This is the second article in a series examining significant considerations in Moore v. United States, No. 22-800. The first article reviewed the history of the realization requirement (Tax Notes Int’l, Sept. 11, 2023, p. 1387).
A tax on property takes as its tax base the value of the property. In contrast, section 965, a tax on income, uses a foreign company’s accumulated earnings as its tax base. Within the context of a tax on income, one can debate the appropriateness of the timing, the base, the identity of the taxpayer, and the rate. But those are matters for Congress to decide, and not questions of constitutional import.
To understand Congress’s 2017 decisions to mostly end deferral of tax on the income earned by foreign corporations and to tax currently the accumulated earnings of those companies to their U.S. shareholders (at a rate significantly lower than that applicable when the earnings were generated), one must understand the history leading up to the wholesale reform of U.S. international tax rules in 2017, in which section 965 played an integral part. This history reflects Congress’s ongoing struggles to tax cross-border income in a way that satisfies U.S. domestic economic and foreign policy goals, achieves those goals in a practical matter, prevents the erosion of the tax base through cross-border profit shifting, and mitigates other foreign tax planning opportunities.
Deferral of Foreign Earnings
To appreciate how section 965 functions as a tax on income — and not on property — one must begin with an analysis of how, why, and when Congress historically has asserted taxing jurisdiction over income earned by foreign persons and over U.S. persons’ foreign earned income. Congress’s evolving approach dates to the early days of the income tax.
In Cook v. Tait, 265 U.S. 47 (1924) — the foundational case of U.S. international taxation — the Supreme Court endorsed the principle that it’s Congress’s right and sovereign authority to tax U.S. persons on their income, wherever earned, emphasizing that “the basis of the power to tax was not and cannot be made dependent upon the situs of the property . . . and cannot be made dependent upon the domicile of the citizen, that being in or out of the United States.” The Court’s holding encapsulates the principle that the 16th Amendment does not circumscribe Congress’s ability to assert taxing jurisdiction over income earned by U.S. persons, regardless of where the property generating the income — or the taxpayer — is located. Scholars have expanded on that principle, explaining that “within its own legal and fiscal framework a country is free to adopt whatever rules of tax jurisdiction it chooses[,] no matter how broad may be the reach of the resulting tax net.” (Martin Norr, “Jurisdiction to Tax and International Income,” 17 Tax L. Rev. 431 (1962).)
Another early Supreme Court case addressed the legitimacy of Congress’s decision of how to tax foreign persons’ income. In Barclay & Co. v. Edwards, 267 U.S. 442 (1925), the Court rejected the taxpayers’ claim that Congress discriminated against U.S. companies in choosing not to tax the foreign earned income of foreign companies, while at the same time subjecting domestic companies to tax on similar income. In so doing, it stressed Congress’s unique power to tax foreign and domestic corporations differently, in the manner that it chooses. Barclay highlights how concerns about tax administration, the practicalities of asserting taxing jurisdiction over foreign persons and foreign income, and foreign policy and U.S. domestic economic implications are intertwined in Congress’s decisions about how to assert taxing rights over foreign persons and foreign earnings.
In applying these principles, Congress necessarily draws some arbitrary lines. For example, the statutory definitions of U.S. persons and foreign persons in section 7701 (including both individuals and corporations) represent an exercise in bright-line drawing with significant consequences for taxpayers. For individuals, status as a U.S. person can follow from the accident of birth. For corporations, the only relevant consideration is under what set of laws the company was organized.
Working within the constraints noted above, Congress has defined the scope of income that, when earned by U.S. or foreign persons, is subject to U.S. tax. For U.S. persons, generally all their worldwide income is subject to U.S. tax. Foreign persons — including foreign individuals and foreign corporations — generally are only subject to U.S. tax on their U.S.-source income, and then only in specific circumstances (such as if the income is effectively connected to a U.S. trade or business, or is fixed, determined, annual, or periodic income subject to withholding taxes (sections 871 and 881)).
Defining the scope of the income and the status of the taxpayers on which to assert taxing jurisdiction have been matters for Congress to legislate. They have little to do with the 16th Amendment’s restriction of the income tax to realized income. Within Congress’s policy choices in this area, its historical decision to exempt some income of foreign corporations from current taxation — a principle generally known as deferral — is, like the deductions allowed by the code, a matter of legislative grace. (See, e.g., White v. United States, 305 U.S. 281 (1938).)
