Charles and Kathleen Moore (the “Taxpayers”) invested in KisanKraft, a corporation, which supplied tools to farmers in India. The Taxpayers invested $40,000 in return for a combined 11% ownership interest in KisanKraft. The company, which was headquartered and incorporated in India, is a controlled foreign corporation (“CFC”). A CFC is a corporation organized outside of the United States that is owned more than 50% by US persons. Since the company’s formation, KisanKraft was managed from India. While the company was profitable every year, it had never distributed earnings to its shareholders. Instead, it reinvested all earnings back into the company. Because the company did not distribute its earnings to shareholders and instead reinvested them (and the earnings were not previously subject to any specific Subpart F inclusion), the Taxpayers had no US tax liability on their earnings prior to 2017.
In 2018, the Taxpayers learned about their tax obligation under the MRT. This tax was added as part of the 2017 Tax Cuts and Jobs Act (“TCJA”), which overhauled US corporate taxation with the intent of shifting it from a worldwide system to a partially territorial one (with many exceptions). Thus, for example, dividends paid by CFCs post-TCJA to US persons are generally eligible for a participation exemption. To facilitate this transition, Congress established a one-time MRT on accumulated, or undistributed, earnings of CFCs. According to their calculations, the Taxpayers found that, based on KisanKraft’s financial statements, their pro rata share of KisanKraft’s retained earnings, or the accumulated portion of the business’s profits that were not distributed as dividends, were $508,000. They would have to include an additional $132,512 in taxable income under the MRT, and their tax liability for 2017 would increase by nearly $15,000 because of the tax. The Taxpayers initially filed an amended return and paid the additional liability, but later filed a second amended return, claiming a refund for the additional liability and challenging the constitutionality of the MRT.
The government subsequently filed a motion to dismiss for failure to state a claim. It argued that the Taxpayers’ claims failed because the MRT is not a direct tax and thus their Apportionment Clause claim should be denied. Further, it argued that the MRT was not retroactive and thus their Fifth Amendment claim should be denied. The district court granted the government’s motion to dismiss, finding that the Taxpayers did not provide any grounds for which the MRT was unconstitutional. The Taxpayers appealed to the United States Court of Appeals for the Ninth Circuit.
Ninth Circuit Holds “The MRT Does Not Violate The Apportionment Clause”
The first issue the Ninth Circuit addressed was whether the MRT violated the Constitution’s Apportionment Clause. The court held the MRT was consistent with the Constitution because the government has the general power to lay and collect taxes. The Apportionment Clause requires that any “direct Tax” levied by the government must be apportioned (or divided) so each state pays its pro rata share of tax. Moore, No. 20-36122 at 9 (citing Nat’l Fed’n of Indep. Bus. v. Sebelius, 567 U.S. 219, 533-534 (2012)). The proration of a direct tax for a given state must be based on its relative population to that of the United States.
The Taxpayers argued that the MRT is an unapportioned direct tax. They contended that the MRT is a tax on personal property because it is assessed on a shareholder’s retained earnings, or ownership interest, in a CFC, and not on the income of the CFC itself. Because the MRT fails to apportion itself among the states, the Taxpayers claimed that it is constitutionally defective under the Apportionment Clause. Alternatively, the Taxpayers argued that the court should rely on their interpretation of two foundational income tax cases, Eisner v. Macomber and Comm’r v. Glenshaw Glass, such that the cases “require income to be realized before it can be taxed.” Moore, No. 20-36122 at 13 (citing Macomber, 252 U.S. 189, 219 (1920); Glenshaw, 348 U.S. 426, 431 (1955)).
Responding to the Apportionment Clause argument, the court noted that the Sixteenth Amendment exempts from apportionment the vague and “expansive category of ‘incomes from whatever source derived.’” Moore, No. 20-36122 at 10 (quoting U.S. Const. amend. XVI). Despite the difficulty of “categorically defining everything that constitutes income,” the court noted “the concept of income is a flexible one.” Moore, No. 20-36122 at 10 (quoting United States v. James, 333 F.2d 748, 753 (9th Cir. 1964)). In essence, the court suggested the MRT should not be strictly construed as an apportioned direct tax given the “wide scope” courts have to define income. Id. To support its holding, the court named previous decisions which found taxes similar to the MRT to be constitutional. The court cited the following cases as precedential: Eder v. Commissioner of Internal Revenue, 138 F.2d 27, 28-29 (2d Cir. 1943) (holding the inclusion of foreign corporate income under a statute predating Subpart F to be valid); Whitlock’s Est. v. Comm.’r, 59 T.C. 490, 508 (1972), aff’d in part, rev’d in part, 494 F.2d 1297, 1298-99, 1301 (10th Cir. 1974) (holding several pre-MRT provisions of Subpart F to be valid despite constitutional challenges); Garlock Inc. v. Comm’r, 489 F.2d 197, 202 (2d Cir 1973) (affirming Tax Court’s ruling that the Subpart F income of a CFC was attributable to its shareholders regardless of whether it was distributed). Moore, No. 20-36122 at 10.
