The MRT is a one-time repatriation tax (or “deemed dividend”) that passes through undistributed accumulated income of U.S.-controlled foreign corporations (CFCs). Section 965 is part of the 2017 Tax Cuts and Jobs Act (P.L. 115-97), which addresses foreign business earnings, including CFCs, inversions and the GILTI tax. The Act generally taxes U.S. shareholders owning 10% or more of a foreign corporation on otherwise tax-deferred foreign earnings.

Charles and Kathleen Moore were minority owners of KisanKraft, a CFC in India. The Moore’s paid $40,000 for 13% of the CFC in 2005. The CFC reinvested all profits back into the business. Under the CFC rules (prior to MRT), tax did not generally accrue to CFC owners until distribution. The MRT eliminated the tax deferral (from prior years) by imposing income tax on CFC accumulated (undistributed) earnings. The Moores paid the MRT ($14,729) and sued for a refund in Federal District Court.

The Moores claimed that the MRT violates the Direct Tax Clause of the U.S. Constitution as an unapportioned direct tax on corporate shares. The Constitution reads: “No Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census or enumeration herein before directed to be taken.” Direct taxes are generally imposed on people and property. The U.S. Constitution requires that direct taxes be apportioned among the states (according to population), while indirect taxes are not subject to apportionment but must be uniform across all states. The apportionment of direct tax may lead to unfair and random tax rates in the different states. Apportionment is thus a significant political obstacle to enacting enforceable federal tax legislation.

In 1895, SCOTUS ruled that direct tax (requiring apportionment) includes tax on income from property by reason of its ownership (Pollock v Farmers’ Loan & Trust Co., 157 U.S. 429 [1895]). The Pollock ruling thus made income from property a direct tax.

The 16th Amendment to the U.S. Constitution (1909) reversed Pollock to enable Congress to tax all income “from whatever sources derived” (i.e., services and property) without regard to apportionment. The Amendment reads: “The 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.”

After the passage of the 16th Amendment (1913), Congress enacted the federal income tax (on indirect earnings). In a later case, Eisner v. Macomber (252 U.S. 189 [1920]), it states that income tax, though avoiding apportionment, may only be imposed on income, the economic benefit from which is “realized” through sale or conversion of capital assets. Income tax may otherwise be imposed on compensation and funds received as rents and interest (i.e., the “fruit of the tree”).

The Moores argued that the MRT amounts to unconstitutional taxation of unrealized income. They claimed that, under the Sixteenth Amendment, income must be realized before it can be taxed. As they could not access or benefit from accumulated CFC earnings (i.e. “realize” the income), Congress may not tax the income.

The Moores claimed that the MRT (on undistributed earnings) is thus a tax on property, subject to required apportionment and thus unconstitutional (as not apportioned). The government claimed that the MRT is a tax on indirect income and that “realization” is not required.    

The trial court rejected the constitutional challenge to the MRT. The Ninth Circuit Court of Appeals affirmed the decision, based on the government’s premise that income realization is not a determinative factor in assessing Congress’s power to tax. The appellate ruling raises the realization issue. Specifically, does the U.S. Constitution require taxpayer realization (economic benefit) of income before Congress may impose tax?

SCOTUS affirmed the appellate court ruling that U.S. owners of a CFC are subject to the MRT. Justice Brett Kavanaugh (author of the opinion) restated the issue as “whether Congress may attribute an entity’s realized and undistributed income to the entity’s shareholders or partners, and then tax the shareholders or partners on their portions of that income. This Court’s longstanding precedents, reflected in and reinforced by Congress’s longstanding practice, establish that the answer is yes.”

The majority (Kavanaugh, joined by John Roberts, Sonia Sotomayor, Elena Kagan, and Ketanji Brown Jackson) clarified that “the MRT does tax realized income, namely income realized by the corporation KisanKraft.” Justice Kavanaugh essentially equated the MRT to long-accepted taxation of pass-through business income (such as K-1 partnership or “S” income). The Court noted, “The Moores explicitly concede that partnership taxes, S-corporation taxes, and subpart F taxes are income taxes that are constitutional and need not be apportioned.”

