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  • Supreme Court Holds U.K. Windfall Profits Tax is Creditable
    May 2013
    On May 20, 2013, the U.S. Supreme Court issued its opinion in PPL Corp. et al. v Commissioner of Internal Revenue,[1] which settles a split between the Third Circuit and the Fifth Circuit as to whether the United Kingdom's "windfall tax" on privatized U.K. companies is a credible tax under U.S. federal income tax law.  By finding the tax to be creditable, the Supreme Court allowed PPL a foreign tax credit for the windfall tax paid by PPL’s privatized U.K. subsidiary.  The credit reduced PPL’s U.S. tax liability with respect to the repatriated earnings of the subsidiary.
    Earlier opinions of the Third and Fifth Circuits had considering the creditability of the windfall tax and come to different conclusions. This month we discuss this opinion of the Supreme Court because it sheds new light on how to interpret the IRS regulations specifying when a foreign levy is creditable for U.S. federal income tax purposes.  We also will review the diverse approaches that have been taken, or proposed, for analyzing the windfall tax because they offer insights to analyzing other foreign levies.
    PPL is a global energy company operating in the United States and the United Kingdom. PPL owned a 25% interest in SWEB, one of the privatized U.K. companies subject to the windfall tax.  SWEB is a U.K. private limited liability company whose principal activities in 1997 (the tax year at issue) included the distribution of electricity in the United Kingdom. The United Kingdom privatized SWEB in 1990, and SWEB paid the windfall tax in 1997.
    The United States allows U.S. corporate shareholders owning at least 10-percent of the voting stock of a foreign subsidiary an "indirect” foreign tax credit for foreign income taxes paid by the subsidiary. The tax credit may be claimed at the time the associated earnings and profits of the subsidiary are repatriated to the U.S. shareholder.
    It appears that PPL received a dividend from SWEB indirectly through other foreign subsidiaries and claimed a foreign tax credit on its 1997 U.S. federal income tax return for a portion of the windfall tax paid by SWEB. In 2007 the IRS denied PPL’s foreign tax credit claim based on its determination that the windfall tax was not creditable under U.S. rules. 
    The Windfall Tax
    During the period 1984 to 1996, the U.K. government sold 32 state-owned companies to private investors. Later, the private investors sold shares of these companies to the public, often at a substantial profit. The increase in share value was due, at least in part, to a U.K. regulatory regime that allowed these companies to keep profits resulting from efficiency gains, rather than passing them through to consumers as reduced prices.
    The United Kingdom enacted the windfall tax in 1997 to address a public perception that these privatized companies had unduly profited from privatization at the cost of consumers.  The windfall tax is a one-time, retrospective, corporate-level tax imposed at a rate of 23% on the difference between the company’s “profit-making value” and its “flotation value,” i.e., the price at which the U.K. government had sold the company to private investors. The profit-making value of the privatized company is determined by reference to the company's profits (“P”) over a period (“D”) of up to four years following privatization and a statutory price-to-earnings (“PE”) ratio of 9.  Stated as a formula:
    Windfall Tax = 23% x [(365 x (P/D) x 9 – FV]
    P = profits during the initial period
    D = number of days in the initial period
    FV = floatation value
    Thus, the company’s profit-making value is the average annual profits of the company for the initial period multiplied by a PE ratio of 9.  As we discuss below, for purposes of determining the creditability of the windfall tax, the central issue is whether that tax is in substance a tax on income, i.e., initial period profits, or a tax on something else, e.g., a difference in two equity values or average profits.  Thus, how one reformulates the tax is key to one’s perspective on the tax’s creditability.
    The Foreign Tax Credit
    The Internal Revenue Code provides a tax credit for “the amount of any income, war profits, and excess profits taxed paid or accrued during the taxable year to any foreign country.”[2]  U.S. income tax treaties generally also provide a credit for foreign income taxes, “subject to the limitations of the law of the United States (as it may be amended from time to time without changing the general principle hereof).”