The court also explained that the realization of income does not determine the constitutionality of a tax. The court made this assertion in response to the Taxpayers’ argument that, under the Sixteenth Amendment, the MRT “cannot be a tax on ‘income’” because it is “not triggered by any realization event by which ‘income’ is ‘derived’ by the taxpayer.” Pls.’ Resp. In Opp’n To Mot. To Dismiss And Cross-mot. For Summ. J., 14-15, Moore v. United States, Civil Action No. 2:19-cv-01539 JCC (W.D. Wash. 2020). The court found it significant to note the “fact that distribution of income is prevented by operation of law, or by agreement
among private parties is no bar to its taxability.” Moore, No. 20-36122 at 11 (citing Eder, 138 F.2d at 28). Pointedly, it stated that the general rule of taxing income only once it is realized is a rule that exists solely for “administrative convenience.” Moore, No. 20-36122 at 11 (citing Helvering v. Enright’s Est., 312 U.S. 636, 641 (1941)). The court further explained that “[w]hat constitutes gain is also broadly construed,” in response to the Taxpayers’ argument that “a CFC’s retained earnings are not its shareholder’s ‘income’ for purposes of the Sixteenth Amendment.” Moore, No. 20-36122 at 11; Pls.’ Resp. In Opp’n To Mot. To Dismiss And Cross-mot. For Summ. J., 16, Moore, Civil Action No. 2:19-cv-01539 JCC (W.D. Wash. 2020). By way of example, the court cited the following as precedential: Helvering v. Bruun, 309 U.S. 461, 469 (1940) (holding a taxable gain should be recognized in a lessee’s improvements to property when the lessor regained possession of the land); Vukasovich, Inc. v. Comm’r, 790 F.2d 1904, 1415 (9th Cir. 1986) (holding the cancellation of indebtedness also created a taxable gain). Moore, No. 20-36122 at 12.
Lastly, the court held that Congress is not barred from setting aside a corporation’s structure to tax its shareholders, in response to the Taxpayers’ argument that Macomber stood for the notion that “the Sixteenth Amendment did not permit . . . a corporation’s earnings [to be] deemed its owner’s income unless it has been realized by them.” Moore, No. 20-36122 at 12; Pls.’ Resp. In Opp’n To Mot. To Dismiss And Cross-mot. For Summ. J., 16-17, Moore, Civil Action No. 2:19-cv-01539 JCC (W.D. Wash. 2020). Noting that there was no dispute in the facts that KisanKraft “earned significant income,” the court pointed out that all tax due on their pro-rata share of the CFC was deferred until the MRT went into effect. Moore, No. 20-36122 at 12. Ultimately, the court held that Subpart F only applies to 10% or greater shareholders in CFCs and that the MRT “builds upon [a] preexisting tax liability attributing a CFC’s income to its shareholders.” Id. The court then zeroed in on the fact that 10% or greater shareholders “have some ability to control distribution.” Id.
Ninth Circuit Holds “The MRT Does Not Violate the Fifth Amendment’s Due Process Clause”
The second argument the court considered was whether the MRT violated the Fifth Amendment’s Due Process Clause. To this point, the Taxpayers argued that, because the MRT was a retroactive and wholly new, one-time tax, there was no governing precedent to support the enactment of it; and the MRT could not be constitutionally implemented. The Taxpayers argued that the MRT is a wholly new tax because they had no reason to expect that the United States would tax them for foreign-corporation income that is not their own income in any aspect and has never previously been subject to US taxation. Pls.’ Resp. In Opp’n To Mot. To Dismiss And Cross-mot. For Summ. J., 22, Moore, Civil Action No. 2:19-cv-01539 JCC (W.D. Wash. 2020) (citing Quarty v. United States, 170 F.3d 961, 967 (9th Cir. 1999) (defining "wholly new tax" as a tax where "the taxpayer has no reason to suppose that any transactions of the sort will be taxed at all")).
The court rejected this argument, and held that the MRT did not violate the Fifth Amendment’s Due Process Clause. While the court assumed, without deciding, that the MRT was retroactive, it pushed back on the argument that the MRT was a “wholly new tax.” To the contrary, it found that it was not a wholly new tax because prior to the MRT, US shareholders were taxed on CFC earnings when they were distributed (or when the CFC’s earnings were subject to certain Subpart F provisions). The court stated that reliance alone is insufficient to establish a constitutional violation, and that “tax legislation is not a promise, and a taxpayer has no vested right in the Internal Revenue Code.” Moore, No. 20-36122 at 16.
Instead, the court considered whether the MRT was constitutional based on the test set forth in United States v. Carlton, 512 U.S. 26 (1994). There, the United States Supreme Court held that, to analyze a due process challenge to retroactive tax legislation, the court should consider whether the retroactive application itself serves a legitimate purpose by rational means. Id. at 30. Ultimately, the court found that the MRT did serve a legitimate purpose of taxing deferred undistributed earnings. The MRT accomplishes this purpose by accelerating the effective repatriation date of undistributed CFC earnings to a date following the TCJA. Therefore, the court held that the MRT did not violate the Fifth Amendment’s Due Process Clause.