Transition Tax on Foreign Earnings Upheld Under Constitution

The Code section 965, often referred to as the transition tax, has been declared or argued unconstitutional in several articles published over the past several years. Unfortunately, tax advisors often promote this position to market their services.  

Before going in deep, let's review what Section 965 is.

Section 965: Introduction

According to Section 965, U.S. shareholders can reduce the income inclusion for certain specified foreign corporations if their earnings and profits are below that of the foreign corporation. In section 965(c) of the Internal Revenue Code, participation deductions adjust the effective tax rates for income inclusions.

The most significant tax legislation passed by Congress since 1986 was passed in 2017. The new regulations, commonly known as the Tax Cuts and Jobs Act of 2017, affected many aspects of the Internal Revenue Code. In addition, a new compliance standard known as the transition tax also was introduced, along with altered tax reporting standards and modifications to individual tax calculations.

What is a specified foreign corporation?

A specified foreign corporation is defined by the Internal Revenue Service under section 965 as:

Any foreign corporation owned by U.S. shareholders, or considered to be owned by U.S. shareholders, on any day during the taxable year, with more than half the combined voting power of all the classes of stock of such a corporation which are entitled to vote.

A foreign corporation―other than a passive foreign investment company―that has a U.S. shareholder that is a domestic corporation.

Cases on November 19, 2020:

Specifically, the first decision concerning this claim was made on November 19, 2020. Moore v. the United States, Case No. C19-1539-JCC (W.D. WA, November 19, 2020). Accordingly, the Federal District Court in Moore ruled with prejudice that the Government should dismiss the taxpayers' refund suit.

A shareholder, Charles Moore, filed a lawsuit in federal court seeking a refund. The shareholders argued (1) the transition tax violates the Apportionment Clause of Article I, Section 9 of the United States Declaration of Independence, as it is an unequally-apportioned tax as opposed to an income tax, and (2) the Tax was imposed retroactively, violating the Fifth Amendment's Due Process Clause.

What is the Apportionment Clause?

According to the Apportionment Clause, direct taxes must be apportioned among the states.

There are three types of direct taxes: taxation based on property, taxation based on headcount (capitation), or taxation based on income.  

Changes in the Apportionment Clause

Amendment XVI, however, changed this clause significantly over one hundred years ago by allowing taxes on income without apportionment.

The taxpayers argued that:

Transition taxes are indirect taxes on property, as they apply to accumulated rather than current income.  

In their argument, taxpayers claimed that there had been no realization event; therefore, the transition tax could not be a valid income tax.

In numerous subsequent cases, the District Court found that the realization standard as expressed in Eisner had been specifically and routinely departed from. Eisner's facts regarding stock dividends appeared to have also been limited by the court. Further, the court found a number of statutory tax regimes - mark-to-market rules - that required the taxation of unrealized income.  

This can also be considered as accumulated income realized by the taxpayers in that their wealth has increased as a result of that additional income. The Tax was simply deferred. Foreign income has never been fully exempted from U.S. income tax, and Congress has the power to grant or deny this exemption.

The claim of stakeholders: Transition tax was retroactive

They also claimed that the transition tax was retroactive and that they had been deprived of property against their will without any legal process. Despite the Government's arguments to the contrary, the court found that the Tax is retroactive "by its very nature," as it was levied on earnings and profits accumulated before the statute's adoption.  

The District Court nevertheless ruled that the Due Process Clause violates not all retroactive taxes despite taxpayers' victory on the retroactivity issue.   

The court found that the means were rationally based on these factors. The TCJA included Section 965, a rational method for preventing the taxation of undistributed earnings and profits on the date of its effective implementation.  

Additionally, it was rational because it retroactively applied to 1986. To determine the rational basis of the Tax Code before the TCJA, the duration of retroactivity was only one factor.  

In this case, the court found no denial of due process due to the long retroactivity period. As a rationally necessary component of the TCJA's overall territorial tax scheme, the transition tax plays an integral role.  

Before the TCJA, CFCs' accumulated earnings were deferred rather than permanently exempt from international Tax. Congress is not legally obligated to maintain taxpayer-friendly rules indefinitely. Tax advisors knowledgeable about international taxation were not surprised when section 965 was enacted. As a result, taxpayers were not denied due process.

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