Congress’s choice — made in the early days of the income tax — to exempt or defer U.S. tax on the income of foreign corporations until those earnings were repatriated to U.S. shareholders has led it on numerous twists and turns, partly because of the opportunities the system created for U.S. taxpayers to defer or eliminate altogether their U.S. income tax liability through various foreign tax planning strategies.
Taxing Foreign Corporations
Congress’s first attempt to address concerns over income shifting and deferral was the enactment of the foreign personal holding company rules in 1937 (sections 551-558, repealed in 2004). Those rules subjected the U.S. shareholders of foreign personal holding companies to current U.S. tax on the earnings of those companies. Courts upheld the tax on foreign personal holding companies’ earnings even when foreign law restricted taxpayers from accessing the foreign company’s earnings. (See Eder v. Commissioner, 47 B.T.A. 235 (1942), aff’d, 138 F.2d 27 (2d Cir. 1943).)
More generally, the evolution of U.S. international tax rules over the last 100 years illustrates how Congress has used tax policy to balance the multiple and sometimes conflicting goals of encouraging business investment — both within the United States and overseas (along with broader foreign policy considerations) — and protecting the U.S. tax base. In that regard, the international tax rules enacted in the early 20th century — of which deferral of U.S. tax on foreign corporations’ earnings was an integral part — reflected the foreign and domestic policy goals of the time. Those included protecting and expanding opportunities for U.S. overseas investment and ensuring that other countries were able to pay their wartime debts to the United States. (See generally Herzfeld, “How to Think About How the US Congress Thinks About International Tax Reforms,” 5 Brit. Tax Rev. 504 (2022).)
Although the importance of overseas investment to rebuild war-torn Western Europe remained a core aspect of U.S. foreign and tax policy through the 1940s, as the domestic economic and foreign policy picture shifted during the 1950s, ideas about the optimal way to tax cross-border income shifted as well. Rising concerns over U.S. balance of payments coincided with heightened awareness of the planning opportunities that countries with low tax rates presented to U.S. taxpayers. This dynamic jump-started the first major set of U.S. international tax law changes since enactment of the income tax.
Subpart F
In 1955 a paper prepared for the House Ways and Means Committee described how the U.S. government’s encouragement of foreign investment helped strengthen other countries’ economies, with benefits including U.S. economic growth and political security, and global stability (Edward R. Barlow and Ira T. Wender, “Foreign Investment and Taxation,” Harvard Law School, International Program in Taxation (1955)). At the same time, the committee recognized that taxpayers could utilize holding companies in low-tax jurisdictions to accumulate low-taxed passive income that escaped residual U.S. tax until repatriated. In light of those concerns, a 1960 report by Stanley Surrey called for reexamining the principle of deferral. (Prior analysis: Tax Notes, Oct. 15, 2018, p. 315.)
The result was the 1962 enactment of the subpart F regime, which was much narrower than President John F. Kennedy’s original proposal to end deferral altogether. Subpart F required current inclusion of specific categories of foreign earnings of controlled foreign subsidiaries, mostly limited to passive and highly mobile income. Congress defined control for this purpose to mean ownership by U.S. shareholders (defined as 10 percent shareholders) of more than 50 percent of a foreign company. That definition has yielded some odd and arbitrary results. For example, because a U.S. partnership is considered a U.S. person under section 7701, ownership of 100 percent of the shares of a foreign company by a U.S. partnership — even if the partnership has no partners who would be 10 percent U.S. shareholders if owning the shares directly — renders the company a controlled foreign corporation subject to the subpart F regime.
Of key relevance here is section 956, a provision within the subpart F regime that subjects U.S. shareholders to current tax on their pro rata share of a CFC’s earnings that have been invested in U.S. property. Like section 965, the tax imposed by section 956 is not limited to current-year earnings; like section 316, which imposes a tax on dividends, section 956 takes into account accumulated earnings going back decades.
How to Fix the International Tax Regime?
By the late 1990s, there was widespread recognition that the subpart F rules, and more broadly the U.S. international tax regime, were inadequate to address economic changes such as globalization, digitalization, and tax competition (Michael J. Graetz, “Taxing International Income: Inadequate Principles, Outdated Concepts, and Unsatisfactory Policies,” 26 Brook. J. Int’l L. 1357 (2001)). The system had perverse results, including almost $3 trillion of CFC earnings locked out of the United States because of the high penalties imposed by the U.S. tax system on repatriation of those earnings (Herzfeld, “Designing International Tax Reform: Lessons From TCJA,” 28 Int’l Tax & Publ. Fin. 1163 (2021)).
