updated 2:11 PM CET, Oct 31, 2023

Suit challenging legality of 'Transition Tax' planned, amid reports final draft issued

Sources representing the interests of expatriate American owners of small non-U.S. businesses say they're preparing to go ahead with a lawsuit they say will challenge the applicability to small businesses of a key component of President Trump’s December 2017 tax reform legislation, the so-called Tax Cuts and Jobs Act (TCJA).

The revelation of the plans to bring the legal challenge comes amid reports that the U.S. Treasury has signed off on the final draft of that legislation without making changes that these sources say expat small-business owners urgently need, if they are to be able to compete with non-U.S. businesses that do not have to comply with the new taxes that Trump’s Tax Cuts and Jobs Act imposes on such businesses.

At issue is what is known as Section 965 of the Internal Revenue Code, which introduces a one-time, retroactive "Transition Tax" on the previously untaxed foreign earnings of foreign corporations (“controlled foreign corporations”, or CFCs), owned by U.S. shareholders.

Among those hit the hardest by this tax, which is retroactive back to 1986, are individual owners of small businesses and partnerships located outside of the U.S., many of whom had been counting on the set-aside funds to either fund their retirements or the planned expansion of their businesses. Some such individuals are said to be facing tax bills in the hundreds of thousands of dollars, and even millions, on the retained earnings in their businesses.

Many expats affected by the tax say they're disappointed and in some cases dismayed to discover that little, if any, effort to address their concerns appears to have been made.  (see Frustration across Expatland as ‘final Transition Tax’ regs published.)  

Although the final regulations have yet to be published in the Federal Register, the IRS last Wednesday posted on its website what it said were its “final regulations implementing Section 965," as originally set out by President Trump in his Tax Cuts and Jobs Act on Dec. 22, 2017, and provisionally re-stated in August of last year.

Experts who have trawled through the 305-page document said the concerns of expat groups around the world – including such organizations as the American Citizens Abroad, which reiterated its strong objections to the transition tax and other elements of the TCJA in Treasury hearings last October – have not been taken into account.

Lawsuit now planned 

Now that the final version of the Transition Tax regulations are effectively out, plans to go ahead with a lawsuit challenging the legislation’s legality will be going ahead, according to Monte Silver, a U.S. tax attorney resident in Israel who is partner and founder of the Tel Aviv-headquartered, U.S. tax law firm Silver & Co.

Silver is among those organizing the lawsuit and raising money, from other expatriates around the world, to fund it.

"It didn't really come as a complete surprise that they didn't make an exception in the legislation for small businesses owned by Americans resident overseas, and thus went ahead and treated them in the same way they do such large companies as Google and Amazon [the main targets of the Transition Tax legislation]," Silver said, adding that there had been no indications that Washington lawmakers saw the concerns of American small-business owners as a genuine priority.

"Everything we asked for that they exempt small businesses, both those owned by Americans abroad as well as those owned by Americans who live in the U.S. they [the Treasury] ignored.

"In doing so, they turned a cold ear to the voices of thousands of small-business owners which they did hear, and which they were aware of." 

According to Silver, the grounds for challenging the Transition Tax’s legality lie in the fact that under U.S. law, U.S. small businesses are protected from “abusive regulations,” through something called the Regulatory Flexibility Act.

As the U.S. Small Business Association explains on its website, the RFA “requires federal agencies to review regulations for their impact on small businesses and consider less burdensome alternatives.” It was originally passed in 1980, and revised in 1996 and 2010.

Silver said he and others have been aware of the potential legal issue for months, and have pointed it out to those drafting the final version of the TCJA, but that they weren’t able to file a lawsuit until the regulations were formally published, which technically is deemed to occur when they appear in the Federal Register. 

Silver said he had warned the Treasury, and even Treasury Secretary Steven Mnuchin, "many times that we were going to do this." 

[A copy of an email Silver sent to Mnuchin and at least eight people in the U.S. Treasury and IRS last August, in which he expressed his "utter disgust at the proposed TCJA regulations," has been seen by this publication.] 

"So they know this is coming. 

"The time has come for us to take a stand and make the U.S. government realise that we will not tolerate their abuse any longer."

Silver said he is acting "as a small business owner who is himself impacted by the Transition/GILTI taxes, a private person who wants to right a wrong," rather than because he has been hired to represent the cause of American small business owners, which he hasn't been. 

For this reason he said he is counting on donations from other small business owners to help finance the lawsuit, which he said will involve retaining legal counsel in the U.S., trips to Washington and other expenses.

"Tax advocacy is not part of my business activity. I'm just a private person, with a stake in a small business, who is saying 'enough is enough'."

TCJA legality also
questioned in academic paper

A research paper published last year by a California-based, Stanford Law School-educated lawyer, meanwhile, cited possible constitutionality concerns in the Trump tax reform act.

In his paper, entitled The Mandatory Repatriation Tax Is Unconstitutional, published by the Yale Journal on Regulation on Oct 3, Sean P. McElroy argues that Section 965 of the TCJA, which is also known as the “mandatory repatriation tax,” or “transition tax,” is unconstitutional because it “is a wealth tax, rather than an income tax,” and because it is “unconstitutionally retroactive.”

McElroy, whose LinkedIn profile shows him to be a law clerk with a Los Angeles court, could not immediately be reached for comment.

His paper is, however, available to read in full and download from SSRN,  a social science research website owned by the Elsevier publishing group.

Elsewhere in his paper, McElroy notes that while the U.S. Supreme Court “has generally upheld retroactive taxes at both the state and federal level over the past few decades, the unprecedented retroactivity of the mandatory repatriation tax – and its potential for taxing earnings nearly three decades after the fact – raises unprecedented Fifth Amendment due process concerns.”

While his focus is not on expatriate owners of non-U.S. businesses, nor does he address the matter of the size of the “controlled foreign corporation”, and whether smaller entities might be entitled to be excluded from Section 965, McElroy’s arguments are likely to be welcomed by the American expat small-business owners community.

'Tax fairness for Americans Abroad' 

As reported here last month, Republican Congressman George Holding introduced a long-anticipated bill aimed at addressing some of the tax issues and other problems many Americans living abroad have been having, in what he called the "Tax Fairness for Americans Abroad Act 2018 (HR 7358)."  Even though it was introduced in the final days of the 2018 legislative session, it is understood that Holding intends to re-introduce it this year, and that Democratic co-sponsors for the bill are currently being sought.

The legislation doesn't address the Transition Tax , but other issues American expats typically struggle with, by effectively giving American citizens who are living abroad the option to elect to be taxed on the basis of their residency, rather than their citizenship. Those who wished to continue to be taxed as U.S. citizens would be allowed to do so. 

To find out more about Silver’s efforts to launch a legal challenge to the Transition Tax, click here.