear the Moore’s challenge to the 965 Transition Tax.

A direct link to the Supreme Court site which will track the progress and filings of all briefs (including what are expected to be a large number of amicus briefs) is here.

Although the 965 Transition Tax was the fact that prompted the litigation, the issue as framed for the Supreme Court was:

22-800 MOORE V. UNITED STATES
DECISION BELOW: 36 F.4TH 930
CERT. GRANTED 6/26/2023

QUESTION PRESENTED:

The Sixteenth Amendment authorizes Congress to lay “taxes on incomes … without apportionment among the several States.” Beginning with Eisner v. Macomber, 252 U.S. 189 (1920), this Court’s decisions have uniformly held “income,” for Sixteenth Amendment purposes, to require realization by the taxpayer. In the decision below, however, the Ninth Circuit approved taxation of a married couple on earnings that they undisputedly did not realize but were instead retained and reinvested by a corporation in which they are minority shareholders. It held that “realization of income is not a constitutional requirement” for Congress to lay an “income” tax exempt from apportionment. App.12. In so holding, the Ninth Circuit became “the first court in the country to state that an ‘income tax’ doesn’t require that a ‘taxpayer has realized income.”‘ App.38 (Bumatay, J., dissenting from denial of rehearing en banc).

The question presented is:

Whether the Sixteenth Amendment authorizes Congress to tax unrealized sums without apportionment among the states.

LOWER COURT CASE NUMBER: 20-36122

The relevant facts as recited in the petition may be found in the Appendix* below.

A lawsuit about the “transition tax” that is not really about the “transition tax”

A number of commentators have observed this lawsuit is less about the 965 Transition Tax and Moore (pun intended) about seeking a judgment to forestall future future wealth taxes. The Moore’s are of course entirely irrelevant and are simply lending their names and facts to make the lawsuit possible. In fact, various commentators have emphasized that this is only a $14,712 case (they aren’t the ones subject to the shakedown) that could upend major components of the U.S. tax system. That may be true. But, one has to start somewhere. By paying the tax the Moore’s created the circumstances that ensured that the lawsuit could be brought.

The Moore’s may not matter. But, they do reveal some truths about the § 965 transition tax

Everybody agrees that the Moore’s don’t really matter and that they (or their circumstances) are not really the issue. Although true, I think it’s important to explain:

Why the imposition of the 965 Transition Tax on the Moore’s (coupled with their payment of the tax) actually results in pure double taxation.

Yes, you heard it – pure double taxation in the exact amount of the 965 transition tax paid!

First the Moore’s were taxed by the United States. Second, the Moore’s would be taxed by India.

Although the Transition Tax was a “reasonably good” tax deal for the multinationals (and an even sweeter deal for individuals who were S corp shareholders), it was pure theft from “individual” shareholders of CFCs – who like the Moore’s lacked the power to vote themselves a distribution even if they wanted to. Individual shareholders received none of the benefits of the transition to a (“wink wink” – GILTI anyone?) territorial tax system. Furthermore, an individual’s share of retained earnings was subject to a tax of 17.54% (higher than the the tax paid by the multinationals).

(In addition the “transition tax” is arguably a violation of the terms of the standard tax treaty which generally prohibits one country from imposing direct taxation on the companies of another country. After all, many Canadian resident owners of Canadian Controlled Private Corporations were forced to liquidate their companies in order to pay the tax. Where else would they get the money to pay the tax?)

Here is how the (double) tax calculation for the Moore’s works (without consideration of a possible 962 election):

1. The company earned $132,512 which was reinvested back into the business and the shareholders received no distribution.

2. The § 965 transition tax required the Moore’s to include the $132,512 earned by the corporation (a separate legal entity) in their income for the 2017 year.

3. The deemed income inclusion of $132,512 resulted in a U.S. tax bill (after a complicated calculation) of $14,729 a U.S. tax rate of approximately 11%.

4. From a U.S. tax perspective that settled any future U.S. taxation of the $132,512 (should it ever be distributed).

Some commentators claim that this is actually a favorable tax outcome for the Moore’s. I believe that is an incorrect claim that appears to disregard the facts that:

A. India has taxation too and India will impose a 25% tax on any future distribution of the profits to the U.S. shareholders;

B. Therefore the minimum tax that the Moore’s will pay is the India tax of 25% plus the 11% U.S. tax already paid through the § 965 transition tax = 36%!! Further 11% of that was prepaid courtesy of the § 965 transition tax (imposed without any certainty that a dividend would ever be paid).

That said proponents of the § 965 transition tax might say:

Well, okay but the tax rate of 36% is close to the top marginal U.S. rate anyway. So, the Moore’s weren’t really harmed, right?

Once again, I believe that this is incorrect. If the § 965 transition tax had never been enacted, the Moore’s:

– would never had to pay a tax without a distribution; and

– in the event of a distribution would have paid only a 25% total tax.

This is the result of a combination of the U.S. tax treaty and the foreign tax credit rules …

1. Article 10 of the U.S. India Tax Treaty gives India the right to impose a 25% tax on dividends paid to a U.S. resident shareholder. (See further commentary here and here.)

2. Because the U.S. has a tax treaty with India the dividends received from the India company are “qualified dividends” which means they are taxable at long term capital gains rates (20% at most).

