U.S. Supreme Court to Rule on Taxing Unrealizing Gains

In the coming days or weeks, the Supreme Court is expected to release an opinion on Moore v. United States, a case with potentially significant consequences for tax policy.

The case revolves around the question of “unrealized income.” Put simply: suppose you have a claim on some money, but the money is sequestered away in a box—a box that you can’t open immediately, or haven’t yet opened, or is located overseas. At what point can the government determine that you have earned the money, and subject it to income tax?

The plaintiffs, Charles and Kathleen Moore, owned a partial but significant stake in an Indian business called KisanKraft. Though KisanKraft was profitable, pre-2017 law typically did not tax the income of businesses like KisanKraft until the income was repatriated. The Tax Cuts and Jobs Act (TCJA) of 2017 made substantial reforms to international taxation, introducing a new tax on certain foreign earnings (called global intangible low-taxed income or GILTI) that would apply immediately, rather than upon repatriation. Furthermore, income unrepatriated as of 2017 was taxed under a provision called the Section 965 transition tax.

The Moores, who are payers of this transition tax under current law, have challenged the tax as unconstitutional, on the basis that income under the Sixteenth Amendment must be realized. The Supreme Court heard oral arguments in December and is expected to release an opinion soon.

For many kinds of income, realization is relatively clear-cut. For example, defined-benefit pension benefits are realized when pensioners receive their checks, not when they accrue years of service that theoretically entitle them to some increase in monthly benefit in the future. But some cases—including the Moores’—leave some room for argument.

The Supreme Court has ruled on the scope of the Sixteenth Amendment before, but cases like Moore offer it additional opportunities to refine that scope. The ruling will, in turn, have an impact on some important issues in tax policy.

Revenue Effects

If the court rules against the Moores, there will likely be no immediate consequences for the tax code (though justices’ opinions may contain passages that are used to support later arguments). However, if the court rules for the Moores, at least some current tax provisions will be rendered unconstitutional, which will reduce federal tax revenues, as estimated in a previous Tax Foundation post.

The Moores argue that Section 965 is unconstitutional, at least as applied to their type of business. If they succeed, the court may strike down the tax for other taxpayers similar to the Moores. At a minimum, this is a sum of roughly $3.5 billion in tax revenue. However, if the court rules that Section 965 is unconstitutional for all businesses, even very large ones, it could result in up to $350 billion of effective tax cuts.

Furthermore, the Supreme Court may use reasoning that calls into question the constitutionality of other tax provisions, including the new corporate alternative minimum tax (CAMT), the TCJA’s GILTI, or even longstanding provisions like Subpart F. Each of these has an impact on arguably unrealized income, or income realized only abroad. A loss of these provisions would cost the Treasury roughly $250 billion, $350 billion, and $78 billion in revenue, respectively, over the next 10 years. And an extremely broad ruling that invalidates any tax on all retained earnings (that is, earnings locked up inside a business) may cost the Treasury trillions of dollars.

In short, the impact of the Moore case could vary wildly depending on the scope of the court’s ruling.

Pillar Two Implementation

Under the global minimum tax agreement known as Pillar Two, jurisdictions are expected to implement domestic and international top-up taxes that ensure businesses pay at least a 15 percent tax rate. Negotiators representing the United States have indicated support for Pillar Two, but Congress has not enacted the Pillar Two taxes.

Under Pillar Two, in theory, the United States should be willing to tax companies abroad with U.S. parents under a provision called an income inclusion rule, even without awaiting repatriation.

While the companies subject to Pillar Two are significantly larger than the holdings of the plaintiffs in Moore, similar questions of unrealized, unrepatriated, or foreign gains come into play, and a broad ruling for the Moores may render it difficult or impossible to constitutionally implement an income inclusion rule.

Tax Timing and the Consumption Tax Base

Tax Foundation researchers have often argued that a traditional income tax base creates a tax distortion over the time value of money, perhaps inadvertently. It may be better for taxes to be assessed when the income is withdrawn from an investment account for the purposes of consumption, rather than when the income is first earned. (For example, this is the treatment of defined benefit pensions or traditional 401[k] plans.)

While a realization principle bears some resemblance to a tax on consumed income or consumption, it does not consistently replicate a consumption base in certain real-life edge cases. For example, it might assess tax on realizations for the purposes of portfolio rebalancing and reinvestment. And it may fail to tax certain strategies where wealthy taxpayers borrow against a stock of unrealized income to spend on consumption.

Handling all of these unusual cases is an onerous and lengthy process, and no opinion issued by the U.S. Supreme Court could possibly render clear guidance on all of them.

Wealth Taxes

Some supporters and opponents of wealth taxes have seen the Moore case as a useful proxy for the discussion, or even constitutionality, of wealth taxes. From an economic perspective, at least, this comparison seems misguided. There are substantial economic differences between a one-time tax on income that has not yet been taxed under the income tax, and an annual compounding tax that repeatedly re-taxes the same wealth.

A ruling on a narrow question of untaxed and unrepatriated income—income that was probably, at a minimum, realized in India by KisanKraft, if not fully returned as cash to its American owners—need not serve as a proxy for the constitutionality of all other kinds of tax imaginable. However, as the issue has been raised, the court may include some discussion of it in a potential opinion.

Overall, the Moore case could have important impacts on tax policy. It may reduce revenues, present an obstacle to the implementation of the global minimum tax deal, compel Congress to restructure the timing of taxes, or even preemptively strike down some wealth tax proposals. Tax professionals of all kinds are likely to keep a close eye out for a ruling.

Originally published by the Tax Foundation. Republished with permission.

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