The tax world is in a tizzy as the Supreme Court is set to consider a case that could fundamentally change the federal income tax code.
Next week, the Court will hear oral arguments in Moore v. United States, a case some claim could undermine the tax code and cost the government trillions of dollars if decided for the petitioners, while others claim a decision for the government could pave the way for a wealth tax.[1]
The question before the Court is whether the Mandatory Repatriation Tax (MRT) enacted in 2017 is constitutional. To answer this question, it is necessary to consider what the Constitution says about taxes.[2]
Article I, Section 2 says, “direct taxes shall be apportioned among the several states… according to their [population].” Article 1, Section 8 says, “Congress shall have power to lay and collect taxes, duties, imposts and excises… but all duties, imposts and excises shall be uniform throughout the United States.” Article 1, Section 9 says, “no capitation, or other direct, tax shall be laid, unless in proportion to the [population],“ and “no tax or duty shall be laid on articles exported from any State.”[3]
But what is a “direct” tax – any tax that is not a duty, impost, or excise – or something else? The Constitution doesn’t say, so that’s where the Supreme Court comes in.
In Hylton v. United States (1796), the Supreme Court adopted a pragmatic approach. Direct taxes must be apportioned; duties, imposts, and excises must be uniform; and other taxes are categorized according to whether they are apportioned or applied uniformly. In this case, the Court held that a tax on carriages was applied uniformly, and thus an “indirect” tax, and therefore constitutional. The Court noted a carriage tax could not be apportioned evenly among the states on a per capita basis because carriage ownership is not proportional to population.[4]
In Pollock v. Farmers’ Loan & Trust Co. (1895), the Supreme Court decided that taxes on property and the income derived from property were direct taxes subject to apportionment. In this case, the Court held that a two percent tax on income – including rent, interest, and dividends – above $4,000 a year was unconstitutional because the tax on property income was not apportioned, even though it was arguably applied uniformly.[5] This decision struck down the federal income tax.
In response, the Sixteenth Amendment was added to the Constitution. This amendment says, “Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration.”[6] Then Congress promptly re-enacted the federal income tax.[7]
Having established Congress’s authority to impose an income tax, the Constitutional questions raised by Moore should be focused on who earned the income and when it was earned.
In 2005, Charles and Kathleen Moore invested $40,000 in a foreign company that provided tools and equipment to farmers in India. In exchange, they received 13 percent of the common shares of the company. Every year, the company reinvested its earnings to expand its business. The company never distributed these earnings to its shareholders. Nevertheless, when Congress enacted the MRT in 2017, the Moores had to pay $14,729 in taxes on their share of the company’s previously reinvested earnings dating back to their initial investment.[8]
According to the attorneys representing the Moores, because they never received their share of the company’s earnings, the MRT is a direct tax on their property (i.e., ownership of common shares) and thus unconstitutional due to the failure to comply with the apportionment requirement. From the Moores’ perspective, the Court should focus on the fact that they did not realize any income.
According to the government, because Congress previously established its authority to tax individual investors on their share of undistributed corporate income, the MRT is a constitutional tax on income in accordance with the Sixteenth Amendment. From the government’s perspective, the Court should focus on the fact that income realized by a corporation is taxable to individual investors.[9]
The objection that the MRT is unconstitutional because the Moores did not realize any income is easily overcome by recognizing that the realization of income occurred at the corporate level. However, the retroactive application of the MRT to income realized between 1986 and 2017, raised another legal issue in the courts below. Do retroactive taxes violate the Fifth Amendment’s due process clause?[10]
The Ninth Circuit Court of Appeals assumed, without deciding, that the MRT is a retroactive tax.
Prior to 2017, the government allowed individual investors to exclude the active business income of controlled foreign corporations (CFC) from their taxable income. Such income was only taxable upon its distribution to individual investors. Other types of CFC income were taxable at the individual level on an annual basis, even when such income was not distributed to investors. The Tax Cut and Jobs Act (TCJA) eliminated the annual tax deferral on active business income earned after 2017.
Because undistributed CFC income is now taxed on an annual basis, any subsequent distribution of this income is excluded from the individual investor’s income to avoid double taxation. However, these new provisions would have the effect of permanently exempting undistributed CFC income earned prior to 2017 because it was not previously taxed on an annual basis and future distributions would also be tax exempt. The MRT was enacted to prevent this outcome by taxing undistributed CFC income earned between 1986 and 2017.
The Ninth Circuit held that the MRT did not violate due process because it served the legitimate legislative purpose of preventing investors from obtaining an undue windfall by never having to pay taxes on undistributed earnings.[11] However, this result could have been achieved without raising due process concerns. For example, Congress could have chosen to tax future distributions on an annual basis until individual investors received an amount equal to their share of 1986-2017 earnings.
The Supreme Court has identified five issues relevant to the due process consideration of tax policy: (1) whether the retroactive provision is “wholly new,” (2) whether the retroactive action resolves uncertainty in the law, (3) the length of the period of retroactivity, (4) whether the affected party had notice of the potential change prior to the conduct that was retroactively regulated, and (5) whether the retroactive provisions are remedial in nature.[12]
The tax deferral of undistributed active business income has existed since 1913. In 2004, Congress encouraged the distribution of this income by providing a temporary preferential “repatriation” tax rate. Critics complained this only encouraged CFC to retain earnings in hopes of future repatriation taxes. Nevertheless, this repatriation tax was consistent with the precedent that undistributed active business income would only be taxed when it was distributed. The MRT breaks that precedent by taxing decades of undistributed active business income by “deeming” a repatriation that never occurred. The argument that a retroactive tax on deemed income is necessary to avoid a permanent tax exemption is unpersuasive when other non-retroactive options are available, as noted above.
Curiously, the Moores’ attorneys did not pursue this due process claim in their appeal to the Supreme Court, and while the Court is not precluded from asking the parties to brief issues beyond those raised on appeal, it has not done so in this case. That’s unfortunate because a finding that the MRT is an unconstitutional retroactive tax in violation of due process would allow the Court to resolve this case without overturning the precedent that a direct tax on property is subject to apportionment (i.e., wealth taxes are still unconstitutional), and without undermining the government’s ability to continue taxing individuals on their share of undistributed corporate income on a non-retroactive basis.
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[1] Guide to Amicus Briefs Filed in Moore v. United States | NYU School of Law
[2] The Federal Taxing Power: A Primer | (congress.gov)
[3] U.S. Constitution | Legal Information Institute | (cornell.edu)
[4] Hylton v. United States :: 3 U.S. 171 (1796) | Justia US Supreme Court Center
[5] Pollock v. Farmers’ Loan & Trust Company :: 158 U.S. 601 (1895) | Justia US Supreme Court Center
[6] 16th Amendment | U.S. Constitution | Legal Information Institute | (cornell.edu)
[7] 16th Amendment to the U.S. Constitution: Federal Income Tax (1913) | National Archives
[8] Moore – Merits Brief | (supremecourt.gov)
[9] United States | (supremecourt.gov)
[10] Fifth Amendment | U.S. Constitution | Legal Information Institute (cornell.edu)
[11] CHARLES MOORE V. USA, No. 20-36122 (9th Cir. 2022) :: Justia
[12] GPX Int’l Tire Corp. v. United States, No. 14-1188 (Fed. Cir. 2015) :: Justia
