This is the first article in a series.
In Moore v. United States, No. 22-800, plaintiffs Kathleen and Charles Moore have asked the Supreme Court to confirm the validity of the realization requirement as articulated in Eisner v. Macomber, 252 U.S. 189 (1920), and in so doing, to strike down section 965. Enacted in 2017 by the Tax Cuts and Jobs Act as part of a transition from a worldwide system of taxation to a territorial one, that provision required U.S. shareholders of specified foreign corporations to include the accumulated earnings of those companies as subpart F income. The Moores have characterized their case as necessary to prevent Congress from expanding the reach of the income tax into a de facto tax on property through a wealth tax.
But the question of the constitutionality of a wealth tax is not before the Court, and in their cert petition, the Moores gloss over the substantive issue by assuming it away. Rather than discussing the essential matter of whether section 965 meets the realization requirement, the petition mostly fights ghosts — namely, two statements made by the Ninth Circuit in dicta about the continuing validity of Macomber. In so doing, the petition discounts the long interpretive history of the term “realization,” a history that demonstrates careful balancing of the interests of protecting the tax system against concerns for taxpayer due process and fairness (Daniel N. Shaviro, “An Efficiency Analysis of Realization and Recognition Rules Under the Federal Income Tax,” 48 Tax L. Rev. 1 (1992)).
In their brief filed August 30, the Moores delve a little deeper into whether section 965, specifically, meets the realization requirement. (Prior coverage: Tax Notes Int’l, Sept. 4, 2023, p. 1267.) But the bulk of their argument remains focused on proving the continuing validity of Macomber, and their discussion of section 965 rests on a mistaken notion of the transition tax as a tax on property rather than income (as will be explained in a subsequent article).
Ultimately, Moore is not and should not be a case about the constitutionality of the realization requirement. That’s because even if the Constitution didn’t mandate such a standard, the courts would have to read it into the law as intrinsically tied to the public’s deep-rooted objection to taxing unrealized gains. This fundamental opposition has been documented by professors Zachary Liscow and Edward Fox, who have shown through surveys that people overwhelmingly view such a tax as counter to notions of fairness and equity (Liscow and Fox, “The Psychology of Taxing Capital Income: Evidence From a Survey Experiment on the Realization Rule,” 213(C) J. Pub. Econ. (2022)).
As the case law that goes back 100 years and the legislative debate around the limits of the realization requirement illustrate, this test can be understood only as part of an analysis in which Congress and the courts weigh the need for a well-functioning income tax system with the constraints imposed by fairness and due process. The balancing act generally leans toward adhering as closely as possible to a cash receipt system. But any well-functioning tax system must acknowledge the limitations of accounting rules in working solely with cash receipts, along with taxpayers’ ability to plan around the laws.
The same evaluation must take place in Moore as the Court considers the facts of the case and the constitutional validity of section 965. A review of the interpretive history of the realization requirement shows that the 2017 amendment to subpart F fits squarely within that requirement as understood by Congress and interpreted by the courts, which have regularly acknowledged the validity of antiabuse provisions, especially when needed to address income shifting outside the United States.
In short, it’s possible to believe simultaneously that the Constitution imposes a realization requirement, that a mere change in the value of property does not constitute income within the meaning of the 16th Amendment, and that section 965 satisfies this requirement (Henry Ordower, “Abandoning Realization and the Transition Tax: Toward a Comprehensive Tax Base,” 67 Buff. L. Rev. 1371, 1393, 1396 (2019)).
Income, Cash Receipts, and Realization
In response to legislative proposals for taxing unrealized gains when individuals renounce their U.S. citizenship, the Joint Committee on Taxation prepared a 1995 report that reviewed the realization requirement (JCT, “Issues Presented by Proposals to Modify the Tax Treatment of Expatriation,” JCS-17-95 (June 1, 1995)). It provides a helpful summary of the debate Congress undergoes when enacting new tax laws that depart from a strictly cash-based receipt system of accounting for income, and the relevant court decisions.
The JCT began by noting that an examination of realization must start with Macomber. It also observed that several code provisions impose income taxes on amounts that — under a literal reading of Macomber — may be viewed as unrealized gains, with no court yet having found them unconstitutional. (See Helvering v. Bruun, 309 U.S. 461 (1940), explaining that “while it is true that economic gain is not always taxable as income, it is settled that the realization of gain need not be in cash derived from the sale of an asset.”)
Any income tax system must determine the scope and character of income subject to tax. Income tax regimes also must be able to measure taxable income and to separate tax periods within well-accepted time frames. To accomplish those objectives, every income tax regime necessarily imposes definitions and constraints on the meaning of income, some not compatible with the model Haig-Simons definition, which would treat as income all accretions to wealth. The U.S. income tax law’s arbitrary division of tax periods into calendar years, which results in gains accrued in one year being separated from losses accrued in another, represents one departure from a conceptually pristine system. Other examples abound, such as the tax system’s ignoring the imputed value of employer-provided health insurance in the computation of individuals’ taxable income. Still other code provisions defer the imposition of tax to achieve various social goals, such as by not taxing currently income that is contributed to qualified retirement plans.