    Reg. § 1.901-2(a), issued in 1983, defines when a foreign levy is an “income tax.” The regulations follow the Supreme Court’s 1939 decision in Biddle v. Commissioner,[3] holding that whether, under a predecessor of section 901, a foreign levy is an income tax is determined by U.S. tax principles.[4]
    The regulations provide that for a foreign levy to be an income tax it must (i) be a tax and (ii) the levy must have the “predominant character…of an income tax in the U.S. sense.”[5]  “A tax either is or is not an income tax, in its entirety, for all persons subject to the tax. . ......”[6]
    The regulations further provides that a levy has the “predominant character” of an income tax if it is “likely to reach net gain in the normal circumstances in which it applies . . .”[7]  A foreign levy is “likely to reach net gain. . . . if and only if the tax, judged on the basis of its predominant character,” satisfies the following three requirements:
    1. The “realization” requirement. A foreign tax satisfies the realization requirement if “judged on the basis of its predominant character, it is imposed . . . [u]pon or subsequent to the occurrence of events (“realization events”) that would result in the realization of income under the income tax provisions of the Internal Revenue Code”;[8]
    2. The “gross receipts” requirement. The tax must be imposed on gross receipts or an amount not greater than gross receipts;[9] and
    3. The “net income” requirement. The tax computation includes the deduction of all significant costs and expenses incurred in earning gross receipts.[10]
    Procedural History
    PPL initiated the case by filing a petition with the U.S. Tax Court challenging the IRS’s determination that the windfall tax was not creditable. The Tax Court held for the taxpayer in an opinion issued September 9, 2010.[11] The government then appealed the Tax Court's decision to the Third Circuit Court of Appeals, which reversed the Tax Court in an opinion issued December 22, 2011.[12] Shortly after the Third Circuit's opinion was issued, the Fifth Circuit Court of Appeals considered the same issue in the case of Entergy v. Commissioner.[13] The Fifth Circuit, in an opinion which held for the taxpayer, addressed many of the Third Circuit's arguments. The Supreme Court granted PPL’s petition for writ of certiorari in order to settle the split in the circuit courts.
    The Opinion of the Tax Court
    In the Tax Court, the government argued that the windfall tax was not creditable because it was the difference between two measures of the value of the company and therefore could not satisfy all three elements of the predominant character requirement specified in the regulations.  The government also rejected PPL’s reformulation of the windfall tax arguing that the tax must be evaluated based on its form.
    The Tax Court, however, found for the taxpayer by the following analysis. First, there was considerable U.K. legislative history that the drafters of the windfall tax intended to tax profits.  The Tax Court found the legislative history helpful in light of the language in the regulations referring to the "predominant character" of the levy and certain U.S. case law which supports considering the foreign country's intent in formulating the levy.
    Second, PPL reformulated the windfall tax as a 51.71% tax on a net amount:
    Windfall Tax = 51.71% x [P1 – (11.11% x FV)] + 51.71% x [P2 – (11.11% x FV)] + . . .
    Pi = the profits in year i
    The Tax Court concluded that this reformulation of the windfall tax was "a legitimate means of demonstrating that Parliament did, in fact, enact a tax that operated as an excess profits tax for the vast majority of the windfall tax companies.”  Thus, the Tax Court concluded that “both the design and effect of the windfall tax was to tax an amount that, under U.S. tax principles, may be considered excess profits realized by the vast majority of the windfall tax companies.” This, in the mind of the Tax Court, was determinative.
    The Opinion of the Third Circuit
    The Third Circuit reversed the Tax Court primarily because it was unwilling to reformulate the windfall tax as a tax on initial period profits alone, as PPL urged. Thus, the Third Circuit implicitly accepts that the windfall tax is based on a difference in values of the privatized company.
    In order to address PPL's argument for reformulation, the court did consider a reformulation of the windfall tax. The Third Circuit reformulated the windfall tax by eliminating the flotation value (FV). Thus,
    Windfall Tax = 23% x (2.25 x P)
    As restated, tax at the statutory rate of 23% was imposed on a multiple of initial period profits. PPL argued that the windfall tax should, instead, be restated as:
    Windfall Tax = 51.75% x P
    Viewed from this perspective, the windfall tax is imposed on profits, but at a rate higher than the U.K. statutory tax rate.
    The Third Circuit was unwilling to view the windfall tax in this manner. To do so, it said, would read the gross receipts requirement out of the regulations.  The Third Circuit referred to an example in the regulations (“Example 3”) which concludes that a petroleum tax that defined gross receipts from extraction income as equal to 105 percent of the fair market value of petroleum extracted did not satisfy the gross receipts requirement in the regulations.[14] In the view of the Third Circuit, the regulations prohibit restating a tax based on a multiple of gross receipts as a tax on gross receipts with a higher tax rate.  The Third Circuit also added, in a footnote, that it believed the windfall tax fails to satisfy the realization requirement.
