United States: Moore Or Less (Tax): U.S. Supreme Court Action Signals Need For Protective Refund Claims For IRC § 965 Inclusions

The U.S. Supreme Court has agreed to consider whether the mandatory repatriation tax (MRT) resulting from the deemed repatriation under IRC § 965 is constitutional. No decision is expected until 2024. Taxpayers generally reported the deemed repatriation on their 2017 tax returns, but for some taxpayers the deemed repatriation was reported on their 2018 returns. Further, taxpayers often elected to pay the MRT in installments over eight years; those taxpayers generally have paid some, but not all, of the MRT. Taxpayers that reported the deemed repatriation should determine whether, and the extent to which, they can timely file protective claims for tax refunds in case the Supreme Court invalidates the MRT, including for installment payments made while we await the Court's decision.

Should the Supreme Court find the MRT violates the U.S. Constitution, there could be broad implications for other tax provisions, possibly even negating taxability under other tax provisions where there is no identifiable realization event (e.g., the entire subpart F income regime, required mark-to-market inclusions, original issue discount, etc.). Taxpayers impacted by these other regimes also should consider whether they should file protective claims.

Background for the MRT

The December 2017 federal tax reform law, commonly referred to as the Tax Cuts and Jobs Act or TCJA, overhauled many aspects of U.S. tax law. One of the more significant changes for U.S. corporations was to shift U.S. taxation from a worldwide system to a more territorial system. The TCJA did not create a pure territorial system because it did not change the "from whatever source derived" prong of the definition of gross income provided by IRC § 61(a). However, the TCJA added new IRC § 245A, which generally provides a 100% dividends received deduction (DRD) for dividends received by a U.S. corporation from 10% or greater owned non-U.S. corporations.

To prevent permanent exclusion of deferred income earned by non-U.S. corporations, the TCJA created the MRT as a transition tax, with IRC § 965 effecting a deemed repatriation from certain non-U.S. corporations. Congress did not limit this MRT to corporations, even though only corporations may claim the IRC Section 245A DRD. ¹

Challenge to the MRT Before the Court

The U.S. Supreme Court has agreed to hear a case next term involving a Washington couple, Charles and Kathleen Moore (the "Moores"), who challenged the MRT. The gravamen of their complaint disputes the ability of U.S. tax law to deem the existence of a repatriation before an actual distribution is received or accrued. The Moores asserted that the MRT and deemed repatriation did not satisfy the requirements of the 16^th Amendment to the U.S. Constitution with respect to an income tax the proceeds from which do not have to be apportioned among the states based on population. Specifically, the Moores argued that long-standing, foundational income tax cases (Eisner v. Macomber, 252 U.S. 189 (1920), and Comm'r v. Glenshaw Glass Co., 348 U.S. 426 (1955)), require that income be "realized" before it can be taxed.

In Moore v. United States, 36 F.4th 930 (2022), the Ninth Circuit Court of Appeals rejected this argument and held that the MRT imposed under IRC § 965 constituted "income, from whatever source derived," for purposes of the 16^th Amendment, with the resulting MRT being constitutional without the need for apportionment even if it was a direct tax. The specific issue for the Supreme Court will be whether the 16^th Amendment requires the type of realization event described in Einser v. Macomber and Glenshaw Glass.

Leaving aside the niceties of the formal legal arguments, everyone appreciates that the challenge is not really about the refund of $15,130 of MRT and many appreciate that the case is not even about the projected $339 billion to be raised by the MRT. Instead, for many the case is being used as a vehicle to address the question of whether Congress can impose a tax on wealth prior to a realization event. See, for example, this Wall Street Journal editorial.

This article does not take a position on the legitimacy of whether the IRC § 965 deemed repatriation is valid or whether the MRT is a direct or indirect tax. Nor do we attempt to guess what would happen to the many other provisions of the Code where income is subject to tax before realization (e.g., the entire subpart F income regime, required mark-to-market inclusions, original issue discount) or is earned by an entity but not yet distributed (e.g., partnerships, S corporations, and Subpart F itself). We simply note that the Supreme Court hears very few tax cases and the fact that they have agreed to hear this case could well indicate a willingness to invalidate the MRT. If the taxpayers in Moore are successful, there likely will be a refund opportunity for those who paid the MRT but, as described more fully below, that refund opportunity will be limited to taxpayers for which the statute of limitations remains open.

What Does Moore Mean to Me?

If the taxpayer prevails in Moore before the Supreme Court, IRC § 965 could be invalidated. Many taxpayers that paid the MRT probably did so on their 2017 tax return (though U.S. taxpayers with interests in foreign corporations who report on a fiscal year other than the calendar year might have paid the tax on their 2018 tax return). Normally refund claims must be filed within three years of filing the tax return or two years from the date the tax was paid. Thus, many taxpayers will have lost the opportunity to pursue a refund claim by 2021 (or 2022).

However, there are at least two categories of taxpayers for whom refund claims could still prove timely for at least some of the MRT. First, taxpayers under audit are often required to extend the statute of limitations and may be able to claim a refund up to six months following the expiration of the statute of limitations.² Second, most taxpayers took advantage of the opportunity to pay the MRT in installments over eight years, with most of the tax payable later in the installment period. Those taxpayers generally should be able to file refund claims for any amounts paid within two years of claim filing.

Accordingly, we recommend that taxpayers who have extended the statute of limitations, or paid the MRT in installments within the last two years, consider filing protective federal and state refund claims based on the potential unconstitutionality of the MRT. At least at the federal level, such protective refund claims need not contain much detail beyond the taxpayers identifying information, years at issue, and clear explanation that the refund claim will be clarified/supplemented following the outcome of the Supreme Court's decision in Moore.³ For example, the taxpayer could state that the claim will be computed if the taxpayer in Moore prevails in that case in a way that supports the protective refund claim, or withdrawn if the government prevails in that case. Just don't expect the IRS to send a refund check anytime soon.

There is also a theoretical chance that the Supreme Court could invalidate all taxes imposed prior to the taxable year in which the taxpayer actually has a right to receive cash. Stated more technically, the Ninth Circuit rejected, but the Supreme Court could adopt, a narrow definition of income taxable without the need for apportionment, such as the Moore's purported definition of income from Glenshaw Glass, which would require:

In such event, large groups of taxpayers theoretically could be entitled to refunds (assuming they timely file refund claims) on income reported to them on Forms K-1, or from IRC 1256 contracts, OID notes, or under Subpart F or similar flow-through tax regimes. We anticipate that some practitioners may encourage such taxpayers to file protective claims for all open years, and there is some justification for that advice — so we concur that it is worth considering. However, we suspect that, if the Supreme Court does invalidate IRC 965 taxes, then they will try to do so in the narrowest way possible to avoid undermining so many other provisions of the tax Code.

Footnotes

1. State reaction to this deemed repatriation has varied. Elsewhere we discuss the general operation of the MRT and the Oregon tax treatment thereof; here we explain how the Oregon Tax Court agreed with our interpretation.

2. IRC 6511(c).

3. IRM 21.5.3.4.7.3 (10-03-2022) and IRM 4.10.11.2.1.3(4) (09-04-2020).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.