The deferral of U.S. tax on income earned by foreign corporations represents another example of a departure from a theoretically pure system. In Barclay & Co. v. Edwards, 267 U.S. 442 (1925), the Supreme Court rejected the taxpayers’ claim that the code’s distinction between U.S. and foreign corporations in how foreign earned income was taxed — the former being subject to current tax and the latter subject to tax only on U.S.-source income — was discriminatory. It emphasized the unique characteristics of foreign corporations, stating that the “power of Congress to make a difference between the tax on foreign corporations and that on domestic corporations is not measured by the same rule as that for determining whether taxes imposed by one state upon the profits of a manufacturing corporation are an imposition of tax upon a subject matter not within the jurisdiction of the taxing state.”
Gains, Deductions, and Inclusions
The realization requirement is relevant not just for determining when taxpayers should have to include amounts in taxable income, but also for when they can use accrued losses to offset income. The appropriate time or triggering event for recognizing losses was the question before the Court in Cottage Savings Association v. Commissioner, 499 U.S. 554, 559 (1991), in which it held that the recognition standard was met when property was exchanged for other property materially different in kind. More fundamentally, section 167, which allows for accelerated depreciation and is a key part of Congress’s toolkit for encouraging business investment, also departs from a pure cash-based system, instead relying on accrual notions that could be viewed as inconsistent with a strict construction of the realization requirement (Douglas A. Kahn, “Accelerated Depreciation — Tax Expenditure or Proper Allowance for Measuring Net Income?” 78 Mich. L. Rev. 1 (1979)).
In various provisions, Congress and the courts have tacitly endorsed the principle that income can be triggered not only by disposing of an asset, but through a change in the taxpayer’s legal rights with respect to it. For example, long-standing regulations under section 1001 provide that a significant modification in the terms of a debt instrument can create a deemed disposition of the instrument for tax purposes. Under those rules, a taxable exchange — which is generally the threshold for income recognition — is deemed to occur when a debt instrument has been subject to a significant alteration of the issuer’s or holder’s legal rights or obligations.
Some of the most frequent departures from a cash-receipts-based system are in Congress’s attempts to properly tax income from financial transactions. Congress’s struggles here — and its efforts to prevent taxpayers from deferring income from financial transactions indefinitely — are reflected in the regime governing the taxation of interest income on bonds with original issue discount (section 1272 et seq.). Those rules generally require taxpayers to include the difference between the redemption price of a bond and its issue price on a periodic basis, regardless of the payment of stated amounts of interest.
Similarly, Congress has enacted accrual-based realization rules — that is, mark-to-market taxation — for taxpayers who own certain regulated futures contracts, foreign currency contracts, non-equity options, and dealer equity options (section 1256). The legislative history indicates that Congress believed this regime was needed to stop the use of futures for tax avoidance purposes (S. Rep. No. 97-144 (1981)). In Murphy v. United States, 992 F.2d 929 (9th Cir. 1993), the court rejected the taxpayer’s argument that section 1256 was unconstitutional because it taxed unrealized gains, finding that the unique accounting method governing futures contracts meant that “the gains inherent in them are properly treated as constructively received,” and that “Congress acted well within its authority when it decided to treat them differently from other capital assets.”
Aside from financial products (and foreign income, discussed below), Congress has been more reluctant to impute income to an owner of an asset before a transactional event giving rise to the receipt of cash. But Congress has still acted when needed to prevent taxpayers from engaging in abusive planning, such as by requiring taxpayers with income from long-term contracts to account for them on a percentage of completion method (section 460). More broadly, the Supreme Court has upheld the validity of the undistributed profits tax, enacted in 1936 (repealed in 1939) as a surtax on undistributed income. In Helvering v. Northwest Steel Rolling Mills Inc., 311 U.S. 46 (1940), the Court acknowledged that although it was true that the surtax was imposed only upon undistributed income, that did “not serve to make it anything other than a true tax on income within the meaning of the Sixteenth Amendment.” (See also Helvering v. National Grocery Co., 304 U.S. 282 (1938), rejecting the taxpayer’s argument that a tax on undistributed corporate profits was tantamount to a direct tax on capital.)
Taxing Cross-Border Income
As described above, Congress has long recognized — and the courts have upheld — the validity of different treatment of U.S. and foreign taxpayers, with U.S. taxpayers historically able to defer the income realized by foreign corporations in which they own shares. At the same time, this beneficial treatment provided to U.S. shareholders of foreign companies has meant that Congress has had to be especially vigilant in protecting the U.S. tax base from taxpayer efforts to shift income and assets to foreign corporations to escape U.S. tax. Congress has actively legislated this area since the 1930s, and the congressional debates — and court rulings — about the provisions that limit U.S. taxpayers’ attempts to shift income to other jurisdictions include discussions about the extent to which the realization requirement is implicated by those rules.