    The Opinion of the Fifth Circuit in Entergy
    Based on the legislative history of the windfall tax, the Fifth Circuit, Entergy, concluded that the windfall tax satisfies the realization and net income requirements. Addressing the realization requirement, the Fifth Circuit concluded that the windfall tax reaches only revenues from the ordinary operations of the utilities “that accrued long before the design and implementation of the tax.”  Revenues from earlier periods were, in the Court’s view, necessarily “realized” in the sense that the term is used in the regulations.  Examining the net income requirement, the Fifth Circuit concluded that the windfall tax, by its terms, “only reached – and only could reach – utilities that realized a profit in the relevant period, calculating profit in the ordinary sense.”  The court determined that this satisfies the net income requirement.
    The Fifth Circuit also discussed, in some detail, the Commissioner’s argument that the tax, as implemented, failed to meet the gross receipts requirement. This issue also was crucial for the Third Circuit. Agreeing with the Tax Court, the Fifth Circuit concluded that, by virtue of the windfall tax’s intended purpose to “claw back” excess profits, such profits being based on “gross receipts less expenses from those receipts, or net income”, the tax necessarily was designed to reach only gross receipts. The Fifth Circuit also discussed the reasoning of the Third Circuit concerning the gross receipts requirement and detailed its disagreement. 
    The Opinion of the Supreme Court
    Justice Thomas wrote the Supreme Court’s unanimous opinion. The opening paragraph of that opinion sets the tone for the analysis to follow: “we apply the predominant character test [of the regulations] using a commonsense approach that considers the substantive effect of the tax.” The Supreme Court’s view of substantive effect rests on a reformulation of the windfall tax similar to that adopted by the Tax Court. The Court’s reformulation sets D = 1,461 (the number of days in the initial period for 27 of the 32 companies subject to the windfall tax) to yield:
                Windfall Tax = 51.71% x [P – (FV/9) x 4.0027]
    Thus, for at least 27 of the 32 companies subject to the windfall tax, the tax can be stated as a tax on initial period profits. The tax thus reaches net gain and satisfies the predominant character test in the regulations.[15]
    The Supreme Court also rejects the government's various arguments. The government urged that a reformulation of the windfall tax was improper, and U.S. courts must evaluate the foreign tax rate and tax bases set out in the foreign statute. This is contrary to the substance over form approach taken by the Supreme Court.  The government also argued that the windfall tax base was grounded in a difference in values, and the United Kingdom was attempting to determine the correct flotation value as of each company's flotation date by using actual realized income. The Supreme Court responds that "taxing actual, realized income in hindsight is not the same as considering past income for purposes of estimating future earnings potential."
    The Supreme Court also responds to the analysis of the Third Circuit based on Example 3. The Supreme Court notes that in Example 3 gross income is deemed to be greater than actual gross receipts, while the windfall tax depends on actual results. The Court also points out that the windfall tax base is net income, while Example 3 addresses gross receipts.
    The Concurring Opinion and the Amicus Briefs
    Several parties filed amicus curiae briefs with the Supreme Court.  Perhaps the most notable was a brief prepared by a group of respected U.S. tax law professors.[16] Justice Sotomayor found the arguments in the Alstott Brief persuasive and issued a concurring opinion that discusses the arguments made in the brief.
    The Alstott Brief emphasizes the language in the regulations that a foreign tax "is or is not an income tax, in its entirety, for all persons subject to the tax." By contrast, Justice Thomas's opinion emphasizes “predominant character” as a route to restricting the reformulation of the windfall tax to the 27 companies subject to the tax that had an initial period (D) of 1,461 days. The other five companies, which had different initial periods, are rejected as "outliers."
    If D is not fixed, however, then, as the Alstott Brief points out, the windfall tax cannot be reformulated as a tax on initial period profits. Instead, it can be stated as a tax on average profits during the initial period. A tax based on average profits would fail to be an income tax in the U.S. sense.[17]
    Justice Sotomayor’s concurring opinion resolves the conflict between the “predominant character” requirement and the “all persons” requirement in favor of PPL:
    At oral argument, the Government apparently rejected the notion that "outliers" . . . are relevant to credibility analysis. . . . The Government also did not argue these outliers' relevance before the Court of Appeals . . . and so this argument, and the regulatory interpretation it depends upon, has only been presented to this court by amici. . . . We are not barred from considering statutory and regulatory interpretations raised in an amicus brief, but we should be "reluctant to do so," Davis v. United States, 512 U.S. 452, 457 n. (1994), when the issue is one of first impression and the Federal Government has staked out what appears to be a contrary position.
