By Anthony Diosdi
Internal Revenue Code Section 965 imposes a one-time transition tax on a U.S. shareholder’s share of deferred foreign income of certain foreign corporations accumulated deferred foreign income (“ADFI”). For Section 965 purposes, a U.S. shareholder is a U.S. person who directly, indirectly, or constructively owns at least 10 percent of either total combined voting power or total value of a foreign corporation’s stock. The transition tax is treated as a mandatory subpart F inclusion.
On June 26, 2023, the United States Supreme Court granted a petition for a writ of certiorari in Moore v. United States to determine constitutionality of the transition tax. The plaintiffs, Mr. and Mrs. Moore invested in an India-based corporation. In exchange for the Mr. and Mrs. Moores’ investment, they received approximately 13 percent of the India company’s common stock. However, the Moores never received a distribution, dividend, or payment from the foreign company. Even though the Moores never received a distribution from the foreign company, under the transition tax they were subject to U.S. income taxes.
The Moores initiated refund litigation in the Western District of Washington. The Moores claimed that the 965 transition tax is a violation of the Sixteenth Amendment because it imposes an unapportioned direct tax on them rather than an income tax. Article I of the Constitution provides that Congress may institute “direct taxes” (taxes levied directly on persons and property if the revenue from the tax is apportioned among the states according to population). The Supreme Court has held that an income tax is a direct tax and must be apportioned. See Pollock v. Farmers’ Loan and Trust Company, 157 U.S. 429 (1895). The United States ultimately enacted the Sixteenth Amendment which permits Congress “to lay and collect tax on income, from whatever source derived, without apportionment.”
The Moores have argued that the Sixteenth Amendment’s exemption from apportionment is limited to taxes on realized gains and that income has to be realized in order for it to be taxed. The Moores argue in the alternative that the transition tax violates the Fifth Amendment because the tax is retractive in nature.
Potential Implications
The Supreme Court is expected to issue its opinion on the Moore case no later than June 2024. If the Moores prevail, the Section 965 transition tax could be invalidated. This could result in a number of complex procedural considerations related to U.S. shareholders that previously paid the transition tax. Since the subpart F and GILTI tax regimes operate in a similar manner as the 965 transition tax, if the Supreme Court finds that the transition tax is unconstitutional, there is speculation that the constitutional validity of subpart F and GILTI could come into question.
Other Potential Impacts of Ruling in Favor of the Moores
If the Supreme Court determines that the Section 965 transition tax is unconstitutional, some U.S. shareholders of foreign corporations could be entitled to a refund to some or all of the transition tax. However, the general statute of limitations for refund of taxes is typically limited to two years from the date a tax is paid or three years from the date of the filing of an original tax return. Most U.S. shareholders paid the transition tax with their 2017 tax year. In many cases, the statute of limitations precludes U.S. shareholders from obtaining a refund of the transition tax. With that said, if a U.S. shareholder paid the transition tax in installment payments or was assessed the transition tax as the result of an IRS audit, the general statute of limitations may still permit a U.S. shareholder of a foreign corporation to request a refund of the transition tax. In these cases, the shareholders of foreign corporations should consider filing protective claims for the refund of the transition tax paid that falls within the statute of limitations.
Conclusion
Shareholders of foreign corporations should carefully watch the developments of the Moore case. A decision in favor of the Moores could support constitutional challenges to not only the transition tax and the anti-deferral tax regimes of subpart F and GILTI, a number of other provisions of the Internal Revenue Code.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.