3. The Moore’s would have the benefit of the U.S. foreign tax credit rules which would allow them to credit the 20% U.S. tax with the 25% tax paid in India. This would (Net Investment Income Tax Excepted) completely eliminate any U.S. tax liability.

In order to test the validity of this conclusion I asked CPA Olivier Wagner of 1040Abroad to prepare a mock US tax return that shows how the $132,512 would be taxed (taking into consideration the tax paid in India) and the U.S. foreign tax credit rules. Here is the result expressed on the return which indicates no U.S. tax owing.

USCI0000_22I_FC

Thanks to Olivier Wagner for taking the time to demonstrate this result!

Conclusion – Payment of the § 965 transition tax ensured the Moore’s paid more than they would have paid had there been no § 965 transition tax – The extra payment was the exact amount of the transition tax!

The § 965 transition tax (imposed without any certainty that a dividend would ever be paid) guaranteed that the Moore’s paid $14,729 that they NEVER would have paid had the transition tax not been imposed. How can this be construed as anything except theft from the Moores?

The § 965 transition tax was probably a good deal for America’s multinational corporations. After all they received:

– a reduction in the corporate tax rate from 35% to 21%

– the § 245A dividends received deduction

The § 965 transition tax was a terrible and devastating tax for individual shareholders of CFCs (other then the sweet deal offered to S corp shareholders). They received none of the benefits that the multinationals received!

Q. How could it be worse for the Moore’s?

A. If the Moore’s were U.S. citizens living outside the United States living in circumstances where their CFCs were actually their pensions.

Interested in Moore about the § 965 transition tax?

Read “The Little Red Transition Tax Book“.

Appendix* – The facts as described in the Cert Petition

As described in the petition, the relevant facts (starting at page 3) are:

A. Factual and Legal Background

1. In 2006, Charles and Kathleen Moore made an investment to help launch an overseas company formed to empower India’s underserved rural farmers. App.70–71. Charles’s friend and former coworker, Ravindra “Ravi” Kumar Agrawal, saw that farmers in India’s most impoverished regions lacked access to even the most basic tools available in American hardware stores. App.70. To improve their livelihoods, he founded an India- based corporation, KisanKraft Machine Tools Private Limited, to import, manufacture, and distribute affordable farming equipment. App.70–71. Moved by Ravi’s vision, the Moores put up $40,000—for them, a significant sum—and received about 13 percent of KisanKraft’s common shares. App.71. Ravi retained approximately 80 percent ownership and moved to India to manage the business. App.72; CA9.ER.36.1

KisanKraft’s rapid growth confirmed that Ravi had identified a genuine need. It was profitable almost from the start, and its revenues increased every year since its founding. CA9.ER.38. True to Ravi’s original business plan, KisanKraft reinvested all its earnings to grow the business, which has expanded to serve farmers across India. App.71, 73; CA9.ER.37–38. By 2017, it employed over 350 representatives in 14 regional offices serving 2,500 local dealers. App.CA9.ER.38.

The Moores received regular updates from Ravi on KisanKraft’s activities, as well as annual financial statements. App.72. Charles visited India several times and was impressed with the difference that KisanKraft was making in the lives of India’s rural poor. App.72. The Moores never received any distributions, dividends, or other payments from KisanKraft. App.73. And as minority shareholders without any role in KisanKraft’s management, they had no ability to force the company to issue a dividend. App.73. For the Moores, it was payment enough that they were able to support KisanKraft’s “noble purpose…to improve the lives of small and marginal farmers in India” and see the good that it was doing. App.71.

Then came the tax bill. In 2018, the Moores learned from Ravi that, under the recently enacted “Mandatory Repatriation Tax,” they owed income tax on KisanKraft’s reinvested earnings going back to 2006. App.74. Specifically, the MRT deemed a portion of KisanKraft’s earnings for each year proportional to the Moores’ ownership stake in 2017 to be the Moores’ 2017 income—even though they hadn’t received a penny from the company and likely wouldn’t for some since time, if ever. App.74. Ultimately, the Moores had to declare an additional $132,512 as taxable 2017 income and pay an additional $14,729 in tax. App.74–75.

2. The MRT was enacted as part of the Tax Cuts and Jobs Act of 2017 (TCJA). App.6. It targets U.S. shareholders who own 10 percent or more (by value or voting power) of foreign corporations that are primarily owned or controlled by U.S. persons. 26 U.S.C. § 965; see also id. § 957 (defining subject corporations). Prior to the MRT, these shareholders were usually taxed when the foreign corporation distributed its earnings. App.6. The MRT, however, simply deems the corporations’ retained earnings going back to 1986 to be the 2017 income of their U.S. shareholders in proportion to their ownership stakes in 2017. 26 U.S.C. § 965(a). The shareholders are then taxed on that deemed “income”—which, by definition, has not been distributed to them—at a rate based on how the corporation held the retained earnings in 2017: 15.5 percent for earnings held in cash or cash equivalents and 8 percent otherwise. Id. § 965(a), (c); see alsoid. § 951(a).2 The MRT taxes shareholders irrespective of whether they owned shares at the time the corporation made the earnings on which they’re being taxed and irrespective of whether they could force the corporation to make a distribution. All that matters is that a given shareholder owned the requisite number of shares in 2017. Id. §§ 965(a), 951(a).

Have a question? Contact John Richardson, Citizenship Solutions, Toronto, Canada and the United States.