    Justice Sotomayor concludes “I reserve consideration of this argument for another day and another context and join in the Court's opinion.”
    The PPL opinion indicates the Supreme Court is willing to read the foreign tax credit expansively, at least in some cases. The Court also is willing to look beyond the form of the tax to algebraic reformulations in order to determine a tax’s true character. With that in mind, taxpayers that have previously concluded that a foreign levy is not creditable in the United States under the regulations, may wish to reexamine such taxes to determine whether, in fact, they may be reformulated as a tax on profits.
    The PPL opinion also offers a gloss on the holding in Biddle that is a little puzzling. Justice Thomas writes:
    Instead of the foreign government’s characterization of the tax, the crucial inquiry is the tax’s economic effect. See Biddle, supra, at 579 (inquiry is “whether [a tax] is the substantial equivalent of payment of the tax as those terms are used in our own statute”). In other words, foreign tax creditability depends on whether the tax, if enacted in the U.S., would be an income, war profits, or excess profits tax. [emphasis added].
    The final sentence could be read to suggest that, based on PPL, a foreign tax must satisfy other requirements than those set out in the regulations (e.g., realization, gross receipts, and net income).  This could include various U.S. constitutional requirements, which probably is not intended.
    The Alstott Brief also points out that a foreign government privatizing a group of companies has an opportunity to shift tax burden to the U. S. fisc.  The privatizing government effectively receives two payments in connection with the privatization: the proceeds from the IPO of the privatized company and subsequent corporate tax payments. A well-advised foreign government may wish to set a lower IPO price in exchange for a higher, creditable corporate tax, such as the windfall tax, in order to shift the burden of that tax to the U.S. fisc. 
    Whether the IRS and Treasury will attempt to limit the holding in PPL by future regulations, and whether a court would find that such a move would conflict with PPL and Biddle, remains to be seen.
    [1] No. 12-43 (Decided May 20 2013) (“PPL”).
    [2] Section 901(b)(1) of the Internal Revenue Code (the “Code”).
    [3] 302 U.S. 573 (1938).
    [4] When considering section 131 of the Revenue Act of 1928 the Supreme Court held:
    Section 131 does not say that the meaning of its words is to be determined by foreign taxing statutes and decisions, and there is nothing in its language to suggest that, in allowing the credit for foreign tax payments, a shifting standard was adopted by reference to foreign characterizations and classifications of tax legislation. The phrase "income taxes paid," as used in our own revenue laws, has for most practical purposes a well understood meaning to be derived from an examination of the statutes which provide for the laying and collection of income taxes. It is that meaning which must be attributed to it as used in § 131.
    Courts, including the Supreme Court in PPL, continue to refer to Biddle and this principle.
    [5] Reg. 1.901-2(a)(1).  This regulation adopts the term “income tax” to refer to an “income tax”, “war tax” or “excess profits tax”.
    [6] Id.
    [7] Reg. §1.901-2(a)(3)(i).
    [8] Reg. §1.901-2(b)(2)(i).
    [9] Reg. § 1.901-2(b)(3)(i).
    [10] Reg. §1.901-2(b)(4)(i).
    [11] 135 T.C. No. 15. (Sept. 9, 2010).
    [12] 665 F.3d 60 (3d. Cir. 2011).
    [13] 683 F. 3d 233 (5th Cir. 2012) (“Entergy”).
    [14] Reg. § 1.901-2(b)(3)(ii), Ex. 3.
    [15] This approach, which excludes five of the 32 companies, creates some tension with the language of the regulations under section 901, which, as noted above, provides: “a tax either is or is not an income tax in its entirety, for all persons subject to the tax [emphasis added]."  In the final footnote of the Court’s opinion, Justice Thomas writes that the Supreme Court expresses no view on the merits of an argument based on the "all persons" language. See the below the discussion of Justice Sotomayor’s concurring opinion, which addresses this issue more fully.
    [16] Brief of Anne Alstott, Marvin Chirelstein, Mihir Desai, Michael Gratetz, Daniel Halperin, Mitchel Kane, Lawrence Lokken, Robert Peroni, and Alvin Warren as Amici Curiae in Support of Respondent, (“Alstott Brief”).
    [17] As the concurring opinion points out, in the case of a tax on average profits a company that earned $100 million over 1461 days would pay approximately the same tax as a company that earned $25 million over 365 days.