Is a Mandatory Repatriation Tax Act (Section 965) Constitutional

Supreme Court to Rule on Validity of Repatriation Tax (Sec 965)

Validity of Section 965 Repatriation Taxes Goes to Supreme Court

Recently, in the case of Bittner, the Supreme Court decided against the Internal Revenue Service on the issue of whether they can issue foreign bank and financial account (aka FBAR) penalties based on the number of accounts a taxpayer failed to report each year — or whether it is limited to just a single penalty per year representing the single FBAR form that is required to be filed to report all of the accounts. As a result of this ruling, the IRS is now more limited in how it can issue non-willful FBAR penalties. Now, another very important ruling that will be coming down the pipeline involves the constitutionality of the Section 965 Repatriation Act. The repatriation tax or ‘transition tax’ is a very complex and complicated law in which taxpayers who have previously untaxed income sitting overseas in certain types of foreign corporations are required to pay a one-time repatriation act. Petitioners here take the position that the law is unconstitutional. Let’s walk through the basics of the 965 rules, how it works, and who it impacts.

Sixteenth Amendment

• • • “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.”

26 U.S.C. Section 965

In pertinent part:

• • • “(a) Treatment of deferred foreign income as subpart F income In the case of the last taxable year of a deferred foreign income corporation which begins before January 1, 2018, the subpart F income of such foreign corporation (as otherwise determined for such taxable year under section 952) shall be increased by the greater of—

      •  (1) the accumulated post-1986 deferred foreign income of such corporation determined as of November 2, 2017, or

      •  (2) the accumulated post-1986 deferred foreign income of such corporation determined as of December 31, 2017.

How Does the Transition Tax/Mandatory Repatriation Tax Law Work?

In essence, foreign earnings that sit inside a controlled foreign corporation that was not previously taxed by the United States are subject to a one-time repatriation tax. One thing to keep in mind is that it applies to controlled foreign corporations and not all foreign corporations. This generally means that the foreign corporation must be owned more than 50% by US persons with at least 10% ownership. The way that the law functions is that any applicable unreported income that was earned between 1986 through December 31, 2017, may be subject to this tax.

What is Subpart F Income?

Generally, Subpart F income is foreign income including passive types of income and insurance company income, but for purposes of this act, the additional income sitting in the foreign corporation that was not previously taxed also gets thrown into the mix.  Prior to the enactment of this code section, typically, taxpayers would only be taxed on income and foreign corporations when that income was distributed, unless it was Subpart F income (and prior to the enactment of the law, this type of income did not qualify as Subpart F income).

Why Was Subpart F Income Created?

The idea behind Subpart F income was that the IRS did not want taxpayers stashing corporate earnings overseas in low-tax jurisdictions, distributing these monies to themselves as loans to themselves and then canceling those loans and not paying any income tax. And, even with harsh Subpart F income rules, there are some exceptions such as the high-taxed exception/exclusion.

Example of a Common Section 965 Case

This is an example of a section 965 scenario involving a foreign corporation that is service-oriented – because one of the main arguments for this law being unfair as enforced is that it impacts taxpayers who were not intended to be impacted by the rule.

Take for example a U.S. citizen who lives in Canada. The U.S. citizen is a doctor and the majority, if not all of the income generated from her medical company is earned income, so it is not traditional Subpart F passive income or insurance income. To save for retirement, the Taxpayer keeps the money in the company. Since the Taxpayer has not paid any U.S. tax on the income, all of the un-taxed income from 1986 forward is taxable under the one-time repatriate act. This is true, even if the Taxpayer lives in the U.S. and does not actually expatriate the money.

How Will the Supreme Court Rule?

Hopefully, the Supreme Court will rule in favor of petitioners and do away with this unfair rule, because while it may target some taxpayers who are skirting their U.S. tax responsibility with complex foreign tax structures and entities — too many hard-working taxpayers who happen to be in countries where they operate their business as a corporation are unfairly getting stuck in the mix.

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