The U.S. Supreme Court hears arguments Tuesday in an obscure tax case with potentially trillions of dollars in tax consequences for the federal budget. It is a case that has tax law specialists both gobsmacked and alarmed.
The words of the 16th Amendment to the Constitution do not roll off the tongue. Enacted in 1913, it says: "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."
In reality, the amendment was passed to reverse a Supreme Court decision that basically had made it impossible to have a federal income tax.
The Trump tax cuts at the heart of the case
The operative understanding of what the amendment has meant for more than a century is now being challenged by Charles and Kathleen Moore. Backed by anti-regulatory groups, they are specifically challenging a provision in then-President Donald Trump's huge 2017 corporate tax cut, a provision that helps pay for some of those tax cuts.
The Moores contend that they have never actually made money from their foreign investment in an Indian company. Yes, they concede their investment has increased in value by well over a half-million dollars. But, they maintain that because they have not yet received any actual money, they are being unconstitutionally taxed on unrealized income.
Some of the facts the Moores have put forth are disputed, but importantly, the case is widely viewed by advocates on both sides as a preventive strike against any wealth tax of the kind proposed by Sen. Elizabeth Warren, D-Mass. Not that anyone thinks such a tax has any chance of passing in Congress.
Still, if the Moores were to win, the federal government could be forced to pay back billions of dollars in corporate tax collections, and the effects for lots of other tax provisions could be profound.
Former House Speaker Paul Ryan, a Republican, shepherded the 2017 tax law through the House, including the provision before the Supreme Court on Tuesday.
"As a person who drafted that ... the goal was to finance a conversion from one system to another," Ryan says. "I'm not for a wealth tax but I think if you use this as an argument to spike a wealth tax, you're going to basically get rid of ... a third of the tax code."
The background to the arguments
The Moores are portrayed as sympathetic plaintiffs in Supreme Court briefs and a video posted on the webpage of the anti-regulatory Competitive Enterprise Institute.
Charles Moore described how he invested $40,000 in his friend Ravi Agrawal's power tool business in India 18 years ago, an investment now worth more than $500,000. "If Indian farmers could be made more productive by bringing power tools to them that are suitable for their types of farms, that would be great," Moore said in the posted interview on the CEI website.
Lawyers for the Moores describe the couple as playing no active role in the company. But documents disclosed by the publication Tax Notes show that Charles Moore was far more involved in the company's management than he suggests. Records show he served on the board of the company for five years between 2012 and 2017, that he was reimbursed for thousands of dollars in travel expenses to and from India, and that he provided the company short-term infusions of cash, that were never used, but repaid with interest 60 days later with 12% interest.
George Callas, who served for 15 years as a Republican staffer for tax-writing committees in Congress, sees all this as suspicious.
"Why would you loan a company money for 60 days, have it sit in a bank account, never be used, and then repay it with a big interest rate, unless you were just trying to find a way to get money out of the company without calling it that?" Callas says.
All of this gets to the critical question posed by the Moores, and their objection to paying a one-time $15,000 tax on an investment that is now worth more than 15 times its original value.
Why the tax was levied
The tax was imposed by Congress as a one-time payment to cover the transfer from one international tax rule to another. Under the old system, if you earned foreign income overseas in a foreign corporation that you owned, you wouldn't have to pay taxes on those earnings until you brought the profits back to the United States. Congress saw that as a perverse incentive to keep profits offshore, and by some estimates there was as much as $3 trillion in shielded offshore profits.
In order to move to a new system, the idea was that a one-time transition tax, at a low rate, was needed. For the Moores, their one-time tax was $15,000, coincidentally roughly the amount Charles Moore was reimbursed for travel expenses. The Moores paid the tax and then challenged it in court as unconstitutional.
"They never saw income. It never hit their bank account. They never got cash. They never got a check," says Ilya Shapiro of the Manhattan Institute, who wrote a brief siding with the Moores in the case. "Their stake in the company increased but they did not get any income." Although the value of the Moores' investment has grown, he contends, they "have never seen a red cent from this investment."
But Callas, who, with Speaker Ryan, drafted and steered the 2017 tax bill through the Republican House, says the Moores' tax is realized income, in just the same way that real estate and other business partnerships are taxed, whether or not the income is distributed. Similarly, he says Congress has over time used various devices to prevent corporations from setting up what are called corporate pocketbooks to escape paying taxes.
"So in the international context, I'm going to set up a corporation in the Cayman Islands ... and I'm going to contribute money, capital to it, and that corporation is going to make investments around the world ... and as long as the profit stays in my Cayman subsidiary, I would never have to pay any tax. So, we have something in the tax code that congress enacted in 1962 ... that prevents that," Callas says.
Broader impact of a ruling
In other words, it's not just the Moores' one-time tax at risk in this case. Remember, this is a tax that is expected to yield $340 billion by 2027, from mainly huge corporations, and the lion's share of those taxes have already been collected.
What's more, various other tax regimes have been enacted to prevent tax dodges by the rich, and those too could be at risk, according to Callas. In the Moores' case, they owned 11% of the Indian company, and under federal law, that is considered a controlling interest, meaning the owners have influence over the timing of any distributions and dividends, a leverage that Congress wanted to rein in to prevent tax avoidance.
"It's not the Supreme Court's job to second-guess Congress on exactly what percentage of ownership should constitute control," Callas says. "That's not their job."
And tax law experts from liberal to conservative warn that if the Supreme Court were to strike down the tax provision, the effects would be disastrous.
Chye-Ching Huang, director of the NYU Tax Law Center, says, "It would be chaos, and we would be facing a tsunami of tax litigation over years and decades trying to sort through the rubble of this."
The justices "are not playing with fire," says Callas. They are playing with "enriched uranium," and they don't even know they could "blow up large portions of the tax code."
That said, a phalanx of conservative, anti-regulatory, and anti-tax groups is arrayed against the tax in Tuesday's case, including the U.S. Chamber of Commerce — even though they supported the 2017 tax bill that included the provision before the Supreme Court on Tuesday.
That clearly alarms tax experts, including Callas, who served as Speaker Ryan's chief tax counsel at the time the bill was negotiated and passed. He notes that at the request of the Chamber of Commerce and other stakeholders, House Republicans made many specific changes to the bill, but there was "no discussion" of any "constitutional vulnerability." It was "purely a discussion of how to design the policy appropriately."
As Callas caustically observes, for the chamber and other stakeholders years later "to discover constitutional concerns that they didn't raise before" strikes me as "opportunistic."