Justice Kavanaugh explained that the Moores tried to distinguish the MRT from (i) partnerships (as not separate from their partners), (ii) “S” shareholders (who chose to be taxed on corporate income) and (iii) subpart F (taxing undistributed foreign corporate passive income). Justice Kavanaugh dismissed the Moores’ distinction of the MRT and seemed reluctant to interfere with existing tax policy and revenue.

Justice Kavanaugh clarified that the MRT taxed income realized by the Indian CFC (avoiding the necessity to review any income realization issue). As income was realized at the entity level (in India), the Court found that defining “realized” became unnecessary. By attributing income (realized by an entity) to its owners, the Court avoided the issues of (i) forced recognition of involuntary “pass-through” income earned in prior years and (ii) whether taxing “unrealized” income (without a direct economic benefit) is constitutionally permissible.

The majority relied on historical precedent that either (but not both) the entity or its owners may be taxed on undistributed income. Specifically, Congress may tax either the entity or owner/shareholder (on income realized, whether from a domestic entity or CFC). The taxpayers were therefore “attributed” with their portion of accumulated (undistributed) earnings of the Indian CFC.

Justice Kavanaugh made clear that the majority ruling only applies to pass-through income:

“That said, we emphasize that our holding today is narrow. It is limited to (i) taxation of the shareholders of an entity, (ii) on the undistributed income realized by the entity, (iii) which has been attributed to the shareholders, (iv) when the entity itself has not been taxed on that income. In other words, our holding applies when Congress treats the entity as a pass-through.” Justice Kavanaugh disclaimed any opinion on a realization requirement to taxing income. Although, Justice Kavanaugh suggested that taxing the entity and shareholders on the same income may not be permissible, tax on wealth or unrealized capital gains “are potential issues for another day.”

One question remains unresolved: When income tax is paid abroad by a foreign non-pass-through entity, why is such tax considered unpaid (allowing for the constitutional imposition of a shareholder-level [pass-through] tax on undistributed earnings from prior years)? Retroactive “attribution” of taxable income (reinvested by the CFC) to a U.S. shareholder (for past years) seems onerous (when the CFC made no such revenue available to the U.S. owner).

Justice Ketanji Brown Jackson concurred with the majority opinion that tax may be imposed. Justice Brown openly rejected any realization obstacle to taxation.

Justice Clarence Thomas dissented (joined by Justice Neil Gorsuch), objecting to the majority’s concept of “attribution.” Thomas and Gorsuch read the Sixteenth Amendment to require income realization before Congress may impose tax (without apportionment). Thomas and Gorsuch, therefore, consider the MRT unconstitutional: “The majority’s Sixteenth Amendment attribution doctrine is a new invention. The majority justifies its creation by plucking superficially supportive phrases from an eclectic section of tax cases. But, none of the cases supports the proposition that the Sixteenth Amendment empowers Congress to freely attribute income to any taxpayer it reasonably chooses.”

Justice Amy Coney Barrett (joined by Samuel Alito) concurred with the majority ruling (seemingly because the taxpayers conceded that Subpart F is constitutional). Justice Coney Barrett found Subpart F (a pass-through tax on passive CFC income) “not meaningfully different from the MRT” and joined the majority ruling to impose tax. Justice Coney Barrett, however, sided with Justice Thomas and Gorsuch, that taxable income must be realized (analogous to a cash distribution of “profits from capital” from a non-pass-through entity or receipt of “something new and valuable”).

Justice Coney Barrett explained: “Because they have not received a dividend, profit from selling their shares, or any other pecuniary benefit from their stock ownership, the Moores have not yet received a return on their original investment in the company. In short, they have not ‘derived income’ from their shares because nothing has come in.” Justice Barrett rejected the constitutionality of a tax on unrealized appreciation, as the stockholder received nothing for his separate use or benefit. Four Justices, therefore, conditioned taxation on the realization of income.

Hopefully, SCOTUS will soon accept review of a case involving a wealth tax or tax on (unrealized) appreciation or unavailable income (not already realized by a pass-though entity). With the exception of Justice Jackson, who rejects realization as a constitutional obstacle to taxation, if only one of the three other Justices under the Kavanaugh opinion sides with Justices Thomas, Gorsuch, Coney Barrett, and Alito, income taxes on wealth or appreciation may be invalidated.