In Moore v. U.S., Mr. and Mrs. Moore challenge the constitutionality of the transition tax under § 965. The Moores ask the Supreme Court to reaffirm a realization requirement for income taxable under the Sixteenth Amendment. The Moores argue that this realization requirement applies to § 965 and that §965, as a tax on unrealized gain, is unconstitutional. In contrast, the government argues that the transition tax is a permissible extension of tax regimes like Subpart F that already tax undistributed corporate earnings. (See our recent client alert on the case generally.)
A ruling on the realization requirement bears on whether Pillar Two might be constitutional in the United States. Specifically, a ruling that § 965 does not comply with a realization requirement, if not suitably cabined, could imperil the ability of the U.S. to implement Pillar Two legally, because Pillar Two might be viewed as similarly not complying with the realization requirement.
Relevant Background on Pillar Two:
Pillar Two is a minimum tax on large multinational entities that is coordinated across multiple jurisdictions. Pillar Two’s Income Inclusion Rule (IIR) allocates to parent entities a pro rata share of tax on the income of their constituent entities, regardless of whether that income is distributed. The allocable tax under the IIR is the Top-up Tax: the difference between a constituent entity’s effective tax rate and the 15% minimum rate. The amount of Top-up Tax owed is calculated, in part, on the basis of Net GloBE Income: an aggregate financial snapshot of the constituent entities in a jurisdiction, determined in accordance with prescribed accounting standards. A parent entity is only liable for tax under the IIR if a constituent entity is determined to be under-taxed, and, hence, subject to a Top-up Tax on the difference to be made up.
Possibility #1: All taxes on unrealized gains are unconstitutional
First assume that Moore holds that § 965 is unconstitutional and any tax on unrealized gain (in the broadest possible sense) is unconstitutional. U.S. shareholders of CFCs can no longer be currently taxed on their pro rata share of undistributed earnings. The likelihood of a U.S. implementation of Pillar Two is dimmest in this possible world.
Possibility #2: Constitutionality hinges on whether income is passive
Assume that a Moore holding reaffirms a realization requirement, but specifies that a tax can satisfy this requirement if the income is passive (like much of the income taxed by Subpart F). A tendency for Pillar Two to tax non-passive income could bring it closer to an impermissible tax on unrealized gain. This may undermine a U.S. implementation of Pillar Two.
Pillar Two’s IIR is likely to sweep non-passive income into its tax base through the determination of Net GloBE Income (aggregate GloBE Income over GloBE Losses for the constituent entities in a jurisdiction). Net GloBE Income is a backbone of the IIR: both the Effective Tax Rate of a jurisdiction—which determines whether a Top-up Tax is imposed at all—as well as the rate of Top-up Tax, are calculated from it. Crucially, Net GloBE Income furnishes much of the tax base on which a Top-up Tax is imposed. The Top-up Tax is imposed on the Excess Profits of a jurisdiction, which is the Net GloBE Income reduced by an imputed 5% return on substantive business activities, including those involving tangible assets. The remainder—the Excess Profits tax base—is intended to capture intangible-related returns. Excluding an imputed rate of return from taxation is a useful, often administratively necessary, device that avoids the difficulties of measuring actual income returns. Such an exclusion, however, is unlikely to bring the Excess Profits tax base into compliance with a realization requirement that meaningfully turns on the character of income taxed. An exclusion for presumptive returns from substantive business activities cannot fully cleanse the Net GloBE Income tax base—which is fairly comprehensive to begin with—of active business income and income resembling unrealized gain. The Pillar Two Top-up Tax is imposed on a tax base that is likely to include non-passive income.
Possibility #3: Constitutionality hinges on whether the parent has control
Now assume that a Moore holding reaffirms a realization requirement and specifies that a tax can satisfy this requirement if the owner has sufficient control over the entity that gives rise to the tax. That is, a U.S. shareholder is permissibly taxed on her pro rata share of a CFC’s undistributed earnings because her control of the CFC is sufficient for a distribution to be deemed, regardless of whether one has been made. Existing statutory definitions of CFC and U.S. shareholder have, built into them, de facto control thresholds that help to justify the attribution of Subpart F income to U.S. shareholders.
If constitutionality hinges on control, a U.S. implementation of Pillar Two may be imperiled. Under the IIR, Top-up Taxes are conventionally allocated to parent entities in proportion to their ownership interest. Unlike Subpart F, the IIR lacks an in-built minimum control threshold—something that might mirror the requirement that CFCs be 50%-owned by U.S. shareholders. Parent entities are likely to be liable for Top-up Taxes arising from their constituent entities, even where only a minority ownership stake is present. The guidelines on Pillar Two issued by the OECD outline scenarios where a parent entity with a minority ownership stake is nevertheless liable for an allocable share of Top-Up Tax arising from a constituent entity. The OECD Global Anti-Base Erosion Model Rules and accompanying Commentary include special provisions for calculating the Top-Up Tax arising from minority-owned constituent entities—constituent entities for which a parent entity owns less than 30%—but these special provisions do not absolve parent entities of liability for their share of Top-up Tax.
The IIR would require the allocation of Top-up Tax to minority stakeholders who lack sufficient control according to both permissive and stringent standards for control. A Moore holding that reaffirms a realization requirement understood in terms of control may complicate a faithful U.S. implementation of Pillar Two.
 Article 2.2.2, Tax Challenges Arising from Digitalisation of the Economy – Global Anti-Base Erosion Model Rules (Pillar Two)
 The “Substance-Based Income Exclusion” is the carveout for imputed returns on substantive business activities. Article 5.3, Tax Challenges Arising from Digitalisation of the Economy – Global Anti-Base Erosion Model Rules (Pillar Two)
 Article 5.3.25, Tax Challenges Arising from Digitalisation of the Economy – Commentary to the Global Anti-Base Erosion Model Rules (Pillar Two), First Edition
 Article 2.2.2, Tax Challenges Arising from Digitalisation of the Economy – Global Anti-Base Erosion Model Rules (Pillar Two) (providing the Inclusion Ratio that determines a parent entity’s share of Top-up Tax owed on a low-taxed constituent entity)
 Annex A, Example 6.3.2A, Tax Challenges Arising from Digitalisation of the Economy – Tax Challenges Arising from Digitalization – Report on Pillar Two Blueprint.
 Article 5.6, Tax Challenges Arising from Digitalisation of the Economy – Global Anti-Base Erosion Model Rules (Pillar Two)