Congress’s efforts to limit cross-border income shifting began with the enactment of the foreign personal holding company rules in 1934 (sections 551-558, repealed in 2004). Those rules required U.S. shareholders of foreign personal holding companies to include the assumed distributed dividends from those companies as U.S. taxable income. In Eder v. Commissioner, 138 F.2d 27 (2d Cir. 1943), aff’g 47 B.T.A. 235 (1942), the taxpayer argued that the foreign personal holding company regime as applied to his circumstances was unconstitutional, because local law prevented him from accessing the company’s earnings. The Second Circuit said that even though the operation of the statutory rules there could be considered “harsh,” that didn’t render the statute unconstitutional, because “the Congressional purpose was valid and the method of taxation was a reasonable means to achieve the desired ends” (internal citation omitted).
Congress further limited the deferral principle and extended current U.S. taxation of the earnings of foreign corporations in 1962 when it passed the subpart F rules, and again in 1986 with the passage of the passive foreign investment company rules (sections 1291-1298).
The congressional debate over passage of the subpart F rules highlights how lawmakers did not take the expansion of U.S. taxing jurisdiction lightly, but instead viewed it as necessary to prevent cross-border tax avoidance. The 1995 JCT report refers to a 1961 memorandum from Treasury general counsel Robert H. Knight to Treasury Secretary Douglas Dillon, that concluded that the subpart F proposals represented a valid exercise of Congress’s constitutional power to regulate foreign commerce, and that they could be supported on the principle of constructive receipt as needed to prevent tax avoidance. Similarly, the JCT in 1961 advised Congress that it could not constitutionally tax shareholders on the undistributed income of foreign corporations, except when “reasonably necessary to prevent evasion or avoidance of tax.”
The courts have regularly upheld the constitutionality of the subpart F regime. In Garlock Inc. v. Commissioner, 489 F.2d 197 (2d Cir. 1973), the court wrote that the taxpayers’ argument that the income inclusion rule was unconstitutional “border[ed] on the frivolous” in light of Eder. (See also Estate of Whitlock v. Commissioner, 59 T.C. 490 (1972), aff’d in part and rev’d in part, 494 F.2d 1297 (10th Cir. 1974).)
The Expatriation Tax
The provision under consideration in the 1995 JCT report was section 877A, which subjects to tax an individual’s unrealized gain upon their rejection of U.S. citizenship. The JCT explained that such a tax could meet the realization requirement because at expatriation, an individual’s property is effectively removed from U.S. taxing jurisdiction and undergoes “a conversion of jurisdictional attributes.” Alternatively, expatriation can be characterized as the transfer of assets from a person subject to the U.S. tax system to a noncitizen. In both cases, the expatriation tax may meet the realization requirement because the legal attributes of the assets owned by the expatriating citizen are modified; if a tax was not imposed at that time, the U.S. government’s inchoate interest in taxing the increase in value of those assets upon disposition would disappear.
Under this line of reasoning, the expatriation tax satisfies the realization requirement because it is not a tax on the unrealized gain in property, but one imposed on inherent gain in the asset that is triggered at an appropriate time to ensure the gain doesn’t escape U.S. tax. In that regard, it shares similarities with the section 965 transition tax.
Inversions
The corporate analogue to the section 877A expatriation tax is found in sections 7874 and 367. Those provisions impose tax at the corporate or U.S. shareholder level on the transfer of assets to a foreign corporation, even if the transaction otherwise meets the nonrecognition provisions of the code and no assets have been formally transferred out of corporate solution. Sections 367 and 7874 — like section 877A — operate to prevent the deferral of U.S. tax on foreign earnings from being converted into permanent tax-free status. Another function of section 367 is to prevent the gain embedded in the value of assets subject to U.S. taxing jurisdiction from escaping U.S. tax altogether.
The Timing Question
The congressional debate over the constitutionality of section 877A reflects the extent to which the question whether the realization requirement has been met is often a question of when income should be recognized (rather than whether the gain in property should be taxed). Even assuming that a comprehensive tax on accretions in wealth is unconstitutional, expatriation could still be considered a sufficient change in the attributes of certain property owned by the expatriate so as to render it a sufficient trigger for imposing a tax on the gains in property.
In United States v. Davis, 370 U.S. 65 (1962), the Court similarly recognized the validity of an acceleration of a realization event, upholding the transfer of property by a husband to his ex-wife, under a divorce settlement as an appropriate time for triggering a tax on the unrealized gains.
Conclusion
The constitutional realization requirement can be described as prohibiting a tax imposed on a change in the value of a taxpayer’s property without a corresponding change in the taxpayer’s relationship to that property, absent specific considerations for preventing abuse and overarching considerations of tax administration. The logical questions that follow in considering the constitutionality of section 965 are whether the TCJA changed taxpayers’ relationship to the foreign earned income of the foreign corporations in which they owned shares, and whether concerns about abuse as part of the United States’ shift from a worldwide to a territorial tax system suffice to justify expanding the definition of subpart F income in 2017 to include accumulated earnings of specified foreign corporations. We consider those topics in the next article in this series.
Mindy Herzfeld is professor of tax practice at University of Florida Levin College of Law, counsel at Potomac Law Group, and a contributor to Tax Notes International.
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