McDermott Will & Emery
Justin Jesse, Martha Groves Pugh, James A.
Riedy, PC and Kevin Spencer
United Kingdom, USA
May 23 2013
In
a rare unanimous decision with potentially far-reaching impact on taxpayers
claiming foreign tax credits, the Supreme Court of the United States ruled that
a “windfall tax” imposed by the United Kingdom was creditable under IRC Section
901.
On
May 20, 2013, in a rare unanimous decision with potentially far-reaching impact
on taxpayers claiming foreign tax credits, the Supreme Court of the United
States ruled that a “windfall tax” imposed by the United Kingdom was creditable
under Internal Revenue Code (IRC) Section 901.
This decision definitively establishes the principles to be applied when
determining whether a foreign tax is creditable under Section 901, expressly
favoring a “substance-over-form” evaluation of a foreign tax’s economic impact.
The
UK windfall tax was enacted in 1997 as a means to recoup excess profits earned
by 32 UK utility and transportation companies once owned by the
government. During the 1980s and 1990s,
the UK sold several government-owned utility companies to private parties. After privatization, the UK Government
prohibited these companies from raising rates for an initial period of
time. Because only rates and not profits
were regulated, many of these companies were able to greatly increase their
profits by becoming more efficient. The
increased profitability of these companies drew public attention and became a
hot political issue in the United Kingdom, which ultimately resulted in
Parliament enacting a windfall tax designed to capture the excess or “windfall”
profits earned by these companies during the years they were prohibited from
raising rates. The tax was 23 percent of
any “windfall” earned by such companies, which was calculated by subtracting
the price for which the company was sold by the United Kingdom from an imputed
value based on the company’s average annual profits. Both PPL Corporation and Entergy Corporation
owned interests in two of these 32 privatized companies and took a U.S. tax
credit for the windfall taxes paid to the United Kingdom.
IRC
Section 901 grants U.S. citizens and corporations an income tax credit for “the
amount of any income, war profits and excess-profits taxes paid or accrued
during the taxable year to any foreign country or to any possession of the
United States.” Whether a foreign tax is
creditable for U.S. income tax purposes is based upon the “predominant standard
for creditability” laid out in Treasury Regulation §1.901-2. Under that approach, a foreign tax is an
income tax “if and only if the tax, judged on the basis of its predominant
character,” satisfies three tests. The
foreign tax must be imposed on realized income (i.e., income that has already
been earned), the basis of gross receipts (i.e., revenue) and net income (i.e.,
gross receipts less significant costs and expenditures). See Treas. Reg. §1.901-2(a)(3).
The
Supreme Court’s decision resolved a split between the U.S. Courts of Appeals
for the Third and Fifth Circuits on how to apply the predominant standard for
the creditability test set forth in the regulations. The Third and Fifth Circuits took opposite
views of two U.S. Tax Court decisions, PPL Corp. v. Commissioner, 135 T.C. 304 (2010), and
Entergy Corp. v. Commissioner, T.C.
Memo. 2010-197, which both held in favor of the taxpayers that the practical
effect of the UK windfall tax, the circumstances of its adoption and the intent
of the members of Parliament who enacted it evidenced that the substance of the
tax was to tax excess profits, and therefore was creditable.
In
PPL Corp. v. Commissioner, 665 F.3d 60 (3d Cir. 2011), the Third Circuit
reversed the Tax Court, refusing to consider the practical effect of the UK
windfall tax and the intent of its drafters.
Instead, the court focused solely on the text of the UK statute, which
in its estimation was a tax on excess value and not on profits. In contrast, in Entergy Corp. v.
Commissioner, 683 F.2d 233 (5th Cir. 2012), the Fifth Circuit affirmed the Tax
Court, finding that the tax’s practical effect on the taxpayer demonstrated
that the purpose of the tax was to tax excess profits. The court explained that Parliament’s
decision to label an “entirely profit-driven figure a ‘profit-making value’
must not obscure the history and actual effect of the tax.”
In
its decision, the Supreme Court agreed with both the Fifth Circuit and the Tax
Court. In applying the rules of the
Treasury Regulations, the Supreme Court reinforced the three basic principles
to determine whether a tax is creditable.
First, a tax that functions as an income tax in most instances will be
creditable even if a “handful of taxpayers” may be affected differently. This means that the controlling factor is the
tax’s predominate character. Second, the
economic effect of the tax, and not the characterization or structure of the
tax by the foreign government, is controlling on whether the tax is an income
tax. This extends the principle of
“substance over form” to the characterization of a foreign tax. Third, a tax will be an income tax if it reaches
net gain or profits. Applying these
principles to the PPL case, the Supreme Court found that the predominate
character of the windfall tax was that of an excess profit tax and was
therefore creditable.
The
PPL decision will likely have far-reaching affects on courts that wrestle with
whether certain taxes paid overseas are creditable for U.S. income tax
purposes.