To address the lockout effect and raise revenues, Congress introduced a repatriation holiday in 2004 as part of the American Jobs Creation Act. The 2004 deemed repatriation tax allowed companies to elect to repatriate foreign earnings at a 5.25 percent tax rate (rather than 35 percent). This provision (also enacted as section 965) was heavily criticized, in part because it failed to achieve its stated goal of increasing domestic investment. (Prior analysis: Tax Notes, Aug. 25, 2008, p. 759.) It was also seen as creating incentives for taxpayers to increase the stockpile of earnings held offshore, in the expectation of future holidays (Thomas Brennan, “What Happens After a Holiday? Long-Term Effects of the Repatriation Provision of the AJCA,” 5 Nw. J. Law & Soc. Pol’y 1 (2010)).
Responding to the intensifying pressure to reform the U.S. international tax system, in 2011 Republican Dave Camp, then-House Ways and Means Committee chair, released a draft of a comprehensive reform proposal that included a dividend exemption system for foreign earnings and an expansion of the subpart F regime to address base erosion concerns made more acute under a territorial system (House Ways and Means Committee, discussion draft of Tax Reform Act of 2011 (Oct. 26, 2011)). A 2013 bipartisan paper on international tax reform published by Senate Finance Committee staff summarized Congress’s objectives in reforming the U.S. international tax rules: increasing U.S. competitiveness and creating U.S. jobs; reducing tax incentives for multinationals to locate overseas and accumulate foreign earnings abroad; and preventing base erosion and profit shifting to low-tax foreign jurisdictions (U.S. Senate Committee on Finance, “Barcus Unveils Proposals for International Tax Reform” (Nov. 19, 2013)). In 2017 the Congressional Research Service described how the high U.S. tax on repatriated earnings meant that companies had an incentive to retain overseas the returns on capital invested abroad (Jane G. Gravelle, “Reform of U.S. International Taxation: Alternatives,” CRS, RL34115, July 21, 2017).
Ultimately, those concerns prompted the Republican-led Congress in 2017 to adopt a number of significant changes to the international tax rules as part of the Tax Cuts and Jobs Act. The changes included moving from a worldwide taxation regime to a territorial one, while at the same time — aware that a territorial regime would exacerbate the challenges posed by cross-border profit shifting — vastly expanding the subpart F rules to include taxation of active earnings of CFCs.
Transition Tax
Section 965 — the 2017 version of a deemed repatriation tax — was an integral part of the U.S. international tax regime’s transition from a worldwide to a territorial system. It helped ensure that accumulated foreign earnings would not escape U.S. tax altogether. Subjecting about $3 trillion of U.S. multinationals’ earnings to immediate U.S. tax achieved one of Congress’s key goals: making sure that those earnings could be repatriated tax free in the future, thereby eliminating the lockout effect.
To compensate taxpayers for the acceleration of tax on the accumulated earnings, section 965 allowed taxpayers to take significant deductions from the statutory tax rates that were in effect when those earnings were generated — as much as 27 points off the rate that would otherwise have been imposed had those earnings been repatriated pre-TCJA. For individual taxpayers, the transition tax was even more generous: Section 965 granted individual U.S. shareholders practically indefinite deferral of the foreign earnings that otherwise would be fully taxable, if the foreign corporation’s shares were owned by an S corporation. For both individual and corporate shareholders, taxpayers subject to the tax could defer payment over eight years.
Incorporating a transition tax into the plans for wholesale reform was not a new idea. It dates to Camp’s 2011 proposal, which offset the costs of shifting to a territorial system with a transition tax that subjected accumulated profits held offshore to a 5.25 percent tax rate, payable over eight years. The 2011 Camp draft imposed this transition tax on both 10 percent U.S. shareholders of CFCs and shareholders of noncontrolled 10/50 corporations (Camp, “Technical Explanation of the Ways and Means Discussion Draft Provisions to Establish a Participation Exemption System for the Taxation of Foreign Income” (Oct. 26, 2011)).
The transition tax proposal generally received praise from business leaders. Michael Mundaca, then co-director of national tax and co-leader of the Americas Tax Center at EY, commented that the Camp draft would generally “be welcomed by much of U.S. business.” (Prior coverage: Tax Notes, Oct. 31, 2011, p. 512.)
The 2014 Camp tax reform bill — H.R. 1, the Tax Reform Act of 2014, which similarly proposed a dividend exemption system — also included a transition tax, bifurcated into different rates depending on whether a company’s earnings had been reinvested in assets of the operating business or were held in cash. The reduced rates were achieved by granting a 90 percent exclusion from tax for earnings not held in cash and a 75 percent exclusion for earnings invested in cash. (Prior analysis: Tax Notes, Feb. 12, 2018, p. 857.)
A 2014 Senate Finance Committee staff report on reform proposals also considered what should be done with accumulated foreign earnings at the time of transition. It highlighted three principles to guide Congress in taxing pre-enactment earnings: addressing the lockout effect; not providing a windfall for U.S. multinationals; and not granting a windfall to the U.S. government. The report concluded that to eliminate the lockout effect, which would continue if pre-enactment foreign earnings were subject to U.S. tax only if repatriated, those earnings should be mandatorily deemed repatriated and taxed accordingly (Senate Finance Committee, Republican staff, “Comprehensive Tax Reform for 2015 and Beyond” (Dec. 1, 2014)).
But the report also warned that taxing accumulated earnings immediately at the full U.S. tax rate would mean a windfall for the government. It recommended spreading out the deemed repatriation over many years or subjecting U.S. shareholders to a lower tax rate on the deemed repatriated earnings, even though this could itself represent a windfall to U.S. taxpayers because the income was earned at a time when a much higher tax rate was in effect. The report concluded that “the worse than expected deal of deemed mandatory repatriation could arguably be offset with the better than expected deal of a lower than 35 percent [corporate statutory] tax rate.”
In its 2017 study, “Reform of U.S. International Taxation: Alternatives,” the CRS considered various ways to tax accumulated deferred earnings upon the transition to a territorial system. It suggested, as an alternative to the Camp transition tax, a requirement that foreign companies pay out a percentage of their income to their U.S. shareholders. Allowing the U.S. tax on accumulated earnings to be deferred indefinitely until the income was repatriated wasn’t considered a viable alternative because it wouldn’t address the distortions created by the lockout effect.
Other suggestions to deal with the disincentives to repatriation included subjecting the accumulated deferred earnings to an interest charge when repatriated (an approach similar to that of the passive foreign investment corporation regime). But no one thought those earnings should escape U.S. tax altogether. While commentators acknowledged that an immediate tax imposed at the time of transition would have to address the challenges for taxpayers of having to pay the tax if lacking access to liquid assets, the dual reduced-rate structure and the eight-year payout were considered sufficient to do that. (Prior analysis: Tax Notes, Apr. 3, 2017, p. 69.)
Generosity for Individuals
Much of the focus in the 2017 reform was on multinational corporations. But the TCJA also included a special rule to address specific concerns of individual shareholders of foreign companies. Section 965(i) allows S corporation shareholders to defer payment of the transition tax liability for an S corporation until a triggering event. This election essentially allowed individual taxpayers owning foreign corporate stock through an S corporation to defer their transition tax inclusions until the occurrence of an event mostly within their control. The TCJA did not include any antiabuse rules to prevent individuals who were direct shareholders of foreign corporations from contributing those shares to an S corporation before the relevant effective dates. The result was that for individual shareholders, being subject to the transition tax was largely a matter of choice or the result of receiving poor tax advice.
Conclusion
If one starts with the correct assumption that the 16th Amendment does not preclude Congress from taxing foreign earnings, it becomes evident that Congress’s historical policy choice to grant deferral of U.S. tax on income earned by foreign corporations is one that it has the ability to change.
The historical considerations that led to Congress’s decision to allow for deferral of tax on foreign companies’ income altered during the debates over the transition to the territorial system enacted in 2017, with Congress attempting to find the right balance between preventing a windfall to either taxpayers or the government. At the same time, the government — primarily focused on the competitiveness of U.S. businesses — provided individual taxpayers with further means of deferring the transition tax on their accumulated deferred earnings. The Moores’ filings give no indication why they decided not to avail themselves of that opportunity.
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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