In this week’s blog, we discuss a recent Supreme Court decision upholding the constitutionality of the Section 965 transition tax, which was imposed at the end of 2017. We also discuss the impact the tax could have on current filers, particularly those catching up using the Streamlined Procedures.
Background
Section 965, as amended by the 2017 Tax Cuts and Jobs Act, imposed a one-time transition tax on untaxed foreign earnings — either at 8% or 15.5%. The tax applied whether or not the foreign earnings were distributed — they were deemed repatriated.
The tax was imposed on U.S. persons owning at least 10% of a controlled foreign corporation (CFC). In brief, Undistributed earnings from after 1986 and prior to 2018 were deemed distributed and taxable in tax year 2017.
The Moore Case
In 2005, the Moores invested $40,000 in exchange for 11% of the common shares of KisanKraft, a company that a friend owned in India. KisanKraft was a CFC for U.S. tax purposes, subjecting its U.S. shareholders to the transition tax in 2017.
At the time the Moores made their investment, U.S. taxpayers did not generally pay U.S. taxes on foreign earnings until those earnings were distributed to them.
The Moores challenged the constitutionality of the transition tax, arguing that it is an unapportioned direct tax and not a tax on income because income must be realized before it can be taxable.
In brief, the Supreme Court upheld the constitutionality of the transition tax as applied to the facts of the case, but also found that in doing so, it was not required to address whether it is a constitutional requirement that income must be realized before it can be taxed.
Impact on U.S. Expats
For many expats holding foreign companies, the transition tax is no longer relevant, because the tax applied way back in 2017.
However, for late filers coming into compliance through the Streamlined Procedures, the transition tax is still relevant today.
This is because a taxpayer who uses the Streamlined Procedures to come into compliance usually must file returns for a specific number of tax years, generally the most recent 3 years for which the U.S. tax return due date has passed. Taxpayers that own a CFC, however, must come into compliance for the Section 965 transition tax in their submission and include the tax year in which the transition tax inclusion might occur (generally 2017) even if that tax year would not be within the standard three-year lookback period.
In other words, the lookback period for any submission to the Streamlined Procedures involving CFCs with a Section 965 inclusion in 2017 must include tax year 2017 and include all subsequent tax years.
