The Supreme Court has agreed to hear a case challenging the constitutionality of the transition tax on deferred foreign earnings imposed by Section 965 of the Internal Revenue Code.
Internal Revenue Code Section 965 imposed a one-time transition tax (essentially a toll charge) on the undistributed, non-previously taxed post-1986 foreign earnings and profits of certain U.S.-owned foreign corporations. The tax, included in the 2017 Tax Cuts and Jobs Act (TCJA), requires mandatory inclusion of deferred foreign income as subpart F income by U.S. shareholders of deferred foreign income corporations (DFICs), including domestic pass-through owners of a domestic pass-through U.S. shareholder. It is a tax on foreign income deemed distributed to shareholders that was previously treated as not currently taxable under the Internal Revenue Code existing prior to the TCJA.
The tax, calculated at a reduced rate dependent upon whether the deferred earnings were held in cash or other assets, could be paid immediately with a 2017 return (generally) or was allowed to be paid in installments over eight years ranging from 8% for the first five installments to 15%, 20%, and then 25%, respectively, over the last three installments.
Taxpayer Challenge to Tax on Income Not Received
Taxpayers from Washington state, Charles and Kathleen Moore (the Moores) are challenging the assessment of tax on their proportionate share of corporate income earned by a foreign corporation. The income was never distributed to them in cash (or other property); rather, the corporation reinvested all earnings in its business of assisting rural farmers in India.
The Moores lost a refund claim case in the Western District of Washington in which they argued that Section 965 violated the Sixteenth and Fifth Amendments to the U.S. Constitution. They appealed to the Ninth Circuit court which affirmed the district court’s ruling. The Moores petitioned the Supreme Court to review the Ninth Circuit’s decision; on June 26, 2023, the Supreme Court agreed to hear whether the tax is constitutional under the Sixteenth Amendment.
The Moores argued that under previous Supreme Court rulings, income had to be realized in order to be taxed. In part, that decision provided that income is realized when there are instances of  undeniable accessions to wealth,  income is clearly realized, and  income is that over which the taxpayers have complete dominion.
The case will be argued before the Supreme Court later this year and a ruling is likely sometime in the middle of 2024.
Possible Ramifications of Supreme Court’s Decision
There are a number of possible (and uncertain) outcomes resulting from the Supreme Court’s decision. Obviously, the Supreme Court could agree with the Ninth Circuit’s decision, in which case the tax regime
would be found to be constitutional and there is no change in law. Another option includes the Supreme Court striking down all or possibly some part of the deemed repatriation tax regime. In this instance, there may be opportunities to recover taxes paid in earlier years.
What Should Taxpayers Do Now?
Taxpayers typically have a limited time to file refund claims with the IRS. Occasionally, this time limit may expire before the taxpayer’s right to the refund claim is finalized and determinable (e.g., during pending litigation). To preserve its right to claim a refund in these instances, the taxpayer can file a protective refund claim.
The deadline for filing for administrative relief is generally the later of three years from the time a return was filed, or two years from the time the tax was paid. However, for taxpayers who made the election under §965(h) to pay the liability over eight years, filed their returns late, or have open years due to audits or other arrangements, they might want to consider the merits of filing a protective claim to preserve the ability to file for refunds on amended returns for tax years that might close between now and the ruling. Given that many taxpayers with this issue may file returns on extension in September and October, the statute of limitations on some tax years might be closing between now and October 15 for some tax years.
However, as with most things in life and tax, there are other positive and/or negative implications of choices that might need to be considered before making a decision to file a protective claim. For help in making this decision, please reach out to your Schneider Downs tax consultant, who can discuss your options with you in more detail.
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