Earlier today, the U.S. Supreme Court heard oral arguments in Moore v. United States, an appeal from a decision from the 9th Circuit U.S. Court of Appeals which held that the Transition Tax under Section 965 of the Internal Revenue Code was a constitutional tax.
Moore involved individual taxpayers who challenged the constitutionality of the Transition Tax as it violated the 16th amendment since it was a direct tax on income which has not been apportioned among the states. The taxpayers owned an 11% interest in a controlled foreign corporation (“CFC”) and never received any actual distributions from the CFC. With the enactment of the Transition Tax, taxpayers were required to include their pro rata share of the accumulated earnings of CFCs owned into their individual taxable income, which resulted in a significant tax liability. The taxpayers argued that the Transition Tax was on earnings that they never realized from the CFC and that the government had imposed a direct tax that must be apportioned among the states.
The Transition Tax, or Section 965, was introduced under the Tax Cuts and Jobs Act in 2017. The Transition Tax required “U.S. shareholders” (defined as U.S. persons owning 10% or more of the total voting power or value of a foreign corporation) to pay a one-time tax on their pro rata share of the accumulated untaxed earnings of foreign corporations as though the earnings had been repatriated to the United States. The Transition Tax provided for a beneficial tax rate for earnings subject to tax as well as provided for an election (the 965(h) deferral election) that taxpayers could make to defer the payment of the tax over eight years.
The Supreme Court’s decision could create different scenarios for taxpayers to consider, each carrying distinct implications. If the Supreme Court deems that the Transition Tax is unconstitutional, individuals and corporations may face the challenge of undoing certain tax attributes created by the inclusion 965 amounts. Alternatively, the Supreme Court could hold that the Transition Tax is unconstitutional solely for individuals based on their cash accounting method, as opposed to the accrual method, which would imply that only corporate shareholders would be restricted from pursuing a refund as the Transition Tax is only applicable to corporations and businesses.
Individuals who paid the Transition Tax and have also received dividends may find it beneficial to refrain from filing a refund claim as the earnings from a CFC would have been subject to a lower tax rate under the Transition Tax regime. Corporations, on the other hand, may find it advantageous to pursue a refund for Section 965 liabilities paid, particularly if they were eligible for a 245A deduction, which has the potential to offer 100% dividend exclusion on foreign-sourced dividends.
The decision may prompt a need for protective refund claims, allowing taxpayers to secure their right to a refund within the statute of limitations period. Generally, the statute of limitations period is three years from the filing of a return or two years from the payment of taxes, whichever is later. Consequently, taxpayers who did not opt for the 965(h) deferral election may not be eligible for a refund due to the expiration of the statute of limitations, unless all prior years are open due to audit. As tax returns that originally included the Transition Tax were filed for the 2017 and 2018 tax years, the three-year period from the date of filing the returns to claim a refund have since passed. However, for taxpayers who made a 965(h) deferral election, there are still open years to claim a refund for 965 liabilities paid. Proper documentation and adherence to these timelines are crucial to the success of protective claims.
As taxpayers and tax practitioners await the decision of the Supreme Court on the Moore Case, taxpayers affected by Section 965 must carefully evaluate their tax positions and decide whether to file a protective refund claim for 965 liabilities paid. It is worthwhile to note that the expiration date for the statute of limitations for claiming a refund for taxes paid by April 15, 2022 is fast approaching and taxpayers may want to take action prior to that date to preserve the right to claim a refund in the event that the Moores prevail.
By understanding their specific situation and staying up to date with the upcoming decision, taxpayers can make informed decisions to navigate these uncertain waters.