Smith Brain Trust / October 4, 2023

How a Repatriation-Tax Challenge Before SCOTUS Could Upend the Tax Code

How a Repatriation-Tax Challenge Before SCOTUS Could Upend the Tax Code

In 2005, Kathleen and Charles Moore invested $40k in exchange for 11 percent of equity in India-based, ag-equipment company KisanKraft. The Washington state couple received no income from its shares over the following decade, as the company operationally reinvested its profits. Nonetheless, in 2018 the U.S. government handed the Moores a $14,729 tax bill on the profits earned by the foreign entity. Reluctantly they paid but subsequently sued, questioning the constitutionality of taxing unrealized income without apportionment among the states.

Now before the Supreme Court, the case, says Smith’s Samuel Handwerger “sends shivers of debits and credits up and down the backs of CPAs, and should concern Congress in a big way, as it could undo numerous precedent tax structures. Heading that list is the fundamental tax approach to S-corporations and partnerships.”

To what extent is a system upheaval looming and how did we get here?

Handwerger, CPA and lecturer of accounting and information Assurance for the University of Maryland’s Robert H. Smith School of Business, gives a big-picture view.

He writes:

Pre- 2017, the 35% tax rate on U.S. multinationals was among the highest such rates in the world and unhealthy for the United States from a global economic perspective.

Firstly, it discouraged corporate enterprise from doing business in the United States. So, resident U.S. companies devised the corporate inversion concept: Flip the top tier U.S. parent company to be a foreign company looking to do business in the United States, as opposed to a U.S. company operating overseas. The inversion shifted significant profits otherwise taxable in the U.S. to being taxed outside, at lower rates.

Secondly, U.S. owners of foreign corporations were incentivized to leave overseas-derived profits in those foreign corporations. Returning those profits to the U.S. owners in the form of dividends from the foreign entity to the US owners, called repatriation, created the 35% tax on those earnings -- a hefty price.

By 2017, unrepatriated profits in foreign corporations exceeded an estimated $2 trillion, and Congress was salivating to tax that money in the United States for significant revenue. Further, those profits, if paid to the US owners in the form of dividends, represented cash that could help the U.S. economy. So clearly it was in our country's best interest to encourage the repatriation of those foreign profits.

Thus, Congress instituted the Mandatory Repatriation Tax (MRT) in the Tax Cuts and Jobs Act of 2017 -- subjecting the unrepatriated $2 trillion to income tax, whether paid in the form of a dividend or not. You could have called it a “deemed dividend” in the eyes of tax law and no CPA worth their weight in salt would have flinched at that terminology. Such “deemed” income tax concepts are a dime a dozen in the Internal Revenue Code.

The law yields for Congress an estimated $340 billion in tax revenue on the $2 trillion unrepatriated income and now U.S. companies can pay that income in the form of a dividend if they so choose, without worry about the tax because it was happening anyway through the deemed dividend concept, like it or not.

Enter the Moores and their tax bill. Their biggest complaint is having to pay a tax on profits that they have not seen -- other than on paper in the foreign entity. In other words, the profits have not been paid to them (or “realized”), and now they are having to find the cash to pay tax on income they do not have.

This “realization” concept is at the heart of the case before the Supreme Court. The Moore’s argue there is an unfairness of taxing income before it’s realized and the constitutional limitation on that was settled in the Supreme Court case of Eisner v. Macomber, in 1920. That ruling established the principle that income must be “realized” to be subject to tax.

But as any introductory tax student learns, there are lots of tax codes where taxpayers pay tax on unrealized profits. The whole taxation regime of partnerships and S corporations are based on the “pass-through” of profits from those entities to the shareholders who pay the income tax on those profits, even if the profits are not paid out to the shareholder.

Because of this, you will find that in any given partnership or S corporation shareholder agreement there often is a requirement or suggestive language that the entity, to the extent possible, pay out to the owners at least the cost of the income tax that they will have to pay on those unrealized profits.

This paying tax on the pass-through, unrealized income, has been a staple of accepted income tax law for years. It can be found in dozens of sections of the law in various other forms as well. So much so, that many tax experts argue that the Eisner realization doctrine has been reversed many times over the past many years.

And now the Supreme Court, by accepting this case, is positioned to overturn the code by 180 degrees. Sort of like global warming pushing temperatures up to the point where traditional weather patterns collapse, disastrously, only in this case potentially overturning hundreds of pages of tax law.

What possessed the Supreme Court to put this case on its docket for the 2023-2024 session? It is speculated that a primary motivation has been the rumors of a Democratic push for a wealth tax. Ostensibly this would be a tax on unrealized income…a tax on the “increase (accretion)” of wealth by increase in value, not through the sale of a profitable asset. An adverse ruling here could put the kabob on such a tax.

Most likely not on the minds of the Supreme Court is the setback this could have on the Organization for Economic Co-operation and Development (OECD) in the final stages of its international tax cooperation initiative known as Pillars 1 and 2.

Pillar 2 establishes a worldwide 15% minimum corporate tax to stem the tide of tax competition amongst countries whereby certain countries strive to be tax-havens; thereby attracting corporations from all over the world to bring their companies and profits there. This competition erodes the tax base from countries where the profits are really made and this “profit erosion” creates an unfair market advantage to countries with the lowest corporate tax rate.

To accomplish this goal Pillar 2 has an Income Inclusion Rule, which allocates to parent entities a pro-rata share of tax on the income of their constituent entities, regardless of whether that income is distributed. If taxing unrealized income is overturned here in the Moore case, the United States will be unable to play along with the Pillar 2 inclusion rule. That will present a major obstacle to the OECD’s successful implementation of Pillar 2.

A Supreme Court ruling on this case could be delayed well into 2024 based on its schedule. In the meantime, the tax code maintains the status quo. On the other hand, expect your friendly neighborhood CPA to become irritable due to many sleepless nights in contemplation of the “what-if.”

Watch: Handwerger discusses Moore v. United States, via “Uncovering Unpaid Dividends and the Global Tax Challenge” produced by Smith’s Center for